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Fin 119

Financial Intermediation and Innovation

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Fin 119Financial Intermediation

At any point in time there are individuals in the economy with both a surplus and shortage of funds. For the economy to function efficiently it should be possible for those with a surplus to lend to those with a deficit.

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Fin 119Bringing Together

Borrowers and Lenders

Direct Financings vs. Indirect FinancingFunds are either exchanged between the borrower and lender directly or via a financial institution.

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Fin 119Direct Financing

The direct exchange of money and financial claims between individuals with excess funds and individuals with a shortage of funds. The participant with a deficit issues a financial claim (a bond for example) purchased by the participant with a surplus of funds.

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Fin 119Direct Financing

Private Placement The entire claim is sold to an individual investor or a small group of investorsBrokers and Dealers

Brokers – Serve as a matchmaker, bringing together the two sides

Dealers and Market Makers – Serve to both buy and sell (at different prices) a given security.

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Fin 119Direct Financing

Investment Bankers Main role is helping those seeking funds market new claims. May purchase a claim directly then sell it off in pieces for a profit (close to intermediation).

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Fin 119Direct Financing

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Fin 119

Problems w/o Financial Institutions

Monitoring is costly

Lack of Liquidity

Price Risks

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Fin 119

Indirect Financing(Intermediation)

An intermediary transforms assets acquired through the market into a more widely preferred asset (which becomes their liability). The intermediary is then holding a direct claim in terms of their assets The participants holding the claims issued by the intermediary are said to have an indirect claim.

Surplus Funds

Households

Business

Government

Direct Financing

Private Placement

Brokers & Dealers

Investment Bankers

Deficit Funds

Households

Business

Government

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Fin 119

The roles of Financial Intermediation

Maturity and Denomination IntermediationMaturity - The intermediary can produce

assets of varying maturities.

Denomination - Similarly the intermediaries can produce a wide variety of denominations in the new assets

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Fin 119Intermediation Examples

Commercial Bank: Accept Deposits and uses the cash to make loans to other participants (both households and businesses)

Mutual Fund Firm: Pooling Funds of individuals and uses them to buy a portfolio of securities – (Form of Denomination Intermediation)

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Fin 119The Roles of Intermediation

DiversificationThe firm is able to change the risk characteristics of the claims. For example a mutual fund

The size of the firm allows it to be more cost effective at producing this risk reduction .

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Fin 119The Roles of Intermediation

Information Cost ReductionSpecialization allows the intermediary to focus on investment analysis. This is a costly process for the individual. Another example is allowing a reduction in loan contracting costs.

Providing a payment mechanismThe firms provide a means of non cash payment (checks, debit card etc…). The intermediaries also provide many claims that are highly liquid, allowing individuals to invest in less liquid assets indirectly.

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Fin 119Special Roles played by FI’s

Brokerage FunctionResearch and information provider (reduces information costs such as agency costs)Economies of Scale (decreases transaction costs and information costs)

Asset – Transformation FunctionPurchase primary claims and issue secondary claims backed by the primary claims (reducing contracting costs)Allows for risk sharing via diversification (reduces price and liquidity risk)

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Fin 119Special Roles played by FI’s

Transmission of Monetary Policy

Credit Allocation

Intergenerational Transfer of Wealth

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Fin 119Special Roles played by FI’s

Economy - Wide ServicesInformation, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation services

Institution Specific ServicesMonetary policy transmission (Depository Institutions)Credit allocation (Thrifts, Farm Banks)Intergenerational Transfers (Insurance and pensions)Payments services (Depository Institutions)Denomination Intermediation (Mutual Funds)

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Fin 119Trends over time.

Intermediaries have traditionally played a key role in the financial markets –

Can you think of any trends that may have been occurring in terms of the importance of different types of intermediaries?

Approximate Share of total financial assets 1955 1975

1998Commercial Banks 45%Mutual Funds 2%Private Pension Funds 5%

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Fin 119Regulation

Given their vital role in the economy FI’s are highly regulated. The goal of this regulation is to protect against a disruption in the services they offer.Some segments of the population could be discriminated against without regulation (race, gender etc)The difference the private benefits and private costs of regulation is the net regulatory burden.

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Fin 119

Justification of Regulation of FI’s

Safety and Soundness RegulationMonetary Policy RegulationPromotion of “Fair” CompetitionCredit Allocation RegulationConsumer Protection RegulationInvestor Protection RegulationEntry Regulation

We will refer to these throughout the semester – Know them!

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Fin 119Forms of Regulation

Disclosure RegulationRequires FI to make public financial information (decreases asymmetric information, and relies on efficient markets)Securities Act of 1933 and Securities Exchange Act of 1934 – Establishment of SEC

Agencies responsible for Trading (NASD, CFTC etc)Federal Reserve SystemInternational Agencies (BIS and IBA)

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Fin 119Regulatory Dialectic

Regulation proceeds as a progression over time, basically a dialogue between the regulators and the institutions being regulated.

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Fin 119Fixed Income Markets

To provide the intermediary role, most of the financial institutions become active participants in the fixed income market.The market provides a source of funds and risk managementNew products have been developed that broaden the market, manage risk, and provide profit opportunities.

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Fin 119

Trends in the MarketTypes of Financial Innovation

Market Broadening InstrumentsIncrease liquidity of the market attracts new investors and provides opportunities for borrowers

Risk Management InstrumentsReallocate financial risks to those willing and able to borrow them

Arbitraging Instruments Allow investors and borrowers to take advantage of differences between markets

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Fin 119Reasons for Innovation

Increased volatility of interest ratesAdvances in TechnologyGreater sophistication among participantsIncreased CompetitionGlobalizationAvoiding Regulation

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Fin 119Asset Securitization

Securitization is the pooling and repackaging of loans so they have the characteristics of security instruments which enable them to be more easily resold. Creates both Maturity Intermediation and Denomination Intermediation.

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Fin 119Securitization

Benefits to IssuersDiversification – Broadens funding sourceAbility to manage capital requirementsProvides Fee IncomeManage interest rate volatility

Benefits to investorsIncreased LiquidityReduced Credit Risk

Benefits to BorrowersReduced spreads

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Fin 119

Asset / Liability Management in FI’s

Liabilities – Determine the amount and timing of cash outflows that are made by the institution. The outflows satisfy the obligations issued by the institution as an intermediary.

Examples include, coupon payments on a bond issued by the institution and interest payments on deposits (banks)

Assets – Provide cash inflows for the institution.Examples include: loans made by the institutions (banks), investments in other assets, fee income, etc

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Fin 119

The Asset / Liability Management Problem

The type of issues associated with managing the firms in flow and outflow depends on the institution

Commercial Banks – Manage Spread IncomeInsurance Firms – Mange Spread and timing of commitmentsPension Funds – cover futures obligations at the lowest possible costInvestment companies – fee income

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Fin 119Liability and Liquidity

The ability to meet obligations creates liquidity risk for financial institutions. Institutions need to have the cash available to meet their cash outflows. Management of short term cash flows is therefore a very important issue.One of the main determinants of a firm’s ability to mange liquidity is the size and timing of the cash out flows.

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Fin 119Liabilities

Amount of Cash Outlay

Timing of Cash Outlay

Example

Type IFixed Rate

Deposit

Type IILife

Insurance

Type IIIFloating Rate CD

Type IVPension

Obligations