Financial Intermediation and Innovation

Financial Intermediation At any point in time there are individuals in the economy with both a surplus and shortage of funds. For the economy to function efficiently it should be possible for those with a surplus to lend to those with a deficit.

Bringing Together Borrowers and Lenders Direct Financings vs. Indirect Financing Funds are either exchanged between the borrower and lender directly or via a financial institution.

Direct Financing The direct exchange of money and financial claims between individuals with excess funds and individuals with a shortage of funds. The participant with a deficit issues a financial claim (a bond for example) purchased by the participant with a surplus of funds.

Direct Financing Private Placement The entire claim is sold to an individual investor or a small group of investors Brokers and Dealers Brokers – Serve as a matchmaker, bringing together the two sides Dealers and Market Makers – Serve to both buy and sell (at different prices) a given security.

Direct Financing Investment Bankers Main role is helping those seeking funds market new claims. May purchase a claim directly then sell it off in pieces for a profit (close to intermediation).

Direct Financing ©2003 McGraw-Hill Companies Inc. All rights reserved

Problems w/o Financial Institutions Monitoring is costly Lack of Liquidity Price Risks

Indirect Financing (Intermediation) An intermediary transforms assets acquired through the market into a more widely preferred asset (which becomes their liability). The intermediary is then holding a direct claim in terms of their assets The participants holding the claims issued by the intermediary are said to have an indirect claim.

Direct Financing Private Placement Brokers & Dealers Investment Bankers Surplus Funds Households Business Government Deficit Funds Households Business Government

The roles of Financial Intermediation Maturity and Denomination Intermediation Maturity - The intermediary can produce assets of varying maturities. Denomination - Similarly the intermediaries can produce a wide variety of denominations in the new assets

Intermediation Examples Commercial Bank: Accept Deposits and uses the cash to make loans to other participants (both households and businesses) Mutual Fund Firm: Pooling Funds of individuals and uses them to buy a portfolio of securities – (Form of Denomination Intermediation)

The Roles of Intermediation Diversification The firm is able to change the risk characteristics of the claims. For example a mutual fund The size of the firm allows it to be more cost effective at producing this risk reduction .

The Roles of Intermediation Information Cost Reduction Specialization allows the intermediary to focus on investment analysis. This is a costly process for the individual. Another example is allowing a reduction in loan contracting costs. Providing a payment mechanism The firms provide a means of non cash payment (checks, debit card etc…). The intermediaries also provide many claims that are highly liquid, allowing individuals to invest in less liquid assets indirectly.

Special Roles played by FI’s Brokerage Function Research and information provider (reduces information costs such as agency costs) Economies of Scale (decreases transaction costs and information costs) Asset – Transformation Function Purchase primary claims and issue secondary claims backed by the primary claims (reducing contracting costs) Allows for risk sharing via diversification (reduces price and liquidity risk)

Special Roles played by FI’s Transmission of Monetary Policy Credit Allocation Intergenerational Transfer of Wealth

Special Roles played by FI’s Economy - Wide Services Information, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation services Institution Specific Services Monetary policy transmission (Depository Institutions) Credit allocation (Thrifts, Farm Banks) Intergenerational Transfers (Insurance and pensions) Payments services (Depository Institutions) Denomination Intermediation (Mutual Funds)

Approximate Share of total financial assets Trends over time. Intermediaries have traditionally played a key role in the financial markets – Can you think of any trends that may have been occurring in terms of the importance of different types of intermediaries? Approximate Share of total financial assets 1955 1975 1998 Commercial Banks 45% Mutual Funds 2% Private Pension Funds 5%

Regulation Given their vital role in the economy FI’s are highly regulated. The goal of this regulation is to protect against a disruption in the services they offer. Some segments of the population could be discriminated against without regulation (race, gender etc) The difference the private benefits and private costs of regulation is the net regulatory burden.

Justification of Regulation of FI’s Safety and Soundness Regulation Monetary Policy Regulation Promotion of “Fair” Competition Credit Allocation Regulation Consumer Protection Regulation Investor Protection Regulation Entry Regulation We will refer to these throughout the semester – Know them!

Forms of Regulation Disclosure Regulation Requires FI to make public financial information (decreases asymmetric information, and relies on efficient markets) Securities Act of 1933 and Securities Exchange Act of 1934 – Establishment of SEC Agencies responsible for Trading (NASD, CFTC etc) Federal Reserve System International Agencies (BIS and IBA)

Regulatory Dialectic Regulation proceeds as a progression over time, basically a dialogue between the regulators and the institutions being regulated.

Fixed Income Markets To provide the intermediary role, most of the financial institutions become active participants in the fixed income market. The market provides a source of funds and risk management New products have been developed that broaden the market, manage risk, and provide profit opportunities.

Trends in the Market Types of Financial Innovation Market Broadening Instruments Increase liquidity of the market attracts new investors and provides opportunities for borrowers Risk Management Instruments Reallocate financial risks to those willing and able to borrow them Arbitraging Instruments Allow investors and borrowers to take advantage of differences between markets

Reasons for Innovation Increased volatility of interest rates Advances in Technology Greater sophistication among participants Increased Competition Globalization Avoiding Regulation

Asset Securitization Securitization is the pooling and repackaging of loans so they have the characteristics of security instruments which enable them to be more easily resold. Creates both Maturity Intermediation and Denomination Intermediation.

Securitization Benefits to Issuers Benefits to investors Diversification – Broadens funding source Ability to manage capital requirements Provides Fee Income Manage interest rate volatility Benefits to investors Increased Liquidity Reduced Credit Risk Benefits to Borrowers Reduced spreads

Asset / Liability Management in FI’s Liabilities – Determine the amount and timing of cash outflows that are made by the institution. The outflows satisfy the obligations issued by the institution as an intermediary. Examples include, coupon payments on a bond issued by the institution and interest payments on deposits (banks) Assets – Provide cash inflows for the institution. Examples include: loans made by the institutions (banks), investments in other assets, fee income, etc

The Asset / Liability Management Problem The type of issues associated with managing the firms in flow and outflow depends on the institution Commercial Banks – Manage Spread Income Insurance Firms – Mange Spread and timing of commitments Pension Funds – cover futures obligations at the lowest possible cost Investment companies – fee income

Liability and Liquidity The ability to meet obligations creates liquidity risk for financial institutions. Institutions need to have the cash available to meet their cash outflows. Management of short term cash flows is therefore a very important issue. One of the main determinants of a firm’s ability to mange liquidity is the size and timing of the cash out flows.

Liabilities Amount of Cash Outlay Timing of Example Type I Fixed Rate Deposit Type II Life Insurance Type III Floating Rate CD Type IV Pension Obligations