Topic 1' Role of Financial Institutions

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Topic 1. Role of Financial Institutions

• 1.1 Financial institutions specialness
• 1.2 Regulation on financial institutions

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1.1 Financial institutions (FIs) specialness

• Without FIs

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1.1 Financial institutions (FIs) specialness

• The following will decrease the attractiveness of
  the investment to the investors
• Information cost
• Too costly for the investors to gather the
  information of the corporations and sometimes
  even impossible to do that.
• Liquidity risk
• Difficult to sell the financial claims in the
  secondary market.
• Price risk
• The sale price of the financial claim will be
  less than their purchase price.

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1.1 Financial institutions (FIs) specialness

• With FIs

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1.1 Financial institutions (FIs) specialness

• FI can act as one, or both of the following
• Broker
• FI acts as an agent for investors to help them
  to purchase or sale of the financial claims from
  corporations and helps them to monitor the
  corporations.
• Asset transformer
• FI transforms the claims issued by corporations
  (primary securities) into the secondary
  securities, with lower liquidity cost and price
  risk, to sell to investors.

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1.1 Financial institutions (FIs) specialness

Simplified Balance Sheets of a Commercial Firm
and an FI
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1.1 Financial institutions (FIs) specialness

• FI helps investors to reduce
• Information cost
• Delegated monitor - by grouping the funds of the
  investors, FI has greater incentive to collect
  information and monitor actions of the
  corporation.
• Information producer through a wide spectrum
  of secondary securities.
• Liquidity and price risk
• Because FI can diversify risks through a
  portfolio of assets, it could issue secondary
  securities with less price and liquidity risk.

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1.1 Financial institutions (FIs) specialness

• Transaction cost
• By aggregating the investors funds, FI can
  purchase the assets in bulk with lower
  transaction costs.
• Risk of mismatching the maturities of assets and
  liabilities
• By issuing new forms of financial contracts with
  different maturities.

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1.1 Financial institutions (FIs) specialness

• Other special services of FIs
• Transmission of monetary policy.
• Credit allocation
• To finance a particular sector of economy which
  is identified as being in special need of
  financing such as home mortgages.
• Intergenerational wealth transfers or time
  intermediation
• To transfer wealth between young and old age and
  across generations. Life insurance Co. and
  pension funds play a key role in it.

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1.1 Financial institutions (FIs) specialness

• Payment service
• For example, check-clearing.
• Denomination intermediation
• Through the mutual fund, to allow the investors
  overcome the constraints to buying assets with
  large denomination.

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1.1 Financial institutions (FIs) specialness

• Types of financial institutions
• Depository institutions
• Insurance companies
• Securities firms and investment banks
• Mutual funds and hedge funds
• Finance companies

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1.2 Regulation on financial institutions

• FIs play the key role for the global economic
  development. Their negative news or failure would
  cause serious impact to the economy over the
  globe.
• Examples
• Bear Stearns
• Lehman Brothers
• Citigroup
• AIG
• Could you imagine what happen to Hong Kong if
  HSBC goes bankrupt?

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1.2 Regulation on financial institutions

• Regulation in US
• Safety and soundness regulation
• Monetary policy regulation
• Credit allocation regulation
• Consumer protection regulation
• Investor protection regulation
• Entry regulation

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1.2 Regulation on financial institutions

• Regulation is not costless
• Net regulatory burden
• Private cost of regulations Private benefit of
  the producers of financial services.
• Example
• Regulations prohibit commercial banks from
  making loan that exceed more than 10 of their
  equity capital even though the loan is
  profitable.
• Private cost Banks loss the investment
  opportunity.
• Private benefit To safeguard the financial
  health of the bank.