CHAPTER 4: FINANCIAL INTERMEDIATION

Introduction

In this chapter, the students will learn how to deficit units, savings units, and intermediaries’
interplay in the business world. Financial intermediation and the role of the different financial
intermediaries play in the business world will be discussed.

Students will also learn what disintermediation is, how it takes place, and its effect on financial
intermediaries. Furthermore, mismatching of securities and how it works to the advantage and
disadvantage of financial intermediaries will be explained.

Financial intermediaries: Definition

Financial intermediaries are the financial institutions that act as a bridge between investors or
savers (surplus units or SUs) and borrowers or security issuers (deficit units or DUs). They may
simply act as a bridge between deficit units and surplus units without owning securities issued
by the deficit units.

Direct and Indirect Finance

Direct Finance

● A borrower-lender relationship is the typical direct finance relationship or transaction. A

bank and a bank depositor are engaged in direct finance.
● The checking account, savings account, or time deposit certificate is originally issued by
the bank to the depositor that acts as the buyer of the security. The depositor “pays” for
the checking, savings, or time certificate of deposit issued by the bank.
● A direct security/primary security flows directly from the borrowing unit to the lending or
investing unit.
Indirect Finance

Indirect finance is like the relationship between the depositor of a bank and the borrowers of
the same bank. The funds lent to the borrowers came from the deposits of the bank’s
depositors.

Changing Nature of Financial Intermediaries

Financial intermediaries have changed over time, not only in structure but also in its functions.
Old simple financial intermediaries, which specialized in a single function like getting deposits
and granting loans, had a complex structure with different departments performing several
functions.

The Old Financial Environment

● Creation of branches was limited and interest rates were duly regulated.
● Thrift institutions, to protect banks, were prohibited to grant consumer and commercial
loans and issue checking accounts and were forced to specialize in long-term fixed rate
mortgages.
● Life insurance companies were allowed only to issue policies and purchase corporate
bonds, not stocks.
● Commercial banks were no longer allowed to underwrite corporate stocks and bonds.
● Households can no longer go to one financial institution and transact all their businesses
there.
● Companies who issue stocks and bonds have to go to an investment bank for
underwriting of their issues and go to a commercial bank for a loan.
● Severe restrictions were placed on the portfolios of depository institutions, especially
thrifts.

The New Financial Environment

● Financial institutions can now perform various financial functions, which enable
households and companies to go to a single financial institution to transact various
financial businesses.
● The government was left with no other choice but to simply protect the health of their
respective economic and financial system.
● In 1977, Merrill Lynch created the cash management account (CMA) by combining
MMMF features with securities account and credit link.
● Credit cards also grew secondary to advances in computer technology, making it
profitable for banks to mass market the same.
 ● It also raised interest rates on deposit to prevent withdrawal of deposits, boosted the
commercial paper market, and allowed small businesses to borrow from finance
companies which issue commercial papers to obtain loanable funds.
● Corporate credit cards are a distinct group within the greater credit card universe,
separate from both personal and small business credit cards.
● In developing such a relationship, the company’s credit is considered, just as an
individual’s credit is considered when applying for a consumer credit card.

CLASSIFICATION OF FINANCIAL INTERMEDIARIES

Financial intermediaries varied but they have one common characteristic. All of
them issue secondary securities to be able to purchase primary securities issued by
deficit units. They can however be grouped into two basic categories:

1. Depository institutions
2. Non-depository institutions

DEPOSITORY INSTITUTIONS

Depository institutions, as the name implies, refer to financial institutions that

accept deposits from surplus units. They issue checking or current accounts/demand
deposits, savings, time deposits, and help depositors with money market placements.
Current or checking accounts can be withdrawn by issuing checks. Most current
accounts do not earn interest, although due to competition, there are now banks offering
interest on these checking or current accounts. These are called NOW accounts.
Savings accounts can be withdrawn by using the passbooks given by the bank to the
depositors when they Initially make their deposits.

These depository institutions pool the deposits of the depositors and lend the
pooled funds to deficit units or purchase securities. The deposits that depository
institutions issue are free of risk as the amount of deposit or principal does not fluctuate
like stocks and bonds. Deposits are only reduced if the depositor makes withdrawals or
if there are certain bank charges, like in cases when deposits go below the allowed
minimum balance. The deposits placed in these institutions, generally, can be
withdrawn on demand or in certain cases only a short notice (if amount to be withdrawn
is too large). Individuals and business companies are depositors and they are also
borrowers.

