Chapter2

FINANCIAL INTERMEDIARIES AND FINANCIAL INNOVATION

Chapter 2Instructor: Mahwish Khokhar

Purpose of the Chapter

The main purpose of this chapter is to introduce financial intermediaries.

Financial intermediaries include: Commercial Banks Savings and loan Associations Investment Companies Insurance Companies Pension Funds

Their main function is inexpensive inflow of money from savers to investors/borrowers.

Financial Institutions

Business entities include nonfinancial and financial enterprises. Nonfinancial enterprises provide following services: Nonfinancial enterprises manufacture products or

provide nonfinancial services

Financial enterprises provide following services:1. Transforming financial assets acquired through

the market and transforming them into different and most widely used asset.

Cont’d..

2. Exchanging the financial asset on behalf of customer

3. Exchanging the financial asset on their own account

4. Assisting in the creation of FA for their customers and then selling those FA to other market participants

5. Providing investment advise

6. Managing the portfolios of other market participants

Cont’d..

Financial Intermediaries also include depository institutions (commercial banks, savings and loan associations, savings bank and credit unions) which acquire bulk of their funds by offering their liabilities to their customers in the form of deposits; insurance companies; pension funds; and finance companies.

Financial intermediaries also provide services like underwriting, brokers and dealers.

Cont’d..

Typically the FI that provide underwriting services also provide

brokerage/dealer services.

Some nonfinancial enterprises also have subsidiaries that provide

financial services. These FI are also called Captive Finance

Companies. For example General Motors acceptance corporation (a

subsidiary of GM).

It means that GM have a subsidiary that provide financing to its parent

company.

General Electric has a subsidiary called General Electric Credit

Corporation.

Role of Financial Intermediaries

FI obtain funds by issuing financial claims against themselves to market participants and then invest those funds.

The investment made by FI can be loan or security. These investments are called direct investment.

The participants who hold those financial claims have said to made indirect investment.

Example: Commercial Banks, Investment Companies (Pooling of Funds). (See book pg. 16)

Cont’d..

FI provide four basic functions:1. Maturity Intermediation: In our example of

commercial banks two things should be noticed:

The maturity of at least a portion of the deposits accepted is typically short term. (certain types of deposits are payable on demand and others have specific maturity date, but most are less than two years).

Cont’d..

Maturity of the loans made by the commercial banks may be considerably longer than two years. (If the Commercial Bank is absent then what will happen?)

The commercial bank by issuing it own financial claim in essence transforms a longer-term asset into a shorter-term one by giving the borrower a loan for the length of the time sought and the investor/depositor a FA for the desired investment horizon. This function of Financial Intermediary is called maturity intermediation.

Cont’d..

2. Reducing Risk via Diversification: FI convert more risky funds into less risky funds. Example: Enron

3. Reducing the costs of contracting and information processing: Investors purchasing FA should take time to develop skills necessary to understand how to evaluate an investment.Once skills are developed, investors should apply those skills to the analysis of specific FA that are candidates for purchase (or subsequent sale).

Cont’d..

Investors who want to make a loan to a consumer or business will need to write the loan contract (or hire an attorney to do so).

In addition to the opportunity cost of time to process the information about the FA and its issuer, there is cost of acquiring this information. All these costs are called information processing costs.

Cont’d..

4. Providing a payment mechanism: Although most transactions made today are not done with cash.

Instead payments are made using checks, credit cards, debit cards, and the electronic transfer of funds. These methods of making payments is called payment mechanisms, are provided by certain financial intermediaries.

Part 1 CompletePart 2 Starts below

Overview of Asset/Liability Management For Financial Institutions

OBJECTIVE:

To know why managers of FI invest in particular types of Financial Assets and the types of investment strategies they employ.

Cont’d..

The nature of the liability dictates which strategy is adopted.

Depository Institutions

Depository institutions buy money and sell money. Banks BUY money by borrowing from depositors or other

sources of funds. And they SELL money by lending it to businesses and

individuals. The difference between the buying and selling value is

called SPREAD. The cost of the funds and the return on the funds sold is

expressed in terms of interest rate per unit of time.

Nature of the Liabilities

By liabilities of FI we mean the amount and timing of the cash outlays that must be made to satisfy the contractual terms of the obligations issued.

The liabilities of any FI can be categorized according to four types, mentioned below:

Liability Type Amount of Cash Outlays

Timings of Cash Outlays

Type I Known Known

Type II Known Uncertain

Type III Uncertain Known

Type IV Uncertain Uncertain

Type I Liabilities

Both the amount and timings are known with certainty. Example: a liability requiring FI to pay $50,000 six

months from now will be a good example. (Principal + Interest). Where interest rate is always fixed.

Type I liabilities are not just sold by depository institutions but also by life insurance companies.

EXAMPLE: Life insurance companies have obligation to fulfill under this contract for some of money called PREMIUM, it will guarantee an interest rate up to some specified maturity date.

Type II Liabilities

In type II liabilities the amount of the cash outlay is known, but the timings are uncertain.

EXAMPLE: Life insurance policy. (will be discussed in chapter 7).

In this type for an annual premium, a life insurance company agrees to make specified $$ payment to the policy beneficiaries/holders upon the death of the insured.

Type III Liabilities

In this type timing of the cash outlay is known but the amount is uncertain.

EXAMPLE: FI issue an obligation in which the interest rate adjusts periodically according to some interest rate benchmark.

Depository Institutions issues: CD: Have stated maturity and Interest rate fluctuate over the life of

the deposit. 3-years floating rate certificate of deposit: Interest rate adjusts

every 3-months and is benchmarked against the Treasury Bill rate plus 1 percentage point. And matures after 3 years.

Type IV Liabilities

There are numerous insurance products and pension obligations that present uncertainty to both the amount and the timings of the cash outlay.

EXAPMPLE: Automobile and home insurance policies in which amount/payment and timings are uncertain.

Also retirement benefits depends on the total number of employment years and this will affect the cash outlay.

Liquidity Concerns

Because of the uncertainty about the timings and amount of the cash outlays, a FI must be prepared to fulfill/satisfy the financial obligations.

EXAMPLE: If the depositor request the withdrawal of the funds prior of the maturity date. The deposit accepting institution will grant this request will take an early withdrawal penalty.

Liquidity Concerns

In certain type of investment companies the shareholders have the right to redeem their shares at any time.

Regulations and Taxation: Numerous regulations ad tax considerations influence the investment policies that FI pursue.

Financial Innovation

Categorization of Financial Innovation: Since 1960s there is significant surge in Financial Innovation. Here are just 3 ways to categorize the innovations suggested by Economic Council of Canada. Market Broadening Instruments: which increase

the liquidity of the markets and the availability of the funds by attracting new investors and offering new opportunities for the borrowers.

Financial Innovation

Risk Management Instruments: which relocate financial risk to those who are less averse to them or who have better diversification.

Arbitraging Instruments and Processes: which enable the investors and borrowers to take advantage of the differences in cost and return between markets, which reflect differences in the perception of the risk, as well as in information, taxations and regulations.

THE END =D