FINANCIAL INTERMEDIATION

Financial Intermediation The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by ultimate borrowers The process by which ultimate savers are matched to ultimate borrowers. Saving = Income – Consumption Typically decisions to save are made independently of decisions to invest

Financial intermediaries Financial intermediaries are institutions that borrow funds from people who have saved and make loans to other people. Financial asset transformation More important source of finance than financial markets, engage in process of indirect finance.

Chanelling of Funds In a simple economy we have firms and households Households are the savers and firms are the investors. The mechanism by which households save is by demanding securities from firms The mechanism by which firms invest is by supplying securities to households These securities are claims to the assets of the firm

Financial system – revisited Indirect finance Financial Intermediaries (e.g. bank) Lender Borrower Money Money Financial instrument A (e.g. saving account) Financial instrument B (e.g. student loans) Regulation Financial instruments (e.g. bond, stock) Financial markets Money Direct finance

Simple model of direct finance FUNDS LENT HOUSEHOLDS FIRMS FINANCIAL CLAIMS

Direct Finance Lending and borrowing can occur as a result of direct transacting. But there are costs associated with direct finance Search costs – searching for potential transactors Verification costs – costs in evaluating investment proposals Monitoring costs – costs of monitoring the actions of borrowing Enforcement costs – costs of enforcing contracts

Efficient Direct Finance Some of these costs can be reduced through the organisation of a market. Direct financing requires the existence of an efficient securities market. However not all costs are minimised through a securities market. An additional issue is that the maturity period of finance for the firm is long term. The maturity period of the household is mostly short term. The maturity mismatch of households and firms provide the incentive for the development of intermediated finance.

Indirect (Intermediated) Finance Funds Lent Financial Intermediary HOUSEHOLDS FIRMS Financial Claims

Who are the savers and borrowers? Savers or lenders are households, firms, governments and foreigners Investors or borrowers are households, firms, governments and foreigners. Savers can hold corporate securities (shares), government securities (bonds), currency, bank deposits, foreign currency assets Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue foreign currency liabilities

Transparent, Transluscent and Opaque FIs

What Services Do FIs Provide? Information Liquidity Reduced Transaction Costs Transmission of Monetary Policy Credit Allocation Payment Services Intergenerational Wealth Transfer

Services of Intermediation Maturity Borrow in the long vs. lend in the short Risk Reduction (Diversification) Eliminate firm specific risk via a portfolio Cost Reduction of Information/Contracting Share information acquired across large set of individuals Payment Mechanisms Checks, Credit Cards, Debit Cards, etc.

Services of Intermediation Asset/Liability Management for Financial Institutions Nature of Business – Buy and Sell Money Buy Low, Sell High – Spread Nature of Liabilities Timing and Amount of Outflow of Cash Liquidity of Claims against Financial Institutions – can obligations be met with current assets of the institution?

Services of Intermediation Growth of Financial Intermediaries through Financial Innovation Market Broadening Instruments – attracts new investors Zero-Coupon Bonds – Government bonds, etc Risk Management Instruments Options Arbitrage Instruments – Price Stability Index Assets for direct trade Motivation? Risk Transfer or Arbitrage

Services of Intermediation Asset Securitization Pledging Cash Flows from a set of borrowers to the lenders of the funds… Example Mortgage Backed Securities Conforming Loans are the security for the Bonds sold to investors and the payment of the mortgage payment flows to bondholders Original Lender to Mortgage does not service loans – just pools loans and sells bonds Costs and Benefits? Implications?

Function of financial intermediaries Indirect finance facilitate borrowing and lending Lower transaction costs Economies of scale, develop expertise Liquidity services ( but bank charges premium) Reduce risk Risk Sharing (e.g. insurance companies) Diversification Alleviate ‘asymmetric information problem’

Transactions Costs Transaction costs, the time and money spent in carrying out financial transactions. Financial intermediaries make profits by reducing transactions costs Reduce transactions costs by developing expertise and taking advantage of economies of scale

Risk Sharing 1. Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). 2. Also lower risk by helping people to diversify portfolios

Asymmetric information Adverse selection Adverse selection is a problem that arises for a buyer of a good, service, or asset when the buyer has difficulty assessing the quality of this item before purchase. ‘lemon car’ loan market: risky borrower are more likely to be ‘selected’

Asymmetric information – Cont’d Moral hazard Moral hazard is said to exist in a market if, after the signing of a contract or transaction: one party changes behavior which might have undesirable results; only imperfectly able to monitor/control insurance, stock market: engage in undesirable (risky) activities

FIs come to the rescue FIs can reduce adverse selection by: Check up on borrowers/do credit research. Develop reputation (keep credit report) for repaying. reduce moral hazard by: develop monitoring expertise. joint ownership FIs make profits from producing information.

