Transcript Slide 1

Chapter 4
FINANCIAL
INTERMEDIATION
©Thomson/South-Western 2006
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The Economic Basis For Financial
Intermediation
Borrowers require money to get businesses started.
Savers seek a place for their money to grow.
Intermediators (either directly or indirectly) help both
parties by getting the available money from savers to
borrowers.
Money
S
Money
S
S
S
S
B
B
B
Intermediaries
B
B
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Risks and Costs in the Absence of
Intermediation
Asymmetric information:
Borrowers have information about
their activities and prospects that
they do not disclose to lenders.
Asymmetric information gives rise to two
problems:
adverse selection
moral hazard
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Risks and Costs in the Absence of
Intermediation
Adverse Selection
Condition in which people who are most undesirable from
the other party’s viewpoint are the ones most likely to
seek to engage in a transaction.
Moral Hazard
Risk that one party to a transaction will undertake
activities that are undesirable from the other’s party
viewpoint.
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How Intermediation Helps
Financial intermediaries:
have superior ability to deal with asymmetric
information and the associated problems of
adverse selection and moral hazard;
specialize in assessing the credit risks of
prospective borrowers;
have access to such private information
are better equipped to monitor borrowers’
activities after the loan is made.
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Transactions Costs
Transactions costs: money and time spent carrying
out financial transactions
Costs associated with asymmetric information
By pooling funds, financial intermediaries can exploit
economies of scale.
By reducing transactions costs, financial
intermediaries benefit both savers and deficit
spenders.
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Benefits of Intermediation
Benefits to Savers
From savers’ viewpoint, financial intermediaries pool
thousands of individuals’ funds and can overcome certain
obstacles that stop savers from purchasing primary claims
directly.
Allows individual savers to diversify
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Benefits of Intermediation
Benefits to Deficit Units
From borrowers/spenders’ perspective, financial
intermediaries broaden the range of instruments,
denominations, and maturities that an institution is
able to issue, borrowing costs  – borrowers can tailor
instruments to best fit their needs.
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Classification & Growth Of Financial
Intermediaries
Financial Intermediaries issue (secondary) claims against
themselves to the public in order to obtain funds with which to
purchase (primary) claims issued by deficit-spending units.
Three categories:
1. depository institutions,
2. contractual savings institutions,
3. investment-type intermediaries.
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Table 4-1
1
2
3
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Table 4-1
1
2
3
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1. Depository Institutions
Types
They:
1.1 Commercial banks
1.2 Savings & loan
associations
1.3 Mutual savings banks
1.4 Credit unions
issue checking, savings,
and time deposits;
use the funds obtained to
make various types of
loans and to purchase
securities.
Deposits issued by these institutions have no market risk
because the principal does not fluctuate in nominal value.
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Figure 4-1
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1.1 Commercial Banks.
Commercial banks are the largest and most
important of all financial intermediaries.
Assets (uses of funds)
mortgages,
government securities,
business (commercial)
loans,
consumer loans
Liabilities (sources of
funds)
demand deposits,
savings accounts,
time deposits.
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1.2 Savings & Loan Associations (S & Ls)
S&Ls were first formed on the East Coast in the 1830s by
groups of people seeking to foster home ownership.
Individuals would pool their savings and make loans to a few
members to finance the purchase of a few homes.
The federal government established the Federal Housing
Administration to insure mortgages, and to encourage the
issue of amortized mortgages through S&Ls.
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Other Institutions
1.3 Mutual Savings Banks (MSBs)
encourage working class employees to save
1.4 Credit Unions (CUs)
not-for-profits
for members
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Table 4-1
1
2
3
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2. Contractual Savings Institutions
2.1 Insurance companies
Life insurance
Non-Life insurance
2.2 Private pension funds
2.3 State & local government retirement funds
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2.1 Life Insurance Companies
Life insurance companies:
Issue policies to customers
Collect premiums as a continuing source of funds
Invest > two-thirds of the funds in corporate bonds and
equities
Typically regulated by the state insurance commissioner.
Life insurance policies:
have a specified cash surrender value--policyholders can
obtain that cash on request.
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2.2 Fire & Casualty Insurance
Companies
Fire and casualty insurance companies sell protection against
loss resulting from fire, theft, accident, natural disaster,
malpractice suits, and other events.
They obtain funds from:
premiums,
retained earnings, and
new stock share issues.
Property losses are more difficult to predict, so fire and
casualty companies’ assets must be more liquid than life
insurance companies’ assets.
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2.3 Private Pension Funds & Government
Retirement Funds
Pension funds manage portfolios more efficiently
than individuals by providing:
financial expertise,
economies of scale,
reduced transactions costs, and
diversification.
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2.3 Private Pension Funds & Government
Retirement Funds
The U.S. tax code encourages pension plans--income
is nontaxable until retirement.
Employers withhold the funds from workers'
paychecks and send them to a pension fund.
The retirement fund invests the contributions in
corporate stocks, bonds and U.S. government
bonds.
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Table 4-1
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2
3
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3. Investment-Type Financial Intermediaries
3.1 Mutual funds
3.2 Finance companies
3.3 Money market mutual funds
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3. Investment-Type Financial Intermediaries
3.1 Mutual funds
Funds seek to maximize various goals (growth, income, etc.)
Funds specialize in industries (tech, health, etc.)
- Open-end: can sell shares back or buy more shares
from to Mutual Fund company @ NAV
- No load fund: pay annual fee
- Load fund: pay up-front fee
- Close-end: sell shares in the market @ market price
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3. Investment-Type Financial Intermediaries
3.2 Finance companies
sales finance companies
consumer finance companies
business finance companies
3.3 Money market mutual funds
same as mutual funds but short-term
invest in highly liquid assets
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3. Investment-Type Financial Intermediaries
These intermediaries provide:
low transactions costs,
the financial expertise & experience supplied by
mutual fund management,
increased diversification relative to that feasible
for a typical individual.
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