1 Chapter 4 FINANCIAL INTERMEDIATION ©Thomson/South-Western 2006.
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Transcript of 1 Chapter 4 FINANCIAL INTERMEDIATION ©Thomson/South-Western 2006.
2
The Economic Basis For Financial Intermediation
Borrowers require money to get businesses
started.
Savers seek a place for their money to grow.
Intermediators (either directly or indirectly)
help both parties by getting the available
money from savers to borrowers.
Intermediaries
Money Money BB
BB
B
SS
SS
S
3
Risks and Costs in the Absence of Intermediation
Asymmetric information:
Borrowers have information about
their activities and prospects that
they do not disclose to lenders.
Asymmetric information gives rise to two problems:
adverse selection moral hazard
4
Risks and Costs in the Absence of Intermediation
Adverse Selection
Condition in which people who are most
undesirable from the other party’s viewpoint are
the ones most likely to seek to engage in a
transaction.
Moral Hazard
Risk that one party to a transaction will
undertake activities that are undesirable from the
other’s party viewpoint.
5
How Intermediation Helps
Financial intermediaries:
have superior ability to deal with
asymmetric information and the
associated problems of adverse
selection and moral hazard;
specialize in assessing the credit risks of
prospective borrowers;
have access to such private information
are better equipped to monitor
borrowers’ activities after the loan is
made.
6
Transactions Costs
Transactions costs: money and time spent carrying out financial transactions
Costs associated with asymmetric information
By pooling funds, financial intermediaries can exploit economies of scale.
By reducing transactions costs, financial intermediaries benefit both savers and deficit spenders.
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Benefits of Intermediation
Benefits to Savers
From savers’ viewpoint, financial intermediaries
pool thousands of individuals’ funds and can
overcome certain obstacles that stop savers from
purchasing primary claims directly.
Allows individual savers to diversify
8
Benefits of Intermediation
Benefits to Deficit Units
From borrowers/spenders’ perspective,
financial intermediaries broaden the range of
instruments, denominations, and maturities
that an institution is able to issue, borrowing
costs – borrowers can tailor instruments to
best fit their needs.
9
Classification & Growth Of Financial Intermediaries
Financial Intermediaries issue (secondary) claims
against themselves to the public in order to obtain
funds with which to purchase (primary) claims issued
by deficit-spending units.
Three categories:
1. depository institutions,
2. contractual savings institutions,
3. investment-type intermediaries.
12
1. Depository Institutions
Types
1.1 Commercial banks
1.2 Savings & loan associations
1.3 Mutual savings banks
1.4 Credit unions
They:
issue checking, savings, and time deposits;
use the funds obtained to make various types of loans and to purchase securities.
Deposits issued by these institutions have no market risk because the principal does not fluctuate in nominal value.
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1.1 Commercial Banks.
Commercial banks are the largest and most important of all financial intermediaries.
Liabilities (sources of funds)
demand deposits, savings accounts, time deposits.
Assets (uses of funds)
mortgages, government securities, business (commercial) loans, consumer loans
15
1.2 Savings & Loan Associations (S & Ls)
S&Ls were first formed on the East Coast in the 1830s
by groups of people seeking to foster home ownership.
Individuals would pool their savings and make loans to
a few members to finance the purchase of a few
homes.
The federal government established the Federal
Housing Administration to insure mortgages, and to
encourage the issue of amortized mortgages through
S&Ls.
16
Other Institutions
1.3 Mutual Savings Banks (MSBs)
encourage working class employees to save
1.4 Credit Unions (CUs)
not-for-profits
for members
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2. Contractual Savings Institutions
2.1 Insurance companies Life insurance
Non-Life insurance
2.2 Private pension funds
2.3 State & local government retirement funds
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2.1 Life Insurance Companies
Life insurance companies:
Issue policies to customers
Collect premiums as a continuing source of funds
Invest > two-thirds of the funds in corporate bonds and equities
Typically regulated by the state insurance commissioner.
Life insurance policies:
have a specified cash surrender value--policyholders can obtain that cash on request.
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2.2 Fire & Casualty Insurance Companies
Fire and casualty insurance companies sell protection against loss resulting from fire, theft, accident, natural disaster, malpractice suits, and other events.
They obtain funds from: premiums, retained earnings, and new stock share issues.
Property losses are more difficult to predict, so fire and casualty companies’ assets must be more liquid than life insurance companies’ assets.
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2.3 Private Pension Funds & Government Retirement Funds
Pension funds manage portfolios more
efficiently than individuals by providing:
financial expertise,
economies of scale,
reduced transactions costs, and
diversification.
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2.3 Private Pension Funds & Government Retirement Funds
The U.S. tax code encourages pension plans--
income is nontaxable until retirement.
Employers withhold the funds from workers'
paychecks and send them to a pension fund.
The retirement fund invests the contributions
in
corporate stocks, bonds and U.S.
government bonds.
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3. Investment-Type Financial Intermediaries
3.1 Mutual funds
3.2 Finance companies
3.3 Money market mutual funds
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3. Investment-Type Financial Intermediaries
3.1 Mutual fundsFunds seek to maximize various goals (growth, income, etc.)
Funds specialize in industries (tech, health, etc.)
- Open-end: can sell shares back or buy more shares from to Mutual Fund company @ NAV
- No load fund: pay annual fee- Load fund: pay up-front fee
- Close-end: sell shares in the market @ market
price
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3. Investment-Type Financial Intermediaries
3.2 Finance companies
sales finance companies
consumer finance companies
business finance companies
3.3 Money market mutual funds
same as mutual funds but short-term
invest in highly liquid assets