©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Chapter Why Are Financial Intermediaries Special?

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-2 Why Are Financial Intermediaries Special? u Objectives: Explain the special role of FIs in the financial system and the functions they provide. Explain why the various FIs receive special regulatory attention. Discuss what makes some FIs more special than others.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-3 Without FIs Corporations (net borrowers) Households (net savers) Cash Equity & Debt

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-4 FIs’ Specialness u Without FIs: Low level of fund flows. Costly for individuals to monitor borrowers »Role of bond covenants in partially alleviating monitoring costs Less liquidity Substantial price risk

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-5 With FIs Cash HouseholdsCorporations Equity & Debt FI (Brokers) FI (Asset Transformers) Deposits/Insurance Policies Cash

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-6 Functions of FIs u Brokerage function Acting as an agent for investors: »e.g. Merrill Lynch, Charles Schwab »Reduce costs through economies of scale Encourages higher rate of savings Asset transformer: »Purchase primary securities by selling financial claims to households These secondary securities often more marketable

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-7 Role of FIs in Cost Reduction u Information costs: Investors exposed to Agency Costs »Role of FI as Delegated Monitor (Diamond, 1984) Shorter term debt contracts easier to monitor than bonds FI likely to have informational advantage

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-8 Role of FIs in Cost Reduction u Liquidity and Price Risk Secondary claims issued by FIs have less price risk FIs have advantage in diversifying risks S&L debacle of 1980s linked to inadequate diversification of S&Ls

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-9 Other Special Services Reduced transaction costs Maturity intermediation Transmission of monetary policy. Credit allocation (Areas of special need such as home mortgages). Intergenerational transfers or time intermediation. Payment services (FedWire and CHIPS). Denomination intermediation.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-10 Specialness and Regulation u FIs receive special regulatory attention. Reasons: »Special services provided by FIs in general. »Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks,thrifts), etc. Negative externalities arise if these services are not provided.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-11 Regulation of FIs u Important features of regulatory policy: Protect ultimate sources and users of savings. »Including prevention of unfair practices such as redlining and other discriminatory actions. Ensure soundness of the system as a whole. u Regulation is not costless Net regulatory burden.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-12 Regulation u Safety and soundness regulation: Regulations to increase diversification Minimum capital requirements Guaranty funds: »FDIC: Bank Insurance Fund (BIF), Savings Association Insurance Fund (SAIF) »Securities Investors Protection Fund (SIPC) Monitoring and surveillance.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-13 Web Resources u For information on regulation of depository institutions and investment firms visit: FDIC SIPC Federal Reserve Web Surf

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-14 Regulation u Monetary policy regulation Federal Reserve directly controls outside money. Bulk of money supply is inside money (deposits). Reserve requirements facilitate transmission of monetary policy.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-15 Regulation u Credit allocation regulation Supports socially important sectors such as housing and farming. »Requirements for minimum amounts of assets in a particular sector or maximum interest rates or fees. »Qualified Thrift Lender Test (QTL). »Regulation Q.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-16 Regulation u Consumer protection regulation Community Reinvestment Act (CRA). Home Mortgage Disclosure Act (HMDA). u Effect on net regulatory burden. u Potential extensions to other FIs such as insurance companies.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-17 Regulation u Investor protection regulation Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility. u Key legislation Securities Acts of 1933, Investment Company Act of 1940.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-18 Regulation u Entry regulation Level of entry impediments affects profitability and value of charter. Regulations define scope of permitted activities. Effects size of net regulatory burden.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-19 Web Resources u For more information on regulation of depository institutions visit: Web Surf

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-20 Changing Dynamics of Specialness u Trends in the United States Decline in share of depository institutions. Increases in pension funds and investment companies. May be attributable to net regulatory burden imposed on depository FIs. Technological changes affect delivery of financial services and regulatory issues

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 1-21 Global Issues u Increased competition from foreign FIs at home and abroad u Mergers involving world’s largest banks u Mergers blending together previously separate financial services sectors