Why Are Financial Intermediaries Special? Chapter 1 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 1-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Are Financial Intermediaries Special?  Objectives: Develop the tools needed to measure and manage the risks of FIs. 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.

McGraw-Hill/Irwin 1-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Without FIs Corporations (net borrowers) Households (net savers) Cash Equity & Debt

McGraw-Hill/Irwin 1-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. FIs’ Specialness  Without FIs: Low level of fund flows. Information costs:  Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquidity Substantial price risk

McGraw-Hill/Irwin 1-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. With FIs Cash HouseholdsCorporations Equity & Debt FI (Brokers) FI (Asset Transformers) Deposits/Insurance Policies Cash

McGraw-Hill/Irwin 1-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions of FIs  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

McGraw-Hill/Irwin 1-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Role of FIs in Cost Reduction  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

McGraw-Hill/Irwin 1-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Specialness of FIs  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  Reduced transaction & information costs economies of scale

McGraw-Hill/Irwin 1-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Special Services 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.

McGraw-Hill/Irwin 1-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Specialness and Regulation  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.

McGraw-Hill/Irwin 1-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation of FIs  Important features of regulatory policy: Protect ultimate sources and users of savings.  Including prevention of unfair practices such as redlining and other discriminatory actions. Primary role: Ensure soundness of the system as a whole.  Regulation is not costless Net regulatory burden.

McGraw-Hill/Irwin 1-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  Safety and soundness regulation: Regulations to increase diversification  No more than 10 percent of equity to single borrower Minimum capital requirements Guaranty funds:  FDIC: Bank Insurance Fund (BIF), Savings Association Insurance Fund (SAIF)  Securities Investors Protection Fund (SIPC) Monitoring and surveillance.

McGraw-Hill/Irwin 1-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on regulation of depository institutions and investment firms visit: FDIC SIPC Federal Reserve

McGraw-Hill/Irwin 1-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  Monetary policy regulation Federal Reserve directly controls outside money. Bulk of money supply is inside money (deposits). Reserve requirements facilitate transmission of monetary policy.

McGraw-Hill/Irwin 1-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  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) 65 percent of assets in residential mortgages  Usury laws and Regulation Q (abolished)

McGraw-Hill/Irwin 1-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  Consumer protection regulation Community Reinvestment Act (CRA). Home Mortgage Disclosure Act (HMDA).  Effect on net regulatory burden FFIEC processed info on as many as 31 million mortgage transactions in  Potential extensions of regulations such as CRA to other FIs such as insurance companies.

McGraw-Hill/Irwin 1-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  Investor protection regulation Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility.  Key legislation Securities Acts of 1933, Investment Company Act of 1940.

McGraw-Hill/Irwin 1-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  Entry regulation Level of entry impediments affects profitability and value of charter. Regulations define scope of permitted activities.  Financial Services Modernization Act of Affects charter value and size of net regulatory burden.

McGraw-Hill/Irwin 1-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For more information on regulation of depository institutions visit:

McGraw-Hill/Irwin 1-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Changing Dynamics of Specialness  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 Potential for regulations to be extended to hedge funds  Result of Long Term Capital Management disaster

McGraw-Hill/Irwin 1-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Future Trends  Weakening of public trust and confidence in FIs may encourage disintermediation  Increased merger activity within and across sectors Citicorp and Travelers, UBS and Paine Webber More large scale mergers such as J.P. Morgan and Chase, and Bank One and First Chicago  Growth in Online Trading

McGraw-Hill/Irwin 1-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Increased competition from foreign FIs at home and abroad  Mergers involving world’s largest banks  Mergers blending together previously separate financial services sectors

McGraw-Hill/Irwin 1-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. World’s Largest Banks Bank Assets ($Millions) Citigroup (USA) 1,097,000 Mizuho Financial Group (Japan) 945,688 UBS (Switzerland) 825,000 Sumitomo Mitsui Fin. (Japan) 802,674 Deutsche Bank (Germany) 794,984 Bank of Tokyo-Mitsubishi (Japan) 789,495

McGraw-Hill/Irwin 1-24 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites The Banker Federal Reserve FDIC FFIEC Investment Co. Institute OCC SEC SIPC Wall Street Journal Thompson Fin. Sec. Data