Depository institutions include:

1. Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks
2. Thrift banks
a. Savings and mortgage banks
b. Savings and loan associations
c. Private development banks
d. Microfinance thrift banks
e. Credit unions
3. Rural banks

Commercial Banks

Commercial banks are perhaps the biggest of the depository institutions.

Universal and commercial banks represent the largest single group of financial
institutions, resource-wise, in the country. They could have been the pioneers in
financial intermediation.

Ordinary commercial banks perform the more simple functions of accepting

deposits and granting loans. They do not do investment functions. Traditionally,
commercial banks grant only short-term loans. These loans were originally extended to
merchants for the transport of their goods in both the domestic and international
markets, as well as to finance the holding of Inventories during the brief period required
for their sale.

Universal banks or expanded commercial banks are a combination of

commercial banks and an investment house. They perform expanded commercial
banking functions (domestic and international) and underwriting functions of an
investment house. They offer the widest variety of banking services among financial
institutions.

The Philippine Deposit Insurance Corporation insures the deposits in the

depository institutions, including commercial banks to help depositors have peace of
mind knowing that their deposits are insured and therefore, safe in the banks. PDIC
helps in maintaining a healthy, financial system in the Philippines.

Regulatory agencies in the Philippines include the Bangko Sentral ng Pilipinas,

Securities and Exchange Commission, Bureau of Internal Revenue, and the provincial,
city, or local governments. Onsite reviews are at times made to ensure the healthy
operations of these depository institutions.

Prior to 1994, the MACRO rating was used by regulatory agencies to gauge credit
standing of banks:

M- Management

A- Asset quality
 C- Capital adequacy

R- Risk management

O- Operating results

In 1994, the Hadjimichalakises (1995) identified the CAMELS rating:

C- Capital adequacy

A- Asset quality

M- Management

E- Earnings

L- Liquidity

S- Sensitivity to risk

The CAMELS rating aims to determine a bank's overall condition and identify its
strengths and weaknesses financially, operationally, and managerially. Each element is
assigned a numerical rating based on the five key components (Pdf.usaid.gov). The
CAMELS rating is a comprehensive rating with one signifying the best rating and five
the lowest. It provides an early warning signal to prevent a collapse. A rating of one
means most stable, two or three are average suggesting supervisory attention, and four
or five for below average signaling a problem bank.

Thrift Banks

Thrift banking system is composed of savings and mortgage banks, stock

savings and loan associations, private development banks, microfinance thrift banks,
and credit unions. Credit unions, although not classified as banks, can be considered as
a thrift institution in the sense that they encourage people to save. These different thrift
institutions cater to the needs of households, agriculture, and industry.

Savings and mortgage banks are banks specializing in granting mortgage

loans other than the basic function of accepting deposits. They are organized for the
purpose of accumulating savings of depositors and investing the same, together with its
capital in highly liquid marketable bonds and other debt securities, commercial papers,
drafts, bills of exchange, acceptances, or notes arising out of commercial transactions
or in loans secured by bonds mortgages, and other forms of security or in loans for
personal or household finance, secured or unsecured, and financing for home building
and improvement.

Mortgage banks do not accept deposits but extend loans. They offer first and
second mortgages on commercial property, residential houses, and residential
apartments. First mortgage represents the first time that a property could be
mortgaged.If the amount of the property is a lot bigger than the amount of the first
mortgage loan, the property can be used. to secure another loan, called second
mortgage. Basically, the first mortgage has priority over the second mortgage. Mortgage
banks are usually privately owned corporations willing to take risks that other banks
reject.

Stock savings and loan associations (S&Ls) accumulate savings of their

depositors/stockholders and use these accumulated savings, together with their capital
for the loans that they grant and for investments in government and private securities.
These associations provide personal finance and long-term financing for home building
and improvement.

Private development banks cater to the needs of agriculture and industry

providing them with reasonable rate loans for medium- and long-term purposes. The
Philippine government has asked the assistance of government agencies like the
Development Bank of the Philippines (DBP), Philippine National Bank (PNB),
Government Service Insurance System (GSIS), Social Security System (SSS), and
other governmental departments to help the private development banks in their effort to
uplift the economic status of the private development banks' clients.

Micro finance thrift banks are small thrift banks that cater to small, micro, and
cottage industries, hence the term "micro." They grant small loans to small businesses
like sari-sari stores, small bakeries, and cottage industries, among others. They help
uplift the standard of living in most rural areas.

