1. Why Are Financial Intermediaries Special?
Chapter 1
Why Are Financial Intermediaries Special?

2. Why Are Financial Intermediaries Special?
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.

3. Without FIs Households (net savers) Corporations (net borrowers)
Cash
Equity & Debt
Corporations
(net borrowers)

4. FIs’ Specialness 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

5. Deposits/Insurance Policies
With FIs
Cash
Households
Corporations
Equity & Debt FI
(Brokers)
(Asset Transformers)
Deposits/Insurance Policies

6. 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

7. 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

8. Role of FIs in Cost Reduction
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

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.

10. 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.

11. 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.
Ensure soundness of the system as a whole.
Regulation is not costless
Net regulatory burden.

12. Regulation 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.

13. Web Resources
For information on regulation of depository institutions and investment firms visit:
FDIC
SIPC
Federal Reserve
Web Surf

14. 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.

15. 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).
Regulation Q.

16. Regulation Consumer protection regulation
Community Reinvestment Act (CRA).
Home Mortgage Disclosure Act (HMDA).
Effect on net regulatory burden.
Potential extensions to other FIs such as insurance companies.

17. Regulation Investor protection regulation Key legislation
Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility.
Key legislation
Securities Acts of 1933, 1934.
Investment Company Act of 1940.

18. Regulation Entry regulation
Level of entry impediments affects profitability and value of charter.
Regulations define scope of permitted activities.
Effects size of net regulatory burden.

19. Web Resources
For more information on regulation of depository institutions visit:
Web Surf

20. 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

21. 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