1. Chapter 2. Financial Intermediaries & Financial Innovation
financial institutions
role of financial intermediaries
asset/liability management
financial innovation

2. I. Financial Institutions
provide financial services
transforming financial assets
(own one type, issue another type)
trade financial assets
create & sell assets on behalf of others
investment advice & management

3. depository institutions
acquire funds mostly from deposits
nondepository institutions
acquire funds from other sources

4. II. Role of Financial Intermediaries
raise funds FOR direct investment
their assets
stock, bonds, loans
raise funds BY indirect investment
issue their own liabilities
accept deposits,
sell insurance policies
sell mutual funds shares

5. indirect investments allow investors
choice of desired maturity
maturity intermediation
diversification w/ small amount of capital
lower transactions costs
alternative payment mechanisms

6. III. Asset/liability Managment
liabilties = claims on financial institution
liabilities differ in the certainty about their amount and timing

7. Type I Liabilities timing and amount is certain fixed rate bank CD
GIC (guaranteed investment contract)
(principal and fixed interest payment due on specified date)

8. Type II Liabilities amount is certain, timing is not
term life insurance policy
(amount of policy is known,
but timing of death is not)

9. Type III Liabilities amount not certain, but timing is
variable rate bank CD
(know the maturity date, but not size of interest payment)

10. Type IV Liabilities amount and timing uncertain auto insurance policy
property insurance policy
(how much is the damage?
when will damage occur?)

11. type of liabilities issued determines the types of assets bought & held
long-term or short-term?
risk?

12. IV. Financial Innovation
creation of new financial assets
new ways to use financial assets
dramatic in past 30 years

13. why does it happen? changing times/ new risks increased volatility in
-- interest rates
-- stock prices
-- exchange rates
led to development of derivatives

14. advances in technology
rapid flow of information
rapid calculation of risks and prices
rapid trading
competition among institutions
for products
for strategies

15. circumvent regulations, tax laws
NOW accounts in 1970s
“selling short against the box”
sophistication of market professionals
devise & use complex securities
price complex securities

16. Asset securitization take individual loans pool them together
issue & sell securities w/ cash flow back by the loan pool payments

17. old way:
bank originates mortgage
bank holds mortgage & collects payments until loan is paid
new way:
bank sells mortgage to Fannie Mae
bank gets fee for servicing mortgage
Fannie Mae issues securities

18. advantages bank capital not tied up in loans
institutions specialize in part of process
pool of loans is diversified (less risk)
loans are more liquid
easier to get
cheaper to get