Financial Institutions

1
Financial Institutions

• Where does financial institutions fit in?
• one of three main sub-fields of finance
• Investments
• how do those with excess financial capital decide
  how to allocate it?
• Corporate
• how do those with need for financial capital
  determine that need and procure it?
• Financial Institutions
• the environment in which those who have and those
  who need financial capital interact
• efficiency is key low cost, high flexibility,
  good matching of needs

2
Financial Institutions

• What is a financial institution?
• if were going to talk about managing them, wed
  better know what they are.
• Corn economy
• everyone has a plot of land and grows corn
• eat some and save some for planting next year
• leads to all sorts of specializations (make
  plows, etc.)
• potential investors (savers) excess corn at the
  end of the year
• exceeds consumption needs and investment capacity
• potential borrowers not enough corn to eat and
  plant
• not enough for consumption needs and investment
  opportunities

3
Financial Institutions

• Borrowing and Lending
• debt contract
• size of loan, terms, etc.
• credit risk
• why does the borrower need corn, unlucky or lazy?
• what will the borrower do with the loan, plant it
  or eat it?
• matching problem
• time consuming (time money)
• financial market
• everyone meet in this field, on this date, at
  this time
• market charges set up and admission fees to
  survive
• may provide standardized or model contracts
• financial intermediary
• specialist in making credit decisions
• borrows from savers and lends to borrowers

4
Financial Markets Brokers

• financial markets
• bring investors (savers) and borrowers together
  for a fee
• no ongoing relationship with either side
• examples
• stock markets
• real estate agents
• investment bankers
• underwriting
• MA assistance

loan funds
SAVERS
BORROWERS
repay loan
Financial Market Place to Meet
5
Financial Intermediaries

• financial intermediaries
• borrow from savers lend to borrowers
• meet specific (often different) needs of each
  side
• maintain ongoing contractual relationship
• earn spread (net of credit losses)
• examples banks, insurance companies, pension
  funds

lend
lend
SAVERS
BORROWERS
Financial Intermediary
borrow
borrow
6
Identifying Financial Intermediaries

• Balance Sheet Test
• Assets Liabilities Equity
• Balance sheet identity
• typical firm
• assets mostly productive PPE
• liabilities debt instruments
• financial intermediary
• assets mostly debt instruments
• liabilities debt instruments
• tend to very highly leveraged (high D/E ratio)

7
Specialness of Financial Intermediaries

• Asset Transformation
• assets and liabilities of FI have different
  structures
• maturity intermediation
• bank converts checking accounts into car loans
• denomination intermediation
• money market fund converts 100,000 T-bills into
  500 accounts
• diversification
• SP 500 index fund allows a 1,000 investment to
  be fully diversified
• liquidity enhancement
• traditional bank invests in illiquid assets (car
  loans, CI loans, mortgages) and produces liquid
  checking accounts
• contingency intermediation (risk pooling)
• what insurers (PC and life) do

8
Specialness of Financial Intermediaries

• Credit allocation decisions
• specialized knowledge and systems
• who gets loans? (key to economic growth)
• Information production
• byproduct of credit allocation decision
• available to all observers
• Monetary policy conduit
• fiscal policy tax spend
• monetary policy interest rates and money supply
• Fed has little control over market interest rates
• banks react to Fed targets voluntary, but based
  on self-interest

9
Trends in Financial Services Industry

• Disintermediation
• Replacement of financial intermediaries with
  (more) direct lending
• Examples
• mortgage broker replaces bank/SL
• junk bond market replaces bank loans
• defined contribution retirement plan replaces
  defined benefit plan
• Driven by growth of
• asset backed securities
• mutual funds
• Consolidation
• thousands of fewer banks, insurance companies
• removal of limitations on cross-industry
  activities (banks offer insurance, insurance
  companies run banks, etc.)

10
Size/Growth of Financial Institutions