The Nature of Financial Intermediation

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The Nature of Financial Intermediation

• Business 4039

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Key Concepts

• Pivotal role of banks and other deposit-taking
  FIs
• Rapid pace of change in markets, technologies and
  non-bank competition
• Information costs are responsible for emergence
  of financial intermediaries
• Financial intermediaries deal with
• Search
• Verification
• Monitoring
• Enforcement costs.

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Important Terms Defined

• Liquidity and funding risk
• The threat of insufficient liquidity on the part
  of the bank for normal operating requirements
• Settlement/payment risk
• Is created when one party to a deal pays money or
  delivers assets before receiving its own cash or
  assets, hence exposing itself to a potential loss
  and interest rate risk.
• Interest rate risk
• The risk that arises from mismatches in both the
  volume and maturity of interest-sensitive assets,
  liabilities and off-balance sheet items
• Market or price risk
• The exposure of banks to losses due to market or
  price fluctuations in well-defined markets
• Foreign exchange or currency risk
• The exposure of banks to fluctuations in foreign
  exchange rates that affect positions held in a
  particular currency for a customer or the bank.
• Sovereign risk
• In which the political or economic conditions in
  a particular country threaten to interrupt
  repayment of loans or other debt obligations
• Operating risk
• Arising from losses caused by fraud, failure of
  internal control, or unexpected expenses, as in
  the case of lawsuits.

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Financial Intermediation

• Information is the underlying, core reason for
  the existence of financial intermediaries.
• Borrowers do not have the means to search out and
  contract with lenders. Even if they do, it is
  an expensive and time consuming and unsystematic
  process that can be prohibitively expensive.
• This situation does existfor example in the case
  of angel capital.

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Financial Intermediaries

• There are many types of financial intermediaries
  that have evolved over time
• Deposit-taking financial intermediaries
• Banks /Trust companies
• Credit unions
• Non-depositor
• Life and PC insurance companies
• Investment dealers
• Finance Companies
• Other
• Mutual funds

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Uniqueness Recognized

• One of the themes dominating FI organization in
  Canada is the degree to which the specialness of
  Fis should be enshrined in law and regulatory
  practice.
• The end result is that financial institutions are
  among the most heavily regulated and heavily
  taxed organizations in our society.
• You are encouraged to follow the current debates
  on this topic in the financial press. Look for
• deposit taking FI regulation
• insurance company regulation
• securities industry regulation
• Bank of Canada policy concerning FIs
• CDIC policy concerning FIs
• Regulatory activities of liability insurers
• international coordination of FI regulation
• Role of OSFI in supervision

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Intermediation Services of FIs

• risk transfer, reduction, and monitoring services
• liquidity services
• maturity intermediation services
• transaction services
• financial information services
• denomination intermediation (mutual funds)

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Deficit-Saving Economic Unit
Surplus-Saving Economic Unit

• Borrowers
• borrow large sums
  (mortgages/commercial/ personal loans)
• for long periods of time
• complex legal transactions because of the
  long-term nature of the debt contracts and the
  need to contractually ensure that the interests
  of the lender are protected.

• Savers
• many of them saving small amounts individually,
  but large amounts in aggregate
• for short periods of time (ie. Need liquidity)
• are generally risk averse
• dont have the capacity, time or sophistication
  to analyze risk or to monitor borrowers

Deposit-taking Financial Intermediary
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Deficit-Saving Economic Unit
Surplus-Saving Economic Unit
Deposit-taking Financial Intermediary

• Deposit-taking FIs
• pool deposits, provide liquidity for depositors,
  collect/analyze/monitor the financial
  positions/activities of borrowers, make credit
  allocation decisions among opportunities to
  lend/invest, negotiate/monitor/enforce loan
  agreements.
• In this manner the need of both savers and
  borrowers are met with efficiency. In the
  absence of FIs failure, confidence in the system
  is built and this encourages full participation,
  thereby reducing monetary leakage.currency in
  circulation is made available for the best
  competing uses in our society.

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Price Risk

• the risk that the sale price of an asset will be
  lower than its purchase price.

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Secondary Claims

• example demand deposit in a deposit-taking FI
• it is a financial asset that has characteristics
  far different than primary securities (bonds,
  stocks, commercial loans) gt often improved
  liquidity/safety of principal, etc.

