The Nature of Financial Intermediation

1
The Nature of Financial Intermediation

• Business 4039

2
Today

• Questions course outline term papers
• Availability of texts who doesnt have a text?
• Handout class problem presentations
• News Current Events
• The Nature of Financial Intermediation

3
Key Concepts

• Pivotal role of banks and other deposit-taking
  FIs
• Rapid pace of change in markets, technologies and
  non-bank competition
• Information costs are responsible for emergence
  of financial intermediaries
• Financial intermediaries deal with
• Search
• Verification
• Monitoring
• Enforcement costs.

4
Important Terms Defined

• Liquidity and funding risk
• The threat of insufficient liquidity on the part
  of the bank for normal operating requirements
• Settlement/payment risk
• Is created when one party to a deal pays money or
  delivers assets before receiving its own cash or
  assets, hence exposing itself to a potential loss
  and interest rate risk.
• Interest rate risk
• The risk that arises from mismatches in both the
  volume and maturity of interest-sensitive assets,
  liabilities and off-balance sheet items
• Market or price risk
• The exposure of banks to losses due to market or
  price fluctuations in well-defined markets
• Foreign exchange or currency risk
• The exposure of banks to fluctuations in foreign
  exchange rates that affect positions held in a
  particular currency for a customer or the bank.
• Sovereign risk
• In which the political or economic conditions in
  a particular country threaten to interrupt
  repayment of loans or other debt obligations
• Operating risk
• Arising from losses caused by fraud, failure of
  internal control, or unexpected expenses, as in
  the case of lawsuits.

5
Financial Intermediation

• Information is the underlying, core reason for
  the existence of financial intermediaries.
• Borrowers do not have the means to search out and
  contract with lenders. Even if they do, it is
  an expensive and time consuming and unsystematic
  process that can be prohibitively expensive.
• This situation does existfor example in the case
  of angel capital.

6
Financial Intermediaries

• There are many types of financial intermediaries
  that have evolved over time
• Deposit-taking financial intermediaries
• Banks
• Trust companies
• Credit unions
• Non-depositor
• Life and PC insurance companies
• Investment dealers Task Force on the Future of
  Financial Services
• Finance Companies
• Other
• Mutual funds

20
K. Hartviksen
7
Uniqueness Recognized

• One of the themes dominating FI organization in
  Canada is the degree to which the specialness of
  Fis should be enshrined in law and regulatory
  practice.
• The end result is that financial institutions are
  among the most heavily regulated and heavily
  taxed organizations in our society.
• You are encouraged to follow the current debates
  on this topic in the financial press. Look for
• deposit taking FI regulation
• insurance company regulation
• securities industry regulation
• Bank of Canada policy concerning FIs
• CDIC policy concerning FIs
• Regulatory activities of liability insurers
• international coordination of FI regulation

21
K. Hartviksen
8
Intermediation Services of FIs

• risk transfer, reduction, and monitoring services
• liquidity services
• maturity intermediation services
• transaction services
• financial information services
• denomination intermediation (mutual funds)

22
K. Hartviksen
9
Deficit-Saving Economic Unit
Surplus-Saving Economic Unit

• Borrowers
• borrow large sums
  (mortgages/commercial/ personal loans)
• for long periods of time
• complex legal transactions because of the
  long-term nature of the debt contracts and the
  need to contractually ensure that the interests
  of the lender are protected.

• Savers
• many of them saving small amounts individually,
  but large amounts in aggregate
• for short periods of time (ie. Need liquidity)
• are generally risk averse
• dont have the capacity, time or sophistication
  to analyze risk or to monitor borrowers

Deposit-taking Financial Intermediary
23
K. Hartviksen
10
Deficit-Saving Economic Unit
Surplus-Saving Economic Unit
Deposit-taking Financial Intermediary

• Deposit-taking FIs
• pool deposits, provide liquidity for depositors,
  collect/analyze/monitor the financial
  positions/activities of borrowers, make credit
  allocation decisions among opportunities to
  lend/invest, negotiate/monitor/enforce loan
  agreements.
• In this manner the need of both savers and
  borrowers are met with efficiency. In the
  absence of FIs failure, confidence in the system
  is built and this encourages full participation,
  thereby reducing monetary leakage.currency in
  circulation is made available for the best
  competing uses in our society.

24
K. Hartviksen
11
Price Risk

• the risk that the sale price of an asset will be
  lower than its purchase price.

26
K. Hartviksen
12
Secondary Claims

• example demand deposit in a deposit-taking FI
• it is a financial asset that has characteristics
  far different than primary securities (bonds,
  stocks, commercial loans) gt often improved
  liquidity/safety of principal, etc.

30
K. Hartviksen
13
Maturity Intermediation

• a service performed by deposit-taking FIs for
  secondary asset holders (depositors)....because
  of pooling and diversification....
• mismatching the maturities of assets and
  liabilities of the FI.

31
K. Hartviksen
14
Securitization

• The creation of a marketable financial asset
  through financial innovationof otherwise
  illiquid financial assets
• Eg. MBSs

15
Economies of Scale

• FIs provide potential economies of scale in
  transactions costs...information collection and
  risk management.

32
K. Hartviksen
16
Institutional Aspects of Special-ness

• money supply transmission (banks)
• credit allocation (banks, trusts, credit unions,
  and finance companies)
• risk offlay (insurance companies)
• intergenerational transfer (pensions, life
  insurance companies, and deposit-taking FIs)
• payment services (banks, trusts, and credit
  unions)
• denomination intermediation (mutual funds,
  pension funds)

33
K. Hartviksen