Why Are Financial Why Are Financial Intermediaries Intermediaries

Special?Special?

Chapter 1

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

1-2Why Are Financial Intermediaries Special?

Objectives: Develop the tools needed to measure and

manage the risks of FIs. Explain the special role of FIs in the financial

system and the functions they provide. Explain why the various FIs receive special

regulatory attention. Discuss what makes some FIs more special

than others.

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Without FIs

Corporations

(net borrowers)

Households

(net savers)

Cash

Equity & Debt

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FIs’ Specialness

Without FIs: Low level of fund flows. Information costs:

Economies of scale reduce costs for FIs to screen and monitor borrowers

Less liquidity Substantial price risk

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With FIs

Cash

Households Corporations

Equity & Debt

FI

(Brokers)

FI

(Asset Transformers)

Deposits/Insurance Policies

Cash

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Functions of FIs

Brokerage function Acting as an agent for investors:

e.g. Merrill Lynch, Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings

Asset transformer: Purchase primary securities by selling financial

claims to households• These secondary securities often more marketable• Transformation of financial risk

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Role of FIs in Cost Reduction

Information costs: Investors exposed to Agency Costs

Role of FI as Delegated Monitor (Diamond, 1984)• Shorter term debt contracts easier to monitor than bonds• FI likely to have informational advantage

FI as information producer• Monitoring power and control • Acting as delegated monitor, FIs reduce information

asymmetry between borrowers and lenders

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Specialness of FIs

Liquidity and Price Risk Secondary claims issued by FIs have less price

risk FIs have advantage in diversifying risks

Reduced transaction & information costs economies of scale Bid-ask spreads narrower for assets bought and

sold in large quantities.

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Other Special Services

Maturity intermediation Transmission of monetary policy. Credit allocation (Areas of special need such as

home mortgages). Intergenerational transfers or time

intermediation. Payment services (FedWire and CHIPS). Denomination intermediation.

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Specialness and Regulation

FIs receive special regulatory attention.Reasons: Special services provided by FIs in general. Institution-specific functions such as money

supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks,thrifts), etc.

Negative externalities arise if these services are not provided.

1-11

Regulation of FIs

Important features of regulatory policy: Protect ultimate sources and users of savings.

Including prevention of unfair practices such as redlining and other discriminatory actions.

Primary role:

Ensure soundness of the system as a whole. Regulation is not costless

Net regulatory burden.

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Regulation

Safety and soundness regulation: Regulations to increase diversification

No more than 10 percent of equity to single borrower Minimum capital requirements Guaranty funds:

Deposit insurance fund (DIF): Securities Investors Protection Fund (SIPC)

Monitoring and surveillance. FDIC monitors and regulates DIF participants.

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Web Resources

For information on regulation of depository institutions and investment firms visit:

FDIC www.fdic.gov

SIPC www.sipc.org

Federal Reserve www.federalreserve.gov

1-14

Regulation

Monetary policy regulation Federal Reserve directly controls outside

money. Bulk of money supply is inside money

(deposits). Reserve requirements facilitate transmission of

monetary policy.

1-15

Regulation

Credit allocation regulation Supports socially important sectors such as

housing and farming. Requirements for minimum amounts of assets in a

particular sector or maximum interest rates or fees. Qualified Thrift Lender Test (QTL)

• 65 percent of assets in residential mortgages

Usury laws and Regulation Q (abolished)

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Regulation

Consumer protection regulation Community Reinvestment Act (CRA). Home Mortgage Disclosure Act (HMDA).

Effect on net regulatory burden FFIEC processed info on as many as 31 million

mortgage transactions in 2006. Potential extensions of regulations such as

CRA to other FIs such as insurance companies in light of consolidation and trend toward universal banking.

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Regulation

Investor protection regulation Protections against abuses such as insider

trading, lack of disclosure, malfeasance, breach of fiduciary responsibility.

Key legislation Securities Acts of 1933, 1934. Investment Company Act of 1940.

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Regulation

Entry regulation Level of entry impediments affects profitability

and value of charter. Regulations define scope of permitted activities.

Financial Services Modernization Act of 1999. Affects charter value and size of net regulatory

burden.

1-19

Web Resources

For more information on regulation of depository institutions visit:

www.ffiec.gov

www.federalreserve.gov

www.fdic.gov

www.occ.treas.gov

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Changing Dynamics of Specialness

Trends in the United States Decline in share of depository institutions. Increases in investment companies. May be attributable to net regulatory burden

imposed on depository FIs. Financial Services Modernization Act

Ethics issues and weakening of public trust

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Future Trends

Further weakening of public trust and confidence in FIs may encourage disintermediation

Increased merger activity within and across sectors Citicorp and Travelers, UBS and Paine Webber More large scale mergers such as J.P. Morgan

and Chase, and Bank One Growth in Online Trading Amendment of SEC 144A

Private placement market effects

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Equity Trading on the Internet

1-23

Global Issues

Increased competition from foreign FIs at home and abroad

Mergers involving world’s largest banks Mergers blending together previously

separate financial services sectors

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World’s Largest Banks ($Billions)

Bank Assets Barclays Bank (UK) 1,591.5UBS (Switzerland) 1,567.6Mitsubishi UFJ (Japan) 1,508.5HSBC Holdings (UK) 1,502.0Citigroup (USA) 1,494.0BNP Paribas (France) 1,484.1Credit Agricole Groupe (France) 1,380.6Royal Bank of Scotland (UK) 1,337.5Bank of America (USA) 1,291.8

1-25

Pertinent Websites

The Banker

Federal Reserve

FDIC

FFIEC

Investment Co. Institute

OCC

SEC

SIPC

Wall Street Journal

Thompson Fin. Sec. Data

www.thebanker.com

www.federalreserve.gov

www.fdic.gov

www.ffiec.gov

www.ici.com

www.occ.treas.gov

www.sec.gov

www.sipc.org

www.wsj.com

www.thompson.com