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Maturity Intermediation

• a service performed by deposit-taking FIs for
  secondary asset holders (depositors)....because
  of pooling and diversification....
• mismatching the maturities of assets and
  liabilities of the FI.

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Securitization

• The creation of a marketable financial asset
  through financial innovationof otherwise
  illiquid financial assets
• Eg. MBSs

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Economies of Scale

• FIs provide potential economies of scale in
  transactions costs...information collection and
  risk management.

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Institutional Aspects of Special-ness

• money supply transmission (banks)
• credit allocation (banks, trusts, credit unions,
  and finance companies)
• risk offlay (insurance companies)
• intergenerational transfer (pensions, life
  insurance companies, and deposit-taking FIs)
• payment services (banks, trusts, and credit
  unions)
• denomination intermediation (mutual funds,
  pension funds)

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Rationale for Regulation

• Relevance of Negative Externalities
• Failure to provide essential intermediation
  services, or the breakdown in provision of these
  services can be costly to both surplus savings
  economic units and deficit-spending economic
  units
• Such failures can have negative implications for
  the government, social stability and for the
  standard of living in an economy
• Financial crisis in one country can have
  contagion effects in other countries
• The foregoing negative externalities are the
  underlying reason for the extra regulatory
  attention paid to financial institutions.
• This extra attention gives rise to net regulatory
  burden (the difference between the private costs
  of regulations and the private benefits for the
  producers of financial services)

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Types of FI Regulation

• Safety and soundness regulation
• Monetary policy regulation
• Credit allocation regulation
• Consumer protection regulation
• Investor protection regulation
• Entry and chartering regulation

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Safety and Soundness Regulation

• Purpose
• To protect depositors and borrowers against the
  risk of FI failure.
• Layers of Protection
• Diversification regulation (no more than 10 of a
  portfolio can be invested in one security/asset)
  banks cannot have loans exceeding 25 of total
  equity capital to any one company or borrower.
• Minimum capital requirements
• Guaranty funds (CDIC, CIPF) to meet insolvency
  losses to small claimholders
• Monitoring and surveillance (OSFI for example)

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Monetary Policy Regulation

• In classical central bank theory, the central
  bank can control the quantity of bank deposits
  (D) using changing reserve requirements (R).
• Where
• (r) desired ratio of cash reserves
• (R) quantity of bank reserves outstanding
• Today, banks in Canada are not subject to reserve
  requirements however, they are all highly
  cognizant of the need for liquidity reserves
  reserves are costly and required reserves are
  seen as a tax
• However, the Bank of Canada does stand ready to
  inject liquidity if necessary to prevent
  technical insolvency.
• The Bank of Canada does use moral suasion and
  through changes in the overnight lending rate,
  affect the level of short-term interest rates in
  the country thereby taking preemptive action to
  try to control inflation.

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Credit Allocation Regulation

• Lending to socially important sectors of society
  such as
• Small business
• Farming
• Poor - Housing
• Consists of price (maximum rates that can be
  charged) and quantity restrictions (amount of
  foreign assets)
• Canada does not use this type of regulation
  however, because of the imposition of private
  costs on our FIs.
• Canada does take other actions to
  encourage/support/subsidize lending to important
  sectors of the economy by creating programs that
  lower the risk to the FI or by providing the
  service itself
• Government providing the service
• Business Development Bank of Canada
• Export Development Canada
• FedNor
• Northern Ontario Heritage Fund
• Government programs to lower the cost to private
  FIs
• All of the foregoing government crown
  corporations and departments work jointly on
  projects and programs that also involve some
  private sector involvement either in financing or
  administration
• CMHC
• Student loan programs
• Government (both federal and provincial programs)
  guarantees for loans to farming, forestry

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Consumer Protection Regulation

• 2001 Bill C-8 created the Financial Consumer
  Agency of Canada
• Provides consumer information on bank accounts
  and investment products
• Examines and imposes fines on FIs that violate
  consumer protection laws
• Privacy laws at the provincial levels
• Pressure on FIs to
• Provide lending to small business
• Provide banking services to low-income Canadians

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Investor Protection Regulation