Types of FIs Depository Institutions Insurance Companies Securities Firms and Investment Banks Mutual Funds Finance Companies Distinctions blurred by the Gramm-Leach-Bliley Act of 1999 that created Financial Holding Companies (FHCs).

Depository Institutions Commercial Banks: accept deposits and make loans to consumers and businesses. Savings Associations Qualified Thrift Lender (QTL) mortgages must exceed 65% of thrift’s assets. Savings Banks Use deposits to fund mortgages & other assets. Credit Unions Nonprofit mutually owned institutions (owned by depositors).

Bank Deposits (US$) Market Share CBZ 762,241,255 23.10% ABC 319,005,000 9.67% Stanbic 312,790,000 9.48% Stan chart 253,931,836 7.69% CABS 233,470,047 7.07% Barclays 213,714,389 6.48% ZB 157,257,458 4.77% FBC 150,689,337 4.57% MBCA 149,878,108 4.54% NMBZ 102,720,193 3.11% Kingdom 92,039,998 2.79% TN 89,220,437 2.70% Metropolitan 78,542,565 2.38% POSB 51,993,063 1.58% Ecobank 45,640,000 1.38% Trust 23,697,552 0.72% ZB BS 15,111,946 0.46% FBC BS 11,308,991 0.34% Others 236,747,825 7.17% Total 3,300,000,000 100%

Commercial banks Long-term illiquid assets financed by short-term liquid deposits Interest rate risk Refinancing / reinvestment risk Credit risk Firm-specific / systematic / country risk Off balance sheet risk (e.g., letter of credit) Operational risk Liquidity risk

Commercial banks (2) Danger of bank runs Eliminating bank runs Sequential service constraint Eliminating bank runs Capital requirements But: may induce more risks Deposit insurance / lender of last resort But: may induce excessive risk-taking by the banks Interbank market But: coordination problem among banks

Commercial banks (3) Securitization: selling claims against a specific part of the bank’s assets Reducing info distortions Better risk sharing But: weaker monitoring incentives Which types of loans are better suited for securitization?

Investment banks Securities intermediation: Issuance by companies and government Purchase by investors Financial advice, project finance, structured products, etc. Cyclical nature of earnings Large profit in a strong market

Insurance companies Transfer risks from clients to themselves for a fee Life / health / property and casualty insurance Fixed liabilities: annuity Long-term investments: bonds, Rising demand Aging of the population Reinsurance: e.g., Lloyds

Mutual funds Role of the management company Management fee: Fund family (complex) Management fee: Asset-based Performance-based

Mutual funds (2) Open vs closed funds Active vs passive (index) funds Shares are “marked to market” daily Active vs passive (index) funds

Benefits of investing via MF Low transaction costs Easy way to buy a diversified portfolio Customer services Liquidity insurance Professional management Selecting right stocks at right time?

Pension funds ‘Fixed’ liabilities More conservative strategy Defined contribution vs defined benefit plans Underfunded vs overfunded pensions More conservative strategy

Features Common to Most FIs High Amount of Financial Leverage Low equity/assets ratios. Capital requirements. Off-balance sheet items Contingent claims that under certain circumstances may eventually become balance sheet items (ex. Derivatives, commitments) Revenue: Interest Income & Fees Costs: Interest Expenses and Personnel

Methods to Ensure Soundness of Intermediaries Restrictions on entry Disclosure Restrictions on assets and liabilities Deposit Insurance Limits on Competition Restrictions on Interest rates

FIs are the most regulated of all firms. Safety and Soundness Regulation Deposit Insurance Monetary Policy Regulation Reserve Requirements Credit Allocation Regulation (eg., mortgages) Consumer Protection Regulation Community Reinvestment Act, Home Mortgage Disclosure Act, Truth in Lending Protection Investor Protection Regulation Entry Regulation

Regulation of Financial Markets Two Main Reasons for Regulation 1. Increase information to investors A. Decreases adverse selection and moral hazard problems B. SEC forces corporations to disclose information 2. Ensuring the soundness of financial intermediaries A. Prevents financial panics B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures

Disintermediation of Funds Disintermediation refers to the withdrawal of funds from a financial intermediary by the ultimate lenders (savers) and the lending of those funds directly to the ultimate borrowers. Disintermediation involves the shifting of funds from indirect finance to direct and semidirect finance.

Disintermediation of Funds Ultimate borrowers (DBUs) Ultimate lenders (SBUs) Financial intermediaries Primary Securities Loanable funds Financial Disintermediation

Disintermediation of Funds Some new forms of disintermediation have appeared over the past two decades. Initiation by financial intermediaries: Some banks sell off their loans because of difficulties in raising capital. Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market.