Financial Intermediaries and Financial Innovation Chapter 2

Learning Objective Participants in Financial Markets Business of Financial institutions Financial Intermediary Economic functions of Financial Intermediaries Asset & Liability management of Financial institutions Government Regulations Primary reasons for financial innovation

Classification of Entities Central governments Agencies of central government Municipal governments Supranational Non- financial businesses Financial enterprises households

Classification of Entities Central governments Debt obligations issued by central Governments carry full faith & credit of the borrowing Government. Agencies of central government Federally related institutions, Government sponsored enterprises Municipal governments Supranational An organization that is formed by two or more central governments through international treaties.

Classification of Entities Non- financial businesses Corporations & non-corporate business Financial enterprises households

Classification of Entities Financial intermediaries Depository institutions-commercial banks, S&L associations and credit unions Insurance companies Pension funds

Classification of Entities Financial Enterprises Exchanging financial assets on behalf of customers. (Brokers) Exchanging financial assets for their own account. (Dealers) Assisting in creation of financial assets for their customers and then selling those financial assets to other market participants. (Underwriting) Providing investment advice to other market participants. Managing portfolios of other market participants.

Services of Financial Institutions 1.Transform fin. assets acquired into assets that are more attractive to the public. (Fin. Intermediaries) 2.Exchange fin. Assets on the behalf of others (Brokers) 3.Exchange fin. Assets for their own. (Dealers) 4.Assist in the creation of fin. assets for their customers and then sell these fin. assets to others.(underwriting) 5.Provide inv. advices 6.Provide portfolio management

Types of Fin. Intermediaries; Depository Institutions – Commercial banks, – Saving and loan associations, – Saving banks, – Credit unions Non-depository Institutions – Insurance companies, – Pension funds, – Finance companies

Role of Financial Intermediaries Obtain funds by issuing financial claims against themselves to market participants, then investing those funds. Direct investments- investments made by the financial intermediaries. (assets can be loans /or securities) Transform financial assets that are less desirable for a large part of the public into other financial assets(their own liabilities ) which are more widely preferred by the public.

Role of Financial Intermediaries This transformation involves four basic economic functions: Transforming of financial assets that are less desirable into other financial assets which are more widely preferred by public Maturity intermediation Risk reduction and diversification Reducing the costs of contracting and information processing Providing a payment mechanism

Overvıew of Asset and Liability Management of Financial Institutions Spread: Difference btw the returns on assets and costs of funds of the depository institutions. Positive spread.

Nature of Liabilities Liability TypeAmount of cash outlay Timing of cash outlay Type IKnown Type IIKnownUncertain Type IIIUncertainKnown Type IVUncertain

Nature of Liabilities Type I liabilities: Fixed deposit account Guaranteed investment contract (GIC) issued by the insurance companies Type II: Life insurance policy

Nature of Liabilities Type III liabilities: Floating rate Certificate of deposits issued by the depository institutions Type IV liabilities: Automobile and home insurance policies

Liquidity Needs Uncertainty about timing and amount of cash outlays Potential for the depositor or policy holder to withdraw cash early.

Liquidity Needs Reduction in cash inflows: Depository institutions- inability to obtain deposits Insurance companies- reduced premium because of the cancellation of policies Investment companies- not being able to find new buyers for shares.

Regulation OF Financial Markets Disclosure Regulation Financial Activity Regulation Regulation of Financial Institutions Regulation of Foreign Participants

Financial Innovation Categorizations of Financial Innovation Market-broadening Instruments- Increase liquidity of markets and availability of funds by attracting new investors and offering new opportunities for borrowers Risk- management instruments reallocate risk to those who are less risk averse.

Financial Innovation Arbitraging instruments and processes- enable investors and borrowers to take advantage of differences in costs and returns between markets.

Motivation for Financial Innovation Causes of Financial Innovation Increased volatility of interest rates, inflation, equity prices and exchange rates Advances in computer and telecommunication technologies Greater sophistication and educational training among professional market partcipants Financial intermediary competition Incentives to get around existing regulation and tax laws Changing global patterns of financial wealth..

Asset Securitization It involves the collection or pooling of loans and sale of securities backed by those loans. It means more than one institution may be involved in lending capital.

Consider the loans for the purchase of automobiles. (1) A commercial bank originates automobile loans. (2) The com. Bank issues securities backed by these loans (3) The com. Bank obtains credit risk insurance for the pool of loans from a private insurance company.

(4) The com. Bank sells the right to service the loans to another company that specializes in the serving of loans. (5) The com. Bank uses the services of a securities firm to distribute the securities to individual and institutional investors.