• Provincial securities acts govern
• Insider trading
• Information disclosure requirements through
  prospectus and continuous reporting requirements
  for seasoned issues
• SROs indirectly provide protection, and if they
  didnt government would step in to impose
  regulation
• Know-your client rules and enforcement of other
  types of compliance

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Trends in Canada

• Gradual movement to universal banking through
  increasingly permissive regulations and
  competitive/strategy moves over time by FIs
• More frequent review and renewal of governing
  legislation including deregulation and an
  increasingly welcoming environment for foreign
  FIs
• Leveling of the playing field through uniform
  requirements for banks and insurance companies
• Access to the payment system extended beyond
  banks to life insurance and underwriting firms
• Incentives for credit union merger and growth
• Continuing limits on chartered banks to sell
  insurance through branches (except for credit
  insurance) and retail consumer leasing
• Completion of the demutualization process for
  life insurers giving these key FIs (SunLife,
  Canada Life, Mutual Life (Clarica)) access to
  capital
• Extension of products lines by Investment Dealers
  and Insurance Companies into savings products,
  chequing products, wrap accounts, etc.
• Continued develop of fee-based income
  (off-the-balance sheet) sources of income for
  banks
• Continued pursuit of international presence by
  Canadian banks
• Consolidation (merger) in the life insurance
  sector
• Takeover of other pillars by banks (TD took over
  Central Guaranty Trust in 1992 and Canada Trust
  in 2000) and all banks have a brokerage arm since
  the 1980s (RBC, CIBC Wood Gundy, etc)

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Entry Regulation

• Chartering/federally-licensing for business,
  banks Bank Act
• Minimum requirements to create FIs.

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Chapter 1The Nature of Financial Intermediation

• Problem Solutions

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Saunders Questions Chapter 1Question 1

• Identify and briefly explain the five risks
  common to financial institutions.
• Default or credit risk of assets
• Interest rate risk caused by maturity mismatches
  between assets and liabilities
• Liability withdrawal or liquidity risk
• Underwriting risk
• Operating cost risk

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Saunders Questions Chapter 1Question 2

• Explain how economic transactions between
  household savers of funds and corporate users of
  fund would occur in a world without financial
  intermediaries.
• Without FIs the users of corporate funds would
  have to approach directly (find/search) the
  household savers of funds in order to satisfy
  their borrowing needs.
• This would be extremely costly and inefficient
  because of the up-front information costs faced
  by potential lenders.
• Cost inefficiencies would arise with the
  identification of potential borrowers, the
  pooling of small savings into loans of sufficient
  size to finance corporate activities, and the
  assessment of risk and investment opportunities
• Lenders would have to monitor the activities of
  borrowers over each loans life span.
• The net result would be an imperfect allocation
  of resources in an economy.

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Saunders Questions Chapter 1Question 3

• Identify and explain three economic
  disincentives that probably would dampen the flow
  of funds between household savers of funds and
  corporate users of funds in an economic world
  without financial intermediaries.
• Investors are generally averse to purchasing
  securities directly because of
• Monitoring costs
• Liquidity costs
• Price risk
• Monitoring the activities of borrowers requires
  extensive time, expense, and expertise.as a
  result, households would prefer to leave this
  activity to others, and by definition, the
  resulting lack of monitoring would increase the
  riskiness of investing in corporate debt and
  equity markets.
• The long-term nature of corporate equity and debt
  would likely eliminate at least a portion of
  those households willing to lend money, as the
  preference of many for near-cash liquidity would
  dominate the extra returns which may be
  available.
• The price risk of transactions on the secondary
  markets would increase without the information
  flows and services generated by high volume.

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Saunders Questions Chapter 1Question 4

• Identify and explain the two functions in which
  FIs may specialize that enable the smooth flow of
  funds from household savers to corporate users.
• FIs serve as conduits between users and savers of
  funds by providing a brokerage function and by in
  engaging in asset transformation function.
• Brokerage Function
• Can benefit both savers and users of funds and
  can vary according to the firm.
• FIs may provide only transaction services, such
  as discount brokerage, or they may also offer
  advisory services which help reduce information
  costs.

