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Quote of the day:

“If you can’t explain it simply, you

don’t understand it well enough.” –
Albert Einstein
 Chapter 1
Why Are Financial
Intermediaries
Special?

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

 Why Are Financial 1-3

Intermediaries Special?
 Objectives:
 Develop the tools needed to measure and
manage the risks of FIs.
 Explain the special role of FIs in the financial
system and the functions they provide.
 Explain why the various FIs receive special
regulatory attention.
 Discuss what makes some FIs more special
than others.
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Financial Institutions specialness
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Financial Institutions
 All Financial Institutions:
(1) hold some assets that are potentially
subject to default or credit risk
(2) Tend to mismatch the maturities of their
balance sheet assets and liabilities to a
greater or lesser extent and are thus
exposed to interest rate risk.
 Exposed to withdrawal or liquidity risk

 Underwriting risk

 Operational Risk
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Financial Institutions Specialness
 In a world without Financial Institutions,
savings would flow from households to
corporations.

 In return, financial claims (equity and

debt securities) would flow from
corporations to household savers.
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Flow of Funds without FIs

Equity & Debt

Households Corporations
(net savers) (net borrowers)
Cash
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FIs’ Specialness
 Without FIs: Low level of fund flows.
 Information costs:

 Economies of scale reduce costs for FIs

to screen and monitor borrowers
 Less liquidity

 Substantial price risk

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Flow of Funds with FIs

FI
(Brokers)
Households Corporations

Cash FI Equity & Debt

(Asset
Transformers)
Deposits/Insurance Cash
Policies
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Functions of FIs
1. Brokerage function
2. Asset transformer
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Functions of FIs
1. Brokerage function
 Acting as an agent for investors:
 Full service brokerage firm e.g. Merrill Lynch, IGI
Securities, AKD securities
 Discount brokers e.g Charles Schwab, standard
capital
 Reduce costs through economies of scale
 Encourages higher rate of savings
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Functions of FIs
Asset transformer:
 Purchase primary securities by selling financial
claims (Secondary securities) to households
 These secondary securities often more marketable
 Transformation of financial risk
 1-14
Role of FIs in Cost Reduction
 The unique ability of FIs to better resolve the
three costs facing a saver who chooses to
invest directly in corporate securities is what
makes them special:

1) Information Costs
2) Liquidity Risk
3) Price Risk
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Role of FIs in Cost Reduction
 Information costs:
 Role of FI as Delegated Monitor
 FI as information producer
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Role of FIs in Cost Reduction
 Information costs:
 Investors exposed to Agency Costs

 Role of FI as Delegated Monitor

 This FI groups funds together and invests in the direct or

primary financial claims issued by firms. This agglomeration
of funds resolves a number of problems.
 First, the large FI now has a much greater incentive to
collect information and monitor actions of the firm because
it has far more at stake than does any small individual
household.
 In a sense, small savers have appointed the FI as a
delegated monitor to act on their behalf.
 Secondly, not only does the FI have a greater incentive to
collect information, the average cost of collecting
information is lower.
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Role of FIs in Cost Reduction
 Information costs:
 FI as information producer
 FIs may develop new secondary securities that
enable them to monitor more effectively
 For example, Bank loans are generally shorter-
term debt contracts than bond contracts.
 This short-term nature allows the FI to exercise
more monitoring power and control over the
borrower.
 Acting as delegated monitor, FIs reduce
information asymmetry between borrowers and
lenders
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Specialness of FIs

 Liquidity and Price Risk

 FIs exploit the law of large numbers in their

investments, achieving a significant amount of

diversification, whereas, many household savers are
constrained to holding relatively undiversified
portfolios.
 As a result, FI can credibly fulfill its promise to

households to supply highly liquid claims with little

price or capital value risk.
 A good example of this is the ability of a bank to offer

highly liquid demand deposits—with a fixed principal

value—as liabilities, while at the same time investing
in risky loans as assets
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Other special services
1. Reduced Transaction Costs
2. Maturity intermediation
3. Transformation of monetary policy
4. Credit Allocation
5. Intergenerational Wealth transfers
6. Payment services
7. Denomination Intermediation
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Specialness of FIs
 Reduced transaction & information costs
 economies of scale
 Bid-ask spreads narrower for assets bought
and sold in large quantities.
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Other Special Services
 Maturity intermediation
 Transmission of monetary policy:
1) open market operations (the purchase and sale
of securities in the U.S. Treasury securities
market),
2) setting the discount rate (the rate charged on
“lender of last resort” borrowing from the
Federal Reserve)
3) setting reserve requirements (the minimum
amount of reserve assets depository
institutions must hold to back deposits held as
liabilities on their balance sheets)
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Other Special Services
 Credit allocation
 Areas of special need such as home mortgages.
 Intergenerational transfers or time
intermediation.
 Life insurance, Pension Funds
 Payment services
 Cheque clearing & wire transfers.
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Other Special Services
 Denomination intermediation.
 Minimum size of a negotiable certificate of
deposit (CD) is $100,000 and commercial paper
(short-term corporate debt) is often sold in
minimum packages of $250,000 or more.
 Individually, a saver may be unable to purchase
such instruments.
 However, by buying shares in a money market
mutual fund along with other small investors,
household savers overcome the constraints to
buying assets imposed by large minimum
denomination sizes
 Specialness and Regulation
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 FIs receive special regulatory attention.

Reasons:
1) Failure to provide special services or a
breakdown in their efficient provision can
be costly to both the ultimate sources
(households) and users (firms) of savings.
2) Individual FI failures may create doubts in
savers’ minds regarding the stability and
solvency of FIs in general and cause
panics and even runs on sound
institutions.
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Regulation of FIs
 Important features of regulatory policy:
 Protect ultimate sources and users of
savings.
 Including prevention of unfair practices such as
redlining and other discriminatory actions.
 Primary role:
Ensure soundness of the system as a whole.
 Regulation is not costless
 Net regulatory burden
 The difference between the private costs of
regulations and the private benefits for the
producers of financial services.
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Regulation of FIs

1) Safety and soundness regulation

2) Monetary policy regulation
3) Credit allocation regulation
4) Consumer protection regulation
5) Investor protection regulation
6) Entry and chartering regulation
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Regulation
 Safety and soundness regulation:
1. Regulations to increase diversification
 No more than 10 percent of equity to single
borrower
2. Minimum capital requirements
3. Guaranty funds:
 Deposit insurance fund (DIF):
 Securities Investors Protection Fund (SIPC)
4. Monitoring and surveillance.
 FDIC monitors and regulates DIF participants.
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Regulation
 Monetary policy regulation
 Federal Reserve directly controls outside
money (notes & coins)
 Bulk of money supply is inside money
(deposits).
 Reserve requirements facilitate transmission
of monetary policy.
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Regulation
 Credit allocation regulation
 Supports socially important sectors such as
housing and farming.
 Requirements for minimum amounts of assets in
a particular sector or maximum interest rates or
fees.
 Qualified Thrift Lender Test (QTL)
• 65 percent of assets in residential mortgages
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Regulation
 Consumer protection regulation
 Community Reinvestment Act (CRA).
 Home Mortgage Disclosure Act (HMDA).
 Effect on net regulatory burden
 Potential extensions of regulations such as CRA to
other FIs such as insurance companies in light of
consolidation and trend toward universal banking.
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Regulation
 Investor protection regulation
 A considerable number of laws protect
investors who use investment banks directly
to purchase securities and/or indirectly to
access securities markets through investing
in mutual or pension funds.

 Protections against abuses such as insider

trading, lack of disclosure, malfeasance,
breach of fiduciary responsibility.
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Regulation
 Entry regulation
 Increasing or decreasing the cost of entry into a

financial sector affects the profitability of firms

already competing in that industry.
 Fis are heavily protected against new entrants by

high direct costs (e.g., through required equity or

capital contributions) and high indirect costs (e.g.,
by restricting individuals who can establish FIs).
 Level of entry impediments affects profitability and
value of charter.
 Regulations define scope of permitted activities.

 Financial Services Modernization Act of 1999.

 Affects charter value and size of net regulatory

burden.
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Changing Dynamics of Specialness

 Trends in the United States

 Decline in share of depository institutions.
 Increases in investment companies.
 May be attributable to net regulatory burden
imposed on depository FIs.
 Financial Services Modernization Act
 Ethics issues and weakening of public trust
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Future Trends
 Further weakening of public trust and
confidence in FIs may encourage
disintermediation
 Increased merger activity within and
across sectors
 Citicorp and Travelers, UBS and Paine
Webber
 More large scale mergers such as J.P.
Morgan and Chase, and Bank One
 Growth in Online Trading
 Private placement market effects
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Equity Trading on the Internet
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Global Issues
 Increased competition from foreign FIs at
home and abroad
 Mergers involving world’s largest banks

 Mergers blending together previously

separate financial services sectors
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Top Largest Banks in the world
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World’s Largest Public companies
Bank Assets
ICBC (China) 4,210.9
China Construction Bank 3,631.6
JP Morgan Chase (US) 2,609.8
Berkshire Hathway (US) 702.7
Citigroup (USA) 1,494.0
BNP Paribas (France) 1,484.1
Credit Agricole Groupe (France) 1,380.6
Royal Bank of Scotland (UK) 1,337.5
Bank of America (USA) 1,291.8
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Pertinent Websites

The Banker www.thebanker.com

Federal Reserve www.federalreserve.gov
FDIC www.fdic.gov
FFIEC www.ffiec.gov
Investment Co. Institute www.ici.com
OCC www.occ.treas.gov
SEC www.sec.gov
SIPC www.sipc.org
Wall Street Journal www.wsj.com
Thompson Fin. Sec. Data www.thompson.com
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Thank you for your time &

Patience 