AK/ECON 3430 3.0 Money, Banking and Finance A Fall 2016 Topic 7A: Financial Intermediation Prof. Brenda Spotton Visano

Primary Financial Services Needs Transfer purchasing power in a period of time to facilitate Exchange of Goods and Services Transfer purchasing power over time from Savers to Users of Funds (Borrowers and Investors)

Secondary Financial Services Needs Develop and maintain payments system Amass or “pool” funds from small savers to provide larger amounts to (1) fund bigger loans and larger investment projects, and (2) provide small savers opportunity for portfolio diversification Collect and process information - Specialize to reduce transactions costs

Household Financing Needs Financial Market/ Instruments Financial Intermediaries/ Financial Contracts Payments system   Savings or borrowing opportunities short term for consumption smoothing Portfolio diversification opportunities longer term for retirement and asset growth  Financial advice and quality information about investments  Mortgage financing house purchase

Business (Non-financial) Financing Needs Financial Market/ Instruments Financial Intermediaries/ Financial Contracts Payments system   Access to working/operating capital (short term funds for buying inputs to produce output for profit)  Small business access to start-up financial capital Medium and large business access to (1) loans for physical capital investment in expanding business and (2) market for selling equity in company 

Financial Specialists: Broker or Intermediary? What is the difference between a Broker and an Intermediary? What is the economic benefit of a Financial Broker? What gaps in the delivery of financial contracts and services could a Broker fill? What is the economic benefit of a Financial Intermediary? What gaps in the delivery of financial contracts and services could an Intermediary fill? Financial Markets and Brokers – facilitate the transfer of funds by enabling purchase and sale of financial contracts directly by principal users and suppliers of funds Financial Intermediaries – facilitate transfer of funds by issuing financial liabilities against themselves and acquiring financial assets

Recall - Limits of Individual Financial Self-Sufficiency When you need to borrow funds, do you issue marketable bonds? Why not? Do you make all your own arrangements for your retirement? Should you alone be responsible for costs of property damage or illness? Are you wealthy enough to adequately diversify your portfolio? Would having insurance for something change your insured behaviour? As a lender, would you lend to anyone who asks to borrow? Why/why not?

Markets and Brokers or Intermediaries? Are there economics of scale or scope in collection and processing of information? How best to structure the Financial Services industry and the financial firms to gain the economic benefits of providing a means of payment? …pooling savings? …increasing liquidity? …diversifying risk? …resolving adverse selection? …minimizing moral hazard?

Financial Intermediaries (FIs) as Portfolio Managers FIs manage a portfolio of financial assets and financial liabilities: Issue liabilities against themselves to acquire income earning assets Can and do transform the terms and conditions of the contract in the ultimate transfer of funds from savers to users of funds (i.e., borrowers, investors)

Problem #1: The Need for a Payments System Advantages and Disadvantages of Rocks? …Specie (e.g., Gold)? … Government Legal Tender/Currency? … Bitcoin? Create a financial specialist firm that will store the means of payment – do the accounting, provide safe-keeping (currency, gold) How to earn a profit? Fees? or… Lend out excess “money” – “buy” interest generating assets – which assets to acquire/which loans to make as a prudent portfolio manager? What are the risks? How much to loan out? If deposits can be exchanged directly then deposits act as “money” Deposit creation process allows for the creation more “money” to be created by this financial firm

Problem #2: Small Savers’ Need for Retirement Financing Limits of Individual Self-sufficiency in Saving for retirement Create a financial specialist who will do the accounting, pool savings, diversify the portfolio over income-earning assets, and distribute asset income to retirees For Employers and Employees - offer Defined Benefit or Defined Contribution Pension Plans - which assets to acquire as a prudent pension portfolio manager? What are the risks to the Employee? …to the Employer?

Economic Contributions of FIs - Asset Transformation Borrow from many people in small denominations, lend in larger amounts to fewer people Borrow short term, lend long term Borrow in liquid debt instruments, lend on illiquid contracts IF these opportunities encourage savings and encourage investment THEN FIs promote economic growth