Class1 Intro Why Are FIs Special

Financial Institutions, J. Sedunov

Introduction to Financial Institutions*


*FIs provide a conduit to channel funds from savers to borrowers

Savers: entities with a surplus of fundsBorrowers: entities with a deficit of funds


This course is about:

The role that the financial institutions play in channeling funds from savers to borrowers

How financial institutions profit from filling this role

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Why study financial institutions instead of auto manufactures or healthcare providers?

What is special about the services they provide?*SaversBorrower


Why study financial institutions instead of auto manufactures or healthcare providers?

What is special about the services they provide?*SaversBuy Financial AssetsBorrowerBuy Real Assets


Consider a world without Financial Institutions

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Ideal World: Investors are perfectly informed they know everything about the company and its actionsInformation is costless There are no market frictions liquidity, transaction costsThere would probably be no need for FIs

Do we live in an ideal world?Investors are never perfectly informedInformation is costlyThere are costs associated with investing (market frictions)

Without FIs: Low level of fund flows!*


Real World: In reality investors face three types of costs when directly lending to companies

Information Costs (Monitoring Costs)

Liquidity Risk

Price Risk

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Adverse Selection Companies who are always in need of money are usually companies who make poor investments and continuously lose moneyPrior to purchasing a firms equity or lending to the firm, individuals must incur costs to investigate the firms quality.If not, they are likely to lend to the poorest (adverse) quality firms.

Moral Hazard A company takes on excessive risk because managers (equity holders) are compensated for good outcomes but they do not bear the full losses for bad outcomes (agency cost!).After a company receives a loan, managers may elect to invest in a riskier project than what was agreed on.Investors can try to monitor the firms actions Monitoring is very costlyFree rider problem*Prior to investingAfter Investing


How can investors reduce information risk? Screening reduces adverse selectionMonitoring reduces moral hazard

Will individual investors screen and monitor?

Why Not?There is a free rider problem

*Not Likely!


Investment Project:Everyone gives me $100I am going to invest in stocks and alternative investments Every Saturday night at 10:00 pm we will meet here and discuss the investment allocation and portfolio performance

How many people plan to attend all the meetings?

Ideally, would you want everyone to screen and monitor?No, it is inefficient ideally the screening and monitoring costs will be incurred one time. If everyone screens and monitors these costs will be incurred several times

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Moral Hazard Adverse Selection

Who was facing the risk?

How were they managing it?(Agency Costs and Delegated Monitor)*


If FIs didnt exist there would be no secondary market for companies debt or equity

There would be no easy way to convert securities to cash investors would have to wait for them to mature

Investors who plan to use the money in the near future would have to hold cash*


If investors could sell securities in a market without FIs, they would not likely get the full value of their securities

Transaction Costs:The price of taking out an advertisementThe price of listing on an exchange Delivery costs

Supply and demand:The buyer may not want to purchase the security as much as the seller needs to sell it*


Conclusion:

Without FIs funds would flow slowly from households to businesses because of:

Information costs Liquidity risk Price Risk*


Now Lets Put FIs Back Into the Economy*


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Asset Transformer

CashDeposits/Insurance PoliciesEquity & DebtCash


FIs act as agents for savers - Perform 2 services

Transaction ServicesPurchase or sell securities for a commission or fee

Information ServicesResearch Securities Provide Recommendations

Reduce costs through economies of scale (lower costs by expanding output)Fixed costs (exchange membership) are spread out over more transactionsCost per trade is lower bulk discount or standardization

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Purchase Primary Securities (stocks, bonds) from firms and sell Secondary Securities (transformed assets) to individuals.

Secondary Assets (Transformed Assets) Certificates of depositInsurance claims Mutual funds

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Reduces Information Costs Due DiligenceDelegated Monitoring

Reduce Liquidity Risk

Reduce Price Risk*


FIs specialize in doing due diligence Collecting information prior to investing.Example Does this reduce adverse selection or moral hazard?

FIs are appointed delegated monitoring watches over the borrower, their actions and how they performExample Does this reduce adverse selection or moral hazard?

