1. FINANCIAL INTERMEDIATION

2. 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

3. 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.

4. 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

5. 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

7. Simple model of direct finance
FUNDS LENT
HOUSEHOLDS
FIRMS
FINANCIAL CLAIMS

8. 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

9. 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.

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

11. 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

12. Transparent, Transluscent and Opaque FIs

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

14. 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.

15. 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?

16. 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

17. 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?

18. 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’

19. 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

20. 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

21. 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’

22. 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

23. 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.

24. 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 that created Financial Holding Companies (FHCs).

25. 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).

26. 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%

28. 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

29. 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

30. 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?

31. 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

32. 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

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

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

35. 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?

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

37. 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

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

40. 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

41. 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

42. 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.

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

44. 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.