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Saunders Questions Chapter 1Question 4

• Identify and explain the two functions in which
  FIs may specialize that enable the smooth flow of
  funds from household savers to corporate users.
• FIs serve as conduits between users and savers of
  funds by providing a brokerage function and by in
  engaging in asset transformation function.
• Asset Transformation Function
• Is accomplished by issuing their own securities,
  such as deposits and insurance policies that are
  more attractive to household savers, and using
  the proceeds to purchase primary securities of
  corporations.
• FIs thus, take on the costs associated with the
  purchase of securities.

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Saunders Questions Chapter 1Question 5

• In what sense are the financial claims of FIs
  considered secondary securities, while the
  financial claims of commercial corporations are
  considered primary securities? How does the
  transformation process, or intermediation, reduce
  the risk, or economic disincentives, to the
  savers?
• Primary securities
• The funds raised by the financial claims issued
  by commercial corporations are used to invest in
  real assets.
• These financial claims, which are considered
  primary securities, are purchased by FIs whose
  financial claims therefore are considered
  secondary securities.
• Secondary securities
• Savers who invest in the financial claims of FIs
  are indirectly investing in the primary
  securities of commercial corporations.
• However, the information gathering and evaluation
  expenses, monitoring expenses, liquidity costs,
  and price risk of placing the investments
  directly with the commercial corporation are
  reduced because of the efficiencies of the FI

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Saunders Questions Chapter 1Question 6

• Explain how financial institutions act as
  delegated monitors.
• Delegated Monitor
• Depositors of excess funds in FIs give FIs the
  responsibility of deciding who should receive the
  money and of ensuring that the money is utilized
  properly by the borrower.
• In this sense, the depositors have delegated the
  FI to act as a monitor on their behalf.
• FI Economies as a Delegated Monitor and Overall
  Benefits
• The FI can collect information more efficiently
  than individual investors
• FIs can use this information to create new
  products, such as commercial loans, that
  continually update the information pool.
• This more frequent monitoring process sends
  important information signals to other
  participants in the market, a process that
  reduces imperfection and asymmetry between the
  ultimate sources and users of funds in the
  economy.

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Saunders Questions Chapter 1Question 7

• What are the five general areas of FI
  specialness that are caused by providing various
  services to sectors of the economy?
• FI Specialness
• FIs collect and process information more
  efficiently than individual savers
• FIs provide secondary claims to household savers
  which often have better liquidity characteristics
  than primary securities such as equities and
  bonds.
• By diversifying the asset base FIs provide
  economies of scale in transaction costs because
  assets are purchased in larger amounts.
• FIs provide maturity intermediation to the
  economy which allows the introduction of
  additional types of investment contracts, such as
  mortgage loans, that are financed with short-term
  deposits.

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Saunders Questions Chapter 1Question 8

• How do FIs solve the information and related
  agency costs when household savers invest
  directly in securities issued by corporations?
  What are agency costs?
• Agency Costs
• Agency costs arise because of the possibility
  that owners and managers may take actions that
  are not in the best interests of the equity
  investor or lender.
• These costs typically result from the failure to
  adequately monitor the activities of the
  borrower.
• If no other lender performs these tasks, the
  lender is subject to agency costs as the borrower
  may not satisfy the covenants in the lending
  agreement.
• Because the FI invests the funds of many small
  savers, the FI has a greater incentive to collect
  information and monitor the activities of the
  borrower.

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Saunders Questions Chapter 1Question 9

• What often is the benefit to the lenders,
  borrowers, and financial markets in general of
  the solution to the information problem provided
  by the large financial institutions?
• One benefit to the solution process is the
  development of new secondary securities that
  allow even further improvements in the monitoring
  process.
• An example is the bank loan that is renewed more
  quickly than long-term debt.
• The renewal process updates the financial and
  operating information of the firm more
  frequently, thereby reducing the need for
  restrictive bond covenants that may be difficult
  and costly to implement.

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Saunders Questions Chapter 1Question 10

• How do FIs alleviate the problem of liquidity
  risk faced by investors who wish to invest in the
  securities of corporations?
• Liquidity risk occurs when savers are not able to
  sell their securities on demand.
• Commercial banks, for example, offer deposits
  that can be withdrawn at any time. yet, the
  banks make long-term loans or invest in illiquid
  assets (mortgages and long-term bonds) because
  they are able to diversify their portfolios and
  better monitor the performance of firms that have
  borrowed or issued securities.
• Thus individual investors are able to realize the
  benefits of investing in primary assets without
  accepting the liquidity risk of direct investment.