Where does the cost reduction come from?Investors now share the cost of collecting information Example: Bloomberg Subscription Secondary securities that the bank creates, are easier to monitorExample: Bank loans, are shorter term and have covenants allow for more frequent updating of information as firms refinance their loans

* An asset manager investigates a companies prior to investing Bank Loan


FIs specialize in engineering securities to have desirable properties.

Increase Liquidity: Deposit contracts can be withdrawn immediatelyThey pay a higher interest rate than holding cash because banks finance these accounts using longer-term mortgages with higher rates. Banks are better able to bear the risk of mismatching maturities of their assets and liabilities (e.g. long maturity assets vs. demand deposits)Mutual funds easier to trade than a individual asset

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Through diversification:

Asset diversification: FIs offer investors shares in diversified portfolios (mutual funds). The portfolio and thus the price of its shares are less exposed to fluctuations in the price of any individual asset.

Claim diversification: Insurance companies pool different types of risk faced by individuals to offer claims that are contingent on certain events.

Through a decrease in transaction costs

It cost less for an investor to buy shares in a mutual fund than to buy all the assets in a portfolio.


FIs add value by reducingInformation RiskLiquidity RiskPrice Risk

Through their roles as:Brokers Asset Transformers*


Transmission of monetary policyBanks control deposits, which are a large part of the money supply. Therefore, FI activity can affect inflation

Credit AllocationFIs are the main and sometimes only source of financing for some sectors of the economy (residential real estate, farming)

Intergenerational wealth transferLife insurance, trusts, pension funds allow savers to transfer wealth across generations.

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Payment Services Without the payment services that DIs provide (ATMs, checking, wire transfer), it would be very difficult to conduct business. Denomination IntermediationSome assets trade in large amounts (commercial paper $250,000; Negotiable CD $100,000). FIs give small investors access to these assets by selling shares of a portfolio.

Maturity IntermediationFIs are in the business of collecting short term deposits and pooling them to issue long-term loans (mortgages)Long-term loans have higher interest rates and generate profit for the bank FIs hold a fraction of the deposits in reserve to satisfy depositor liquidity needs*


Safety and soundness regulationMeant to enhance FI stability include: diversification requirements, guaranty funds, monitoring and surveillance, equity capital requirements

Monetary policy regulationRegulations meant to ensure that monetary policies can be transmitted through FIs quantitative easing or reserve requirements

Credit allocation regulationProvide special treatment for certain sectors to ensure that financing is available (farming )

Consumer protection regulationRegulations to prevent discriminatory lending practices

Investor protection regulationReduce moral hazard problem insider trading, lack of disclosure

Entry and charter regulationLimits the entry of new FIs through charting by state or federal agencies *


FIs allow funds to easily flow from savers to borrowers FIs reduce Information riskLiquidity riskPrice risk

They reduce risks through their roles as brokers and asset transformers

FIs also providePayment services Denomination IntermediationMaturity Intermediation

Because they are special FIs are subject to special regulation

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*******How dose it help investors reduces information costs, reduces transaction costs***How is a bank loan an example of delegated monitoring? Individuals give their funds to a bank in exchange for a deposit account and the bank makes a loan to the firm using the collection of funds plus its own equity.

As a larger stake holder, the bank has greater incentives to monitor the firm. It also incurs lower due diligence and monitoring costs

Example Bloomberg: Bloomberg costs $2,000 per month An individual investor can buy a subscription and might trade 1,000 shares in a month cost = 2 per shareInstitutional investor can buy a subscription maybe they make 100,000 trades per month cost - $.02 per share ***Safety and soundness regulationDiversification: FI can not lend more that a certain fraction of their equity capital to a single borrower. This limits their exposure to the fallout of a single borrower.Guaranty funds: FIs pay into various insurance funds (FDIC depository fund) which protect investors against losses should the FI failMonitoring and Surveillance: various government agencies monitor the activities of Fis

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Documents

Class1 Intro Why Are FIs Special