Credits unions are cooperatives organized by people from the same

organization (whether formally or informally organized) like farmers, fishermen,
teachers, sailors, employees, and so on. Credit unions grant loans to these people, who
become members of the credit union, and get deposits from them. Usually, the
members avail of loans as a multiple (two or three times) of their deposits. Cooperatives
are under the supervision of the Cooperative Development Authority under the Office of
the President.

Rural and Cooperative Bank

Their role is to promote and expand the rural economy in an orderly and effective
manner. Rural and cooperative banks are the more popular type of banks in the rural
communities by providing the people in the rural communities with basic financial
services. Rural and Cooperative banks help farmers through the stages of production
from buying seedlings to marketing of their produce. Rural banks and cooperative banks
are differentiated from each other by ownership. While rural banks are privately owned
and managed, cooperative banks are organized/owned by cooperatives or federation of
cooperatives.

NON-DEPOSITORY INSTITUTIONS

Non-depository institutions issue contracts that are not deposits. These are
pension funds, life insurance companies, mutual funds, and finance companies like
depository institutions which perform financial intermediation. Pension funds and
insurance companies issue contracts for future payments under certain specified
conditions. Mutual funds issue shares in a portfolio of securities or "basket" securities.
Mutual funds differ in accordance with the types of securities they buy for their
portfolios. Money market mutual funds issue accounts like checking accounts that can
be withdrawn by checks. Finance companies raise funds that they lend to households
and firms by selling marketable securities and borrowing from banks.

Non-depository institutions can be classified into the following:

1. Insurance companies

a Life insurance companies

b. Property/casualty insurance companies

2. Fund managers

3. Investment banks/houses/companies

4. Finance companies

5. Securities dealers and brokers

6. Pawnshops

7. Trust companies and departments

8. Lending investors
Life Insurance Companies

Life Insurance Companies are financial intermediaries that sell life insurance
policies. Policyholders pay regular insurance premiums. Life Insurance companies
provide protection over a contracted period or term, which may be a year, 5 years, or for
a lifetime.

Face Value – amount of money given to the beneficiary when the policy expires.

Loan Value – the amount that can be borrowed against the policy during the
term pf the policy

Cash Surrender Value – the amount that will be given to the insured or
beneficiary if the insured decides to surrender the policy before the term ends, which
means the policy is discontinued.

Property/ Casualty Insurance Companies

Property and casualty insurance gives protection against property losses to one’s
business, home, or car and against legal liability that may result from injury or damage
to the property of others. This type of insurance can protect a person or a business with
an interest in the insured physical property against losses.

Examples of the sort of damages that property casualty insurance may cover
(Allstate.com):

Medical Bills – whether the injured person has medical insurance or not is
beside the point. If you are found to be at fault, you could be held responsible for the
payment of those medical bills.

Pain and Suffering – This is another type of damage people typically claim
when in an accident. Medical bills aside, if someone is seriously injured, he can also
seek to hold you financially responsible for the monetary equivalent of the pain and
suffering he has experienced as a result of the accident.

Loss of Wages – if someone gets injured severely at your fault, he may not be
able to work for quite a while. If this happens, you could be held liable for those lost
earnings.

Legal Fees – being sued can cost you to hire lawyer to defend you. Casualty
insurance typically covers your attorney’s fees if someone injured in you home sues you
for damages.

• Homeowners Insurance - insures one's house and its contents

• Auto Insurance - covers one's, spouses, and relatives’ home and other licensed
drivers to whom the insurer gives permission to drive his car.

• Flood Insurance – is a special type of insurance that covers damage to any

structure, or the contents therein caused by flood.

• Umbrella Liability Policy - is also a special type of insurance that provides

coverage over and above one's automobile or homeowner's policy.

• Health Insurance - is a type of insurance that covers the cost of an insured

individual's medical and surgical expenses during an illness.

• Long-term Care (LTC) - is defined as a need for assistance with some of the
activities of daily living (often called ADLs)

• Professional liability Insurance - protects professionals, such as doctors, financial

advisors, nursing home administrators, lawyers, etc. against financial losses from
lawsuits filed against them by their clients or patients.

• Credit Insurance - is an optional protection purchased from lenders and often

associated with mortgages, loan, or credit cards.

Fund Managers

The fund managers are pension fund companies and mutual fund companies.
Pension fund companies sell contracts to provide income to policyholders during their
retirement years. Pension funds can be funded by employees only or by both
employees and their employers during the policy-holders income earning years.

Investment Banks/Houses/companies

Investment companies are financial intermediaries that pool relatively small amount of
investors' money to finance large portfolios of investments that justify the cost of
professional management.

The Philippine Investment Funds Association (PIFA) is an association that contributes to

nation-building through the effective mobilization of long-term savings by increasing the
citizenry's awareness regarding investments.

Investment banks underwrite new issues of equity and debt securities. In an

underwriting transaction, the investment bank, also known as merchant bank,
guarantees the sale of the issues at an agreed price.

Finance Companies
 Finance companies are profit-oriented financial institutions that borrow and lend
funds to households and businesses. Finance companies do not issue checking or
savings accounts and time deposits.

Finance companies had been traditionally grouped into three:

o Sales finance companies - provide installment credit to buyers of big-ticket items

like cars and household appliances

o Consumer finance companies - grant credit to consumers

o Commercial finance companies - also known as Business finance companies,

grant credit to businesses.

Securities Dealers and Brokers

Securities Dealers and Brokers can be counted among the other finance companies.

o Securities brokers are only compensated by means of commission

o Securities Dealers buy securities and resell them and make a profit on the
difference between their purchase price and their selling price.

Pawnshops

Pawnshops are in the business of lending money on the security of pledged

goods left in pawn, or in the business of purchasing tangible personal property to be left
in pawn on the condition that it may be redeemed or repurchased by the seller for a
fixed price within a fixed period.

Trust Companies / Departments

Trust companies as corporations organized for the purpose of accepting and

executing trusts and acting as trustee under wills, as executor, or as guardian.

A trust company or trust department is usually a division or an associated

company of a commercial bank. Trusts and similar arrangements managed for eventual
transfer are managed for profit, which it may take out of the assets annually or upon
transfer to the beneficial third party.

Some trust companies, mostly banks, perform banking services with a special
trust department. They can perform trust functions for companies issuing bonds to
ensure that bondholders are paid as needed. They can act as fiscal agents or paying
agents for the government.
Lending Investors

A lending investor finds people with money and matches them with people who
need money and are willing to pay a certain rate of interest for it. Lending investors are
individuals or companies who loan funds to borrowers, generally consumers or
households. Lending Investors perform granting loans, but they are not as big as the
regular financial intermediaries.

Risk of Financial Intermediation

Risk is a possibility that actual returns will deviate or differ from what is expected.
If you expect prices to go up and you buy securities, you are taking a risk because
prices could go either up or down. If prices go up, you gain; if prices go down, you lose.
Financial intermediation is highly market sensitive, that is, it changes with the changes
in the market environment.

Interest Rate / Market price Risk

Financial intermediaries perform what is known as asset transformation in their

buying primary securities and selling secondary securities. They also perform
mismatching of maturities. Short-term liabilities are pooled and converted to long-term
assets. These asset transformation and mismatching of maturities of assets and
liabilities expose financial intermediaries to what is termed interest rate or market price
risk. Interest rate or market value/price risk is that the market value (price) of an asset
will decline (when interest rate rises), resulting in a capital loss when sold. The market
value of an asset or liability is theoretically equal to its discounted future cash flows.
Therefore, when interest rates increase, the discount rate on those cash flows increases
and reduces the market value of the asset or liability. On the other hand, when interest
rates fall, the market values of the assets and liabilities increase. In short, securities
decline in price when interest rates rise. Interest rate risk and market price risk go in
opposite directions. When prices rise, interest rates fall and when prices fall, interest
rates rise.

Reinvestment Risk

Reinvestment risk arises as a result of the interest rate/market price risk.

Reinvestment risk is the risk that earnings from a financial asset need to be reinvested
in lower-yielding assets or investment because interest rates have fallen or decreased.
Uncertainty about the interest rate at which a company could reinvest funds borrowed
for a longer period is also reinvestment risk. If the cost of borrowing is, say 10%, the
financial intermediary should be able to earn more than 10% when it reinvests the
borrowed funds.

Refinancing Risk

Refinancing risk is the risk that the cost of rolling over or re-borrowing funds
could be more than the return earned on asset investments. If the cost of rolling over
borrowed funds is, say 10%, and the return that will be earned on investing the
borrowed funds will only result in a rate of return of, say 9%, the financial intermediary
loses 1%.

