FINANCIAL INTERMEDIARIES AND FINANCIAL NNOVATION

Chapter # 2Part 1FINANCIAL INTERMEDIARIES AND FINANCIAL INNOVATIONPurpose of the chapterThe main purpose f this chapter is to introduce financial intermediaries.

Financial intermediaries include: Commercial Banks Savings and loan Associations Investment Companies Insurance Companies Pension Funds Financial InstitutionsBusiness entities include nonfinancial and financial enterprises. Nonfinancial enterprises provide following services:Nonfinancial enterprises manufacture products or provide nonfinancial services

Financial enterprises provide following services:Transforming financial assets acquired through the market and transforming them into different and most widely used asset. This function is performed by financial intermediaries, the most important type of financial institution.Contd..Exchanging the financial asset on behalf of customerExchanging the financial asset on their own accountAssisting in the creation of FA for their customers and then selling those FA to other market participantsProviding investment adviseManaging the portfolios of other market participants

Contd..Financial Intermediaries also include depository institutions (commercial banks, savings and loan associations, savings bank and credit unions) which acquire bulk of the funds of customers by offering their liabilities to them in the forms of deposits; insurance companies; pension funds; and finance companies.

Financial intermediaries also provide services like underwriting.ContdTypically the FI that provide underwriting services also provide brokerage/dealer services.

Some nonfinancial enterprises also have subsidiaries that provide financial services. These FI are also called Captive Finance Companies. For example General Motors acceptance corporation (a subsidiary of GM)

Role of Financial IntermediariesFI obtain funds by issuing financial claims against themselves to market participants and then invest those funds.The investment made by FI can be loan or security. These investments are called direct investment.The participants who hold those financial claims have said to made indirect investment.Example: Commercial Banks, Investment Companies (Pooling of Funds)Contd.. Functions of Financial IntermediariesFI provide four basic functions:Maturity Intermediation: In our example of commercial banks two things should be noticed:

The maturity of at least a portion of the deposits accepted is typically short term. (certain types of deposits are payable on demand and others have specific maturity date, but most are less than two years). Contd..Maturity of the loans made by the commercial banks may be considerably longer than two years.

The commercial bank by issuing it own financial claim in essence transforms a longer-term asset into a shorter-term one by giving the borrower a loan for the length of the time sought and the investor/depositor a FA for the desired investment horizon. This function of Financial Intermediary is called maturity intermediation.Contd..Reducing Risk via Diversification: FI convert more risky funds into less risky funds.

Reducing the costs of contracting and information processing: Investors purchasing FA should take time to develop skills necessary to understand how to evaluate an investment.Once skills are developed, investors should apply those skills to the analysis of specific FA that are candidates for purchase (or subsequent sale).Contd..Investors who want to make a loan to a consumer or business will need to write the loan contract (or hire an attorney to do so).In addition o the opportunity cost of time to process the information about the FA and its issuer, there is cost of acquiring this information. All these costs are called information processing costs. Contd..Providing a payment mechanism: Although most transactions made today are not done with cash. Instead payments are made using checks, credit cards, debit cards, and the electronic transfer of funds. These methods of making payments is called payment mechanisms, are provided by certain financial intermediaries. Part 1 CompletePart 2 Starts below

Overview of Asset/Liability Management for Financial InstitutionsOBJECTIVE:

To know why managers of FI invest in particular types of financial assets and the types of investment strategies they employ.

To know the problem of asset/liability management.Contd..The nature of the liability dictates which strategy is adopted.Depository InstitutionsDepository institutions buy money and sell money. Banks BUY money by borrowing from depositors or other sources of funds.And they SELL money by lending it to businesses and individuals.The difference between the buying and selling value is called SPREAD.The cost of the funds and the return on the funds sold is expressed in terms of interest rate per unit of time. Nature of the LiabilitiesBy liabilities of FI we mean the amount and timing of the cash outlays that must be made to satisfy the contractual terms of the obligations issued.

The liabilities of any FI can be categorized according to four types, mentioned below:

Liability TypeAmount of Cash OutlaysTimings of Cash OutlaysType IKnownKnownType IIKnownUncertainType IIIUncertainKnownType IVUncertainUncertainContd..Type I LiabilitiesBoth the amount and timings are known with certainty.Example: a liability requiring FI to pay $50,000 six months from now will be a good example. (Principal + Interest). Where interest rate is always fixed.

Type I liabilities are not just sold by depository institutions but also by life insurance companies.

EXAMPLE: Life insurance companies have obligation to fulfill under this contract for some of money called PREMIUM, it will guarantee an interest rate up to some specified maturity date.Contd..Type II LiabilitiesIn type II liabilities the amount of the cash outlay is known, but the timings are uncertain.

EXAMPLE: Life insurance policy. (will be discussed in chapter 7).

In this type for an annual premium, a life insurance company agrees to make specified $$ payment to the policy beneficiaries/holders upon the death of the insured. Contd..Type III LiabilitiesIn this type timing of the cash outlay is known but the amount is uncertain. EXAMPLE: FI issue an obligation in which the interest rate adjusts periodically according to some interest rate benchmark.

Depository Institutions issues:CD: Have stated maturity and Interest rate fluctuate over the life of the deposit.

3-years floating rate certificate of deposit: Interest rate adjusts every 3-months and is benchmarked against the Treasury Bill rate plus 1 percentage point. And matures after 3 years.

Contd..Type IV LiabilitiesThere are numerous insurance products and pension obligations that present uncertainty to both the amount and the timings of the cash outlay.

EXAPMPLE: Automobile and home insurance policies in which amount/payment and timings are uncertain.

Also retirement benefits depends on the total number of employment years and this will affect the cash outlay.Contd..Liquidity ConcernsBecause of the uncertainty about the timings and amount of the cash outlays, a FI must be prepared to fulfill/satisfy the financial obligations.EXAMPLE: If the depositor request the withdrawal of the funds prior of the maturity date. The deposit accepting institution will grant this request will take an early withdrawal penalty.

In certain type of investment companies the shareholders have the right to redeem their shares at any time.

Regulations and Taxation: Numerous regulations ad tax considerations influence the investment policies that FI pursue. Financial InnovationCategorization of Financial Innovation: Since 1960s there is significant surge in Financial Innovation. Here are just 3 ways to categorize the innovations suggested by Economic Council of Canada.Market Broadening Instruments: which increase the liquidity of the markets and the availability of the funds by attracting new investors and offering new opportunities for the borrowers. Risk Management Instruments: which relocate financial risk to those who are less averse to them or who have better diversification.Arbitraging Instruments and Processes: which enable the investors and borrowers to take advantage of the differences in cost and return between markets, which reflect differences in the perception of the risk, as well as in information, taxations and regulations. THE END =D