An institutions that connect borrowers and lenders by
accepting funds from lenders and loaning funds to
1. All FIs are exposed to some degree of
liability withdrawal or liquidity risk
2. Most FIs are exposed to some type of
3. All FIs are exposed to operating cost risks
In such a world, savings would flow from households
to corporations; in return, financial claims (equity and
debt securities) would flow from corporations to
Is serve as conduits between users and savers of funds
by providing a brokerage function and by engaging in
an asset transformation function.
Brokerage Function can benefit both savers
and users of funds and can vary according to
the firm. FIs may provide only transaction
services, such as discount brokerages, or
they also may offer advisory services which
help reduce information costs, such as full-
Asset transformation function is
accomplished by issuing their own securities,
such as deposits and insurance policies that
are more attractive to household savers, and
using the proceeds to purchase the primary
securities of corporations.
The concept that the cost reduction in
trading and other transaction services results
from increased efficiency when FIs perform
An FI issues financial claims that are more
attractive to household savers than the
claims directly issued by corporations.
Securities issued by corporations and backed
by the real assets of those corporations.
Securities issued by FIs and backed by
The aggregation of funds in an FI provides
greater incentive to collect information
about customers (such as corporations) and
to monitor their actions. The relatively large
size of the FI allows this collection of
information to be accomplished at a lower
average cost (so-called economies of scale)
than would be the case for individuals.
Costs relating to the risk that the owners and
managers of firms that receive savers’ funds
will take actions with those funds contrary to
the best interests of the savers.
An economic agent appointed to act on behalf of
smaller agents in collecting information and/or
investing funds on their behalf.
By putting excess funds into financial
institutions, individual investors give to the
FIs the responsibility of deciding who should
receive the money and of ensuring that the
money is utilized properly by the borrower.
The FI can utilize this information to
create new products, such as commercial
loans, that continually update the
information pool. This more frequent
monitoring process sends important
informational signals to other participants in
the market, a process that reduces
information imperfection and asymmetry
between the ultimate providers and users of
funds in the economy.
FIs provide financial secondary claims to
household savers with superior liquidity
attributes and with lower price risk.
Banks and Thrifts issue transaction account
deposit contracts with a fixed principal value
(and often a guaranteed interest rate) that
can be withdrawn immediately on demand by
Money market mutual funds issue shares to
household savers that allow those savers to
enjoy almost fixed principal contracts while
often earning interest rates higher than
those on bank deposits.
Life insurance companies allow policyholders
to borrow against their policies held with
the company at very short notice.
Reducing risk by holding a number of
securities in a portfolio.
The less diversified the FI, the higher the
probability that it will default on its liability
obligations and the more risky and illiquid its
claim. In reality, the majority of financial
institution failures involve small FIs that are
relatively undiversified product wise and