Chapter 5 Why Are FIs Special

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Chapter 5 - Why Are FIs Special?

• Business 4039

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Terms Definitions

• Negative Externality
• covenant
• liquity
• price risk
• Name at Lloyds
• reinsurance
• asset transformer
• primary security
• agency costs

• delegated monitor
• maturity intermediation
• time intermediation
• denomination intermediation

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Why are FIs Special?

• This short chapter serves both as a summary of
  Part I the Financial Services Sector, and as a
  transition to Part II Risk Measurement.
• Unlike Chapters 1-3, it is largely conceptual,
  summarizing the functions of FIs and their
  importance to society.

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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.
• Students 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

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Intermediation Services of FIs

• risk transfer, reduction, and monitoring services
• liquidity services
• maturity intermediation services
• transaction services
• financial information services

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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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Covenant

• legal clauses in a bond contract that require the
  issuer of bonds to take or avoid certain actions

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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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Name at Lloyds

• the final risk bearer in an insurance contract
  underwritten in the market organized by Lloyds
  of London.

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Agency Costs - cost of monