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8/7/2019 Fin Interm-tion
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Financial Intermediation and
Financial Intermediaries
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Q.:
1. Intermediation and Financial
Intermediaries, its Functions
2. Types of Financial Institutions
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1. Intermediation and Financial
Intermediaries, its Functions� Financial intermediaries channel funds between
borrowers and lenders.
Intermediation transforming assets
± the function of transforming assets or liabilities into
other assets or liabilities
� Liabilities ± deposits
� Assets ± loans
± this is the principal activity of most financial
institutions.
± intermediation improves social welfare by
channeling resources to their most effective use.
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The Functions of Intermediation
� Facilitate the acquisition/payment of goods
&services via lower transactions costs
± Chequing services provided by banks improve economic
efficiency.
� Facilitate the creation of a ³portfolio´
± A portfolio is a collection of financial assets
± The financial system provides economies of scale & scope
� Economies of Scope: cost savings that stem from engaging incomplementary activities.
� Economies of Scale: obtained when the unit cost of an
operation decreases as more of it is done.
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� Ease liquidity constraints
± Reallocate consumption/savings patterns
� Often the liquidity required to make certain purchases is not in line
with the immediate flow of income available to individuals.
± The ability to influence the allocation of consumption and
investment is probably the most important function of
intermediation.
� Provide security
± Intermediation provides a host of services that reduce or shift
risk.
± Financial institutions can also influence the riskiness of financial transactions [contracts and insurance].
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� Reduce asymmetric information problem
Asymmetric information can take on many forms, and is quite
complicated. However, to begin to understand the implicationsof asymmetric information, we will focus on two specific forms:
Adverse selection and Moral hazard
± Moral hazard
� the chance that an individual may have an incentive to act in away such as to put that individual at greater risk; the individualperceives as beneficial actions that are deemed undesirable byanother .
± Adverse selection
� decision making that results from the incentive for some peopleto engage in a transaction that is undesirable to everyone else
± Banks have a comparative advantage in offering specializedservices that help to reduce this problem.
± Banks can also take advantage of this asymmetricinformation problem, with dire consequences.
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Adverse Selection
1.Before transaction occurs
2.Potential borrowers most likely toproduce adverse outcomes are onesmost likely to seek loans and be selected
Moral Hazard
1.After transaction occurs
2.Hazard that borrower has incentives toengage in undesirable (immoral)activities making it more likely that won¶tpay loan back
Financial intermediaries reduce adverse
selection and moral hazard problems, enabling
them to make profits
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The Function of Financial Institutions
� Brokerage an ³agency´
function
± Brokers are agents who bring would-bebuyers and sellers together so transactions
can be made.
Intermediation provides value-added
but there are potential³externalities´. One intermediary¶s
actions can have consequences for
the entire system.
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� Banks are particularly adept at
intermediation because they can
perform the necessary functions
more cheaply than most institutions.� Technological change and
deregulation have narrowed the
comparative advantage of banks.
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Function of Financial Markets1. Allows transfers of funds from
person or business withoutinvestment opportunities to onewho has them
2. Improves economic efficiency
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Indirect finance, which involves the activities
of financial intermediaries, is many times
more important than direct finance, in
which businesses raise funds directly
from lenders in financial markets.
Financial intermediaries, particularly banks,are the most important source of external
funds used to finance businesses.
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2. Types of Financial Institutions
� Deposit-taking (depository institutions) accept and
manage deposits and make loans. These institutions
are divided into banks and other deposit-takinginstitutions (near-banks). Other deposit-taking
institutions:
± Trust companies ± also provide administrative services for
estates and trusts (fiduciaries).
± Credit unions ± these are member owned so that depositorsare also shareholders.
± Mortgage loan companies ± also permit investors to invest
in a portfolio of assets primarily real estate.
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� Insurance Companies and Pension Funds
± Insurance companies provide the means of
channeling savings to provide for unforeseen
expenses by pooling the risks of their
clientele.
± There are also institutions that specialize in
the management of pension plans and funds. Government legislation plays are large role in
dictating how these pensions are
administered.
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� Investment Dealers and Investment Funds
± The plethora of investment funds (mutual funds) pool funds for
investment in a wide range of activities and instruments without
providing the other functions of a typical bank
± Investment dealers primarily underwrite corporate andgovernment securities.
� Government financial institutions
± Deposit-taking role
± Channeling funds from the public to private sector
± Protecting private funds by providing deposit insurance (KDIF).
� Other Intermediaries
± Sales, finance, and consumer loan companies.
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The ³Four-Pillars´
� Chartered banks: personal, commercial loans and
deposits
� Trust companies and credit unions: fiduciary
responsibilities, personal loans and deposits
� Insurance companies: underwriting insurance
contracts.
± Further subdivided into Life Insurers and Property and Casualty
Insurers
� Investment dealers: underwriting and brokering
securities.
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16
Primary Assets and Liabilities of Financial Intermediaries
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Regulation
Two Main Reasons for Regulation
1.Increase information to investorsA. Decreases adverse selection and moral hazard
problemsB. Securities commissions force corporations to
disclose information
2.Ensuring the soundness of financial
intermediariesA. Prevents financial panics
B. Chartering, reporting requirements, restrictionson assets and activities, deposit insurance, andanti-competitive measures
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Key Points
� Intermediation is a central concept
� Financial institutions can be classifiedby type, size, function
� Financial markets can be classified bysize, term, organization, type of assetsissued
� Banks are the most adept at theintermediation function
� Financial systems should strive for efficiency
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Case: Financial Development
andE
conomic Growth� Financial repression leads to low growth
� Why?
1. Poor legal system2. Weak accounting standards
3. Government directs credit (state-owned banks)
4. Financial institutions nationalized
5. Inadequate government regulation
� Financial Crises
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Financial Crises and Aggregate
Economic Activity
Analysis of the affects of adverse selection
and moral hazard can also assist us in
understanding financial crises, major
disruptions in financial markets. Then end
result of most financial crises in the
inability of markets to channel funds from
savers to productive investmentopportunities.
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Financial Crises and Aggregate
Economic Activity
� Factors Causing Financial Crises
1. Increases in Interest Rates
2. Increases in Uncertainty
3. Asset Market Effects on Balance Sheets
� Stock market effects on net worth
� Unanticipated deflation� Cash flow effects
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Financial Crises and Aggregate
Economic Activity
� Factors Causing Financial Crises
4. Problems in the Banking Sector
5. Government Fiscal Imbalances
U.S. Financial Crisis
� The U.S. has a long history of banking
and financial crises, dating back to 1819. � The next figure outlines the events
leading to a financial crisis.
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Case: The Great Depression
� In 1928 and 1929, stock prices doubled in
the U.S. The Fed tried to curb this period
of excessive speculation with a tight
monetary policy. But this lead to a
collapse of more than 60% in October of
1929.
� Further, between 1930 and 1933, one-third of U.S. banks went out of business.
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Case: The Great Depression
� Adverse selection and moral hazard in
credit markets became severe. Firms with
productive uses of funds were unable to
get financing. The prolonged economic
contraction lead to an unemployment rate
around 25%.
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Home task
1. Per capital income in the RK and the
developed countries (3-5 countries).
2.
Financial crises:description and factorsgenerated last crisis.
3. How financial crisis was reflected in
efficiency of financial intermediaries
activity?