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Saunders Questions Chapter 1Question 11

• How do FIs help individual savers diversify
  their portfolios risks? Which type of financial
  institution is best able to achieve this goal?
• Money placed in any financial institution will
  result in a claim on a more diversified
  portfolio.
• Banks lend money to many types of corporate,
  consumer, and government customers, and insurance
  companies have investments in many different
  types of assets.
• Investment in a mutual fund may generate the
  greatest diversification (depending on the type
  of fund) benefit because of the funds investment
  in a wide array of stocks and fixed income
  securities.

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Saunders Questions Chapter 1Question 12

• How can financial institutions invest in
  high-risk assets with funding provided by
  low-risk liabilities from savers?
• Diversification of risk occurs with investments
  in assets that are not perfectly positively
  correlated.
• One result of extensive diversification is that
  the average risk of the asset base of an FI will
  be less than the average risk of the individual
  assets in which it has invested.
• Thus, individual investors realize some of the
  returns of high-risk assets without accepting the
  corresponding risk characteristics.

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Saunders Questions Chapter 1Question 13

• How can individual savers use financial
  institutions to reduce the transaction costs of
  investing in financial assets?
• By pooling the assets of many small investors,
  FIs can gain economies of scale in transaction
  costs.
• This benefit occurs whether the FI is lending to
  a corporate or retail customer, or purchasing
  assets in the money and capital markets.
• In either case, operating activities that are
  designed to deal in large volumes typically are
  more efficient than those activities designed for
  small volumes.

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Saunders Questions Chapter 1Question 14

• What is maturity intermediation? What are some
  of the ways in which the risks of maturity
  intermediation are managed by financial
  intermediaries?
• If net borrowers and net lenders have different
  optimal time horizons, FIs can service both
  sectors matching their asset and liability
  maturities through on- and off-balance sheet
  hedging activities and flexible access to the
  financial markets.
• The FI can offer relatively short-term
  liabilities desired by households and also
  satisfy the demand for long-term loans such as
  home mortgages.
• By investing in a portfolio of long- and
  short-term assets that have variable- and
  fixed-rate components, the FI can reduce maturity
  risk exposure by utilizing liabilities that have
  similar variable- and fixed-rate characteristics,
  or by using futures, options, swaps and other
  derivative products.

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Saunders Questions Chapter 1Question 15

• What are the five areas of institution-specific
  FI specialness, and which types of institutions
  are most likely to be the service providers?
• Chartered Bank key players for transmission of
  monetary policy
• Depository FIs such as banks, trusts, financial
  acceptance and credit unions provide financing
  for consumers and corporations. For example,
  Canada Mortgage and Housing Corporation provides
  mortgage insurance for residential mortgages.
• Life insurance and pension funds provide
  mechanisms to transfer wealth across generations.
• Depository financial institutions, insurance
  companies and brokerage firms provide payment
  services
• Mutual funds provide denomination intermediation.
  (Brokerage/investment firms may as well, as in
  the case of T-bills)

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Saunders Questions Chapter 1Question 16

• How do deposit-taking institutions such as
  chartered banks assist in the implementation and
  transmission of monetary policy?
• The Bank of Canada can involve banks directly in
  the implementation of monetary policy through
  changes in the target Overnight Rate. The open
  market sale and purchase of Government of Canada
  securities by the Bank of Canada involves the
  banks in the implementation of monetary policy in
  a less direct manner.

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Saunders Questions Chapter 1Question 17

• What is meant by credit allocation regulation?
  What social benefit is this type of regulation
  intended to provide?
• Credit allocation regulation refers to the
  requirement faced by FIs to lend to certain
  sectors of the economy, which are considered to
  be socially important. These may include housing
  and farming. Presumably the provision of credit
  to make houses more affordable or farms more
  viable leads to a more stable and productive
  society.