Default/Credit Risk

Default risk or credit risk is the risk that the borrower will be unable to pay interest
on a loan or principle of a loan or both. If a company issues bonds at this unable to pay
interest on interest payment dates or fail to pay the principal on bond redemption date,
the company is said to be in default. This is the reason there are credit investigators
who investigates background of borrowers before companies or banks are able to grant
loans requested by borrowers. Suppliers investigate background of buyers before
granting credit to these buyers because of the risk of default.

Inflation/Purchasing Power Risk

Inflation risk or purchasing power risk is the risk of increase in value of goods and
services reducing the purchasing power of money to purchase goods and services.
Families struggle with the price of staple commodities like rice, fish, meat and
vegetables rise. Their earnings can only buy less of these commodities making survival
difficult. As prices rise, purchasing power decreases. They go in opposite directions just
like the market prices and interest rates do.

Political Risk

Political risk is the risk that the government laws or regulation will affect the
investors expected return on investment and recovery of investment adversely or
negatively. Even in extreme cases, this can leas to total loss of invested capital.
Increase taxes on petroleum products will reduce return on stockholders of petroleum
companies. Regulated interest rates on depositors and motivate them to move their
funds to other higher earning investments as money market mutual funds or T-bills.

Off-Balance-Sheet Risk

Off-balance-sheet transactions are usually engaged in by financial institutions.

Off- balance -sheet transactions are those transactions that do not appear in the
financial institutions balance sheet but represent transactions that pose contingent
assets or contingent liabilities on the financial institution. Something is contingent if it
does not actually exist currently, but may happen in the future, perhaps upon the
happening of a certain event. Happening of contingent assets is favorable but
happening of a contingent liability becomes unfavorable and disadvantages of financial
intermediary. A financial institution that grants a letter of credit to the company for its
issuance of bonds will create a liability on the part of the financial institution should the
company fail to meet its interest and principal payment on its bond. The financial
institution will be forced to pay such interest and principal on the bonds issued by the
company. The happening of such event is only the time that such liability will be shown
in the balance sheet of the financial institution.

Technology and Operation Risk

Technological and operation risks are related because technological inventions

generally involve and affect operations. Advancement in technology poses an
operational risk to all businesses, including financial institutions. These businesses
need to update their own operations by investing in software and hardware as computer
knowledge advances and international networking and communication become
prevalent. Technology and operations risk arises when these investments in technology
do not produce the desired results, that is, fail to get more customers, unable to produce
economies of scale as desired and fail to increase puppet of reduced cost, among
others.

Liquidity Risk

Financial intermediaries also face liquidity risk. Liquidity risk results from
withdrawal of funds by investors or exercise of loan rights or credit lines of clients.

Currency or Foreign Exchange Risk

Currency or Foreign Exchange Risk is the possible loss resulting from an

unfavorable change in the value of foreign currencies.

Diversification reduces their foreign exchange risk because holding only

securities denominated in one currency will make the financial intermediary at a losing
end should the currency of the securities it is holding fall in value without any security to
offset the loss.

Country or Sovereign Risk

Country or sovereign risk overrides credit risk from a foreign borrower because
even if the borrower is in good credit standing, the government of that foreign country
can set up regulations that prohibit debt repayments to outside or foreign creditors.

Roles of financial Intermediaries in Socio-Economic Development

It is the financial intermediary that brings the available funds from the urban
areas to rural areas, which has the most needs for such banks.
 In addition to rural banks, cooperative banks, and microfinance thrift banks, the
growth of commercial banks in the rural areas has helped the areas tremendously by
making credit available to the rural residents so they can use the same to advance
themselves.

Moreover, these financial intermediaries have helped a lot of the rural folks
escape usurers.

Economic bases for Financial Intermediation

Financial intermediaries help both the surplus units and the deficit units. They
help surplus units by pooling funds of thousands of individuals and entities overcoming
obstacles that stop them from purchasing primary claims directly.

Financial intermediaries also help the deficit units by broadening the range of
instruments, denominations, and maturities of financial instruments enabling even small
savers or surls units to take advantage of the safer and more profitable investment
alternatives.

ROLE OF TWO MARKET IMPERFECTIONS

1. Transaction Cost- refers to all fees, commissions, and other charges paid
when buying or selling securities including research cost, cost of distributing securities
to investors, cost of SEC registration, and the time and hassle of the financial
transaction.

2. Information Gathering- Financial intermediaries are major contributors to

information productions. They are especially good at selling information about a
borrower's credit standing.

Economic bases for Financial Intermediation

Economic bases for Financial Intermediation