Chapter 1 Saunders Cornett McGraw

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Transcript of Chapter 1 Saunders Cornett McGraw

The Nature of Financial IntermediationBusiness 4039

Key Concepts

Pivotal role of banks and other deposit-taking FIs Rapid pace of change in markets, technologies and non-bank competition Information costs are responsible for emergence of financial intermediaries Financial intermediaries deal with:

Search Verification Monitoring Enforcement costs.

Important Terms Defined

Liquidity and funding risk

The threat of insufficient liquidity on the part of the bank for normal operating requirements Is created when one party to a deal pays money or delivers assets before receiving its own cash or assets, hence exposing itself to a potential loss and interest rate risk. The risk that arises from mismatches in both the volume and maturity of interest-sensitive assets, liabilities and off-balance sheet items The exposure of banks to losses due to market or price fluctuations in well-defined markets The exposure of banks to fluctuations in foreign exchange rates that affect positions held in a particular currency for a customer or the bank. In which the political or economic conditions in a particular country threaten to interrupt repayment of loans or other debt obligations Arising from losses caused by fraud, failure of internal control, or unexpected expenses, as in the case of lawsuits.

Settlement/payment risk

Interest rate risk

Market or price risk

Foreign exchange or currency risk

Sovereign risk

Operating risk

Financial Intermediation

Information is the underlying, core reason for the existence of financial intermediaries.

Borrowers do not have the means to search out and contract with lenders. Even if they do, it is an expensive and time consuming and unsystematic process that can be prohibitively expensive.

This situation does existfor example in the case of angel capital.

Financial Intermediaries

There are many types of financial intermediaries that have evolved over time:

Deposit-taking financial intermediaries

Banks /Trust companies Credit unions Life and P&C insurance companies Investment dealers Finance Companies Mutual funds



Uniqueness Recognized

One of the themes dominating FI organization in Canada is the degree to which the specialness of Fis should be enshrined in law and regulatory practice. The end result is that financial institutions are among the most heavily regulated and heavily taxed organizations in our society. You are encouraged to follow the current debates on this topic in the financial press. Look for:

deposit taking FI regulation insurance company regulation securities industry regulation Bank of Canada policy concerning FIs CDIC policy concerning FIs Regulatory activities of liability insurers international coordination of FI regulation Role of OSFI in supervision

Intermediation Services of FIs

risk transfer, reduction, and monitoring services liquidity services maturity intermediation services transaction services financial information services denomination intermediation (mutual funds)

Deficit-Saving Economic UnitBorrowers: borrow large sums (mortgages/commercial/ personal loans) for long periods of time complex legal transactions because of the long-term nature of the debt contracts and the need to contractually ensure that the interests of the lender are protected.

Surplus-Saving Economic UnitSavers:

Deposit-taking Financial Intermediary

many of them saving small amounts individually, but large amounts in aggregate for short periods of time (ie. Need liquidity) are generally risk averse dont have the capacity, time or sophistication to analyze risk or to monitor borrowers

Deficit-Saving Economic Unit

Surplus-Saving Economic Unit

Deposit-taking FIs:

Deposit-taking Financial Intermediary

pool deposits, provide liquidity for depositors, collect/analyze/monitor the financial positions/activities of borrowers, make credit allocation decisions among opportunities to lend/invest, negotiate/monitor/enforce loan agreements. In this manner the need of both savers and borrowers are met with efficiency. In the absence of FIs failure, confidence in the system is built and this encourages full participation, thereby reducing monetary leakage.currency in circulation is made available for the best competing uses in our society.

Price Risk

the risk that the sale price of an asset will be lower than its purchase price.

Secondary Claims

example: demand deposit in a deposit-taking FI it is a financial asset that has characteristics far different than primary securities (bonds, stocks, commercial loans) => often improved liquidity/safety of principal, etc.

Maturity Intermediation

a service performed by deposit-taking FIs for secondary asset holders (depositors)....because of pooling and diversification.... mismatching the maturities of assets and liabilities of the FI.


The creation of a marketable financial asset through financial innovationof otherwise illiquid financial assets Eg. MBSs

Economies of Scale

FIs provide potential economies of scale in transactions costs...information collection and risk management.

Institutional Aspects of Special-ness

money supply transmission (banks) credit allocation (banks, trusts, credit unions, and finance companies) risk offlay (insurance companies) intergenerational transfer (pensions, life insurance companies, and deposit-taking FIs) payment services (banks, trusts, and credit unions) denomination intermediation (mutual funds, pension funds)

Rationale for Regulation

Relevance of Negative Externalities Failure to provide essential intermediation services, or the breakdown in provision of these services can be costly to both surplus savings economic units and deficit-spending economic units Such failures can have negative implications for the government, social stability and for the standard of living in an economy Financial crisis in one country can have contagion effects in other countries The foregoing negative externalities are the underlying reason for the extra regulatory attention paid to financial institutions. This extra attention gives rise to net regulatory burden (the difference between the private costs of regulations and the private benefits for the producers of financial services)

Types of FI Regulation1. 2. 3. 4. 5. 6.

Safety and soundness regulation Monetary policy regulation Credit allocation regulation Consumer protection regulation Investor protection regulation Entry and chartering regulation

Safety and Soundness RegulationPurpose:To protect depositors and borrowers against the risk of FI failure.

Layers of Protection:1.

2. 3. 4.

Diversification regulation (no more than 10% of a portfolio can be invested in one security/asset) banks cannot have loans exceeding 25% of total equity capital to any one company or borrower. Minimum capital requirements Guaranty funds (CDIC, CIPF) to meet insolvency losses to small claimholders Monitoring and surveillance (OSFI for example)

Monetary Policy Regulation

In classical central bank theory, the central bank can control the quantity of bank deposits (D) using changing reserve requirements (R). Where:

(r) = desired ratio of cash reserves (R) = quantity of bank reserves outstanding

Today, banks in Canada are not subject to reserve requirements however, they are all highly cognizant of the need for liquidity reserves reserves are costly and required reserves are seen as a tax However, the Bank of Canada does stand ready to inject liquidity if necessary to prevent technical insolvency. The Bank of Canada does use moral suasion and through changes in the overnight lending rate, affect the level of short-term interest rates in the country thereby taking preemptive action to try to control inflation.

1 D = R r

Credit Allocation Regulation

Lending to socially important sectors of society such as:

Small business Farming Poor - Housing

Consists of price (maximum rates that can be charged) and quantity restrictions (amount of foreign assets) Canada does not use this type of regulation however, because of the imposition of private costs on our FIs. Canada does take other actions to encourage/support/subsidize lending to important sectors of the economy by creating programs that lower the risk to the FI or by providing the service itself:Government providing the service Business Development Bank of Canada Export Development Canada FedNor Northern Ontario Heritage Fund Government programs to lower the cost to private FIs All of the foregoing government crown corporations and departments work jointly on projects and programs that also involve some private sector involvement either in financing or administration CMHC Student loan programs Government (both federal and provincial programs) guarantees for loans to farming, forestry

Consumer Protection Regulation

2001 Bill C-8 created the Financial Consumer Agency of Canada

Provides consumer information on bank accounts and investment products Examines and imposes fines on FIs that violate consumer protection laws

Privacy laws at the provincial levels Pressure on FIs to:

Provide lending to small business Provide banking services to low-income Canadians

Investor Protection Regulation

Provincial securities acts govern:

Insider trading Information disclosure requirements through prospectus and continuous reporting requirements for seasoned issues

SROs indirectly provide protection, and if they didnt governmen