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Saunders Questions Chapter 1Question 18

• Which financial intermediaries best fulfill the
  intergenerational wealth transfer function? What
  is this wealth transfer process?
• Life insurance and pension funds often receive
  special taxation relief and other subsidies to
  assist in the transfer of wealth from one
  generation to another. In effect, the wealth
  transfer process allows the accumulation of
  wealth by one generation to be transferred
  directly to one or more younger generations by
  establishing life insurance policies and trust
  provisions in pension plans. Often this wealth
  transfer process avoids the full marginal tax
  treatment that a direct payment would incur.

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Saunders Questions Chapter 1Question 19

• What are two of the most important payment
  services provided by financial institutions? To
  what extent do these services efficiently provide
  benefits to the economy?
• The two most important payment services are
  cheque clearing and wire transfer services. Any
  breakdown in these systems would produce gridlock
  in the payment system with resulting harmful
  effects to the economy at both the domestic and
  potentially the international level.

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Saunders Questions Chapter 1Question 20

• What is denomination intermediation? How do FIs
  assist in this process?
• Denomination intermediation is the process
  whereby small investors are able to purchase
  pieces of assets that normally are sold only in
  large denominations.
• Individual savers often invest small amounts in
  mutual funds. The mutual funds pool these small
  amounts and purchase money market securities
  which can only be sold in minimum increments of
  100,000, but which often are sold in million
  dollar packages.
• Similarly, commercial paper often is sold only in
  minimum amounts of 100,000. Therefore small
  investors can benefit in the returns and low risk
  which these assets typically offer.

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Saunders Questions Chapter 1Question 21

• What is negative externality? In what ways do
  the existence of negative externalities justify
  the extra regulatory attention received by
  financial institutions?
• A negative externality refers to the action by
  one party that has an adverse affect on some
  third party who is not part of the original
  transaction.
• For example, in an industrial setting, smoke from
  a factory that lowers surrounding property values
  may be viewed as a negative externality.
• For financial institutions, one concern is the
  contagion effect that can arise when the failure
  of one FI can cast doubt on the solvency of other
  institutions in that industry.

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Saunders Questions Chapter 1Question 22

• If financial markets operated perfectly and
  costlessly, would there be a need for financial
  intermediaries?
• To a certain extent, financial intermediation
  exists because of financial market imperfections.
  
• If information is available costlessly to all
  participants, savers would not need
  intermediaries to act as either their brokers or
  their delegated monitors.
• However, if there are social benefits to
  intermediation, such as the transmission of
  monetary policy or credit allocation, then FIs
  would exist even in the absence of financial
  market imperfections.

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Saunders Questions Chapter 1Question 23

• What is mortgage redlining?
• Mortgage redlining occurs when a lender
  specifically defines a geographic area in which
  it refuses to make any loans.
• The term arose because of the area often was
  outlined on a map with a red pencil.

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Saunders Questions Chapter 1Question 24

• Why are FIs among the most regulated sectors in
  the world? When is net regulatory burden
  positive?
• FIs are required to enhance the efficient
  operation of the economy. Successful financial
  intermediaries provide sources of financing that
  fund economic growth opportunity that ultimately
  raises the overall level of economic activity.
  Moreover, successful financial intermediaries
  provide transaction services to the economy that
  facilitate trade and wealth accumulation.

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Saunders Questions Chapter 1Question 24 2

• Why are FIs among the most regulated sectors in
  the world? When is net regulatory burden
  positive?
• Conversely, distressed FIs create negative
  externalities for the entire economy. That is,
  the adverse impact of an FI failure is greater
  than just the loss to shareholders and other
  private claimants on the FI's assets. For
  example, the financial markets suffer if an FI
  fails and other FIs also may be thrown into
  financial distress by a contagion effect.
  Therefore, since some of the costs of the failure
  of an FI are generally borne by society at large,
  the government intervenes in the management of
  these institutions to protect society's
  interests. This intervention takes the form of
  regulation.

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Saunders Questions Chapter 1Question 24 3

• Why are FIs among the most regulated sectors in
  the world? When is net regulatory burden
  positive?
• However, the need for regulation to minimize
  social costs may impose private costs to the
  firms that would not exist without regulation.
  This additional private cost is defined as a net
  regulatory burden. Examples include the cost of
  holding excess capital and/or excess reserves and
  the extra costs of providing information.
  Although they may be socially beneficial, these
  costs add to private operating costs. To the
  extent that these additional costs help to avoid
  negative externalities and to ensure the smooth
  and efficient operation of the economy, the net
  regulatory burden is positive.

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Saunders Questions Chapter 1Question 25

• What forms of protection and regulation do
  regulators of FIs impose to ensure their safety
  and soundness?
• FIs are required to diversify their assets. For
  example, federally-regulated FIs must follow
  OSFIs Guidelines on Large Exposure Limits.
• FIs are required to maintain minimum amounts of
  capital to cushion any unexpected losses. In the
  case of banks, OSFI standards require a minimum
  core and supplementary capital of 7 percent of
  their risk-adjusted assets.
• Regulators have set up guaranty funds such as
  CDIC, CIPF to protect individual investors
  against losses on the insolvency of FIs
• Regulators also engage in periodic monitoring and
  surveillance, such as on-site examinations, and
  request periodic information from the FIs.

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Saunders Questions Chapter 1Question 26

• What legislation has been passed specifically to
  protect investors who use investment banks
  directly or indirectly to purchase securities?
  Give some examples of the types of abuses for
  which protection is provided.
• While the discussion of a national securities
  regulator for Canada is under discussion, the
  regulation of securities dealers is a provincial
  and territorial responsibility in Canada.
• Through self-regulating organizations (SROs),
  securities dealers, including mutual funds, are
  subject to rules affecting possible abuses such
  as insider trading, lack of disclosure, outright
  malfeasance, and breach of fiduciary
  responsibilities.

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Saunders Questions Chapter 1Question 27

• How do regulations regarding barriers to entry
  and the scope of permitted activities affect the
  charter value of financial institutions?
• The profitability of existing firms will be
  increased as the direct and indirect costs of
  establishing competition increase.
• Direct costs include the actual physical and
  financial costs of establishing a business. In
  the case of FIs, the financial costs include
  raising the necessary minimum capital to receive
  a charter.
• Indirect costs include permission from regulatory
  authorities to receive a charter. As these
  barriers to entry are stronger, the charter value
  for existing firms will be higher.

56
Saunders Questions Chapter 1Question 28

• What reasons have been given for the growth of
  investment companies at the expense of
  traditional banks and insurance companies?
• The recent growth of investment companies can be
  attributed to two major factors
• Investors have demanded increased access to
  direct securities markets. Investment companies
  and mutual funds allow investors to take
  positions in direct securities markets while
  still obtaining the risk diversification,
  monitoring, and transactional efficiency benefits
  of financial intermediation. Some experts would
  argue that this growth is the result of increased
  sophistication on the part of investors others
  would argue that the ability to use these markets
  has caused the increased investor awareness. The
  growth in these assets is inarguable.
• b. Both the banking and insurance industries have
  been subject to an increase in regulation and
  governmental oversight, thereby increasing the
  net regulatory burden of traditional companies.
  As such, the costs of intermediation have
  increased, which increases the cost of providing
  services to customers.

57
Saunders Questions Chapter 1Question 29

• What are some of the methods which banking
  organizations have employed to reduce the net
  regulatory burden? What has been the effect on
  profitability?
• Through regulatory changes, FIs have begun
  changing the mix of business products offered to
  individual users and providers of funds. For
  example, banks have acquired mutual funds, have
  expanded their asset and pension fund management
  businesses, and have increased the security
  underwriting activities. As the size of banks
  has grown, an expansion of possible product
  offerings has created the potential for lower
  service costs.
• The emphasis in recent years has been on products
  that generate increases in fee income, and the
  entire banking industry has benefited from
  increased profitability in recent years.

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Saunders Questions Chapter 1Question 30

• What characteristics of financial products are
  necessary for financial markets to become
  efficient alternatives to financial
  intermediaries? Can you give some examples of
  the commoditization of products which were
  previously the sole property of financial
  institutions?
• Financial markets can replace FIs in the delivery
  of products that
• (1) have standardized terms,
• (2) serve a large number of customers, and
• (3) are sufficiently understood for investors to
  be comfortable in assessing their prices.
• When these three characteristics are met, the
  products often can be treated as commodities.
  One example of this process is the migration of
  over-the-counter options to the publicly traded
  option markets as trading volume grows and
  trading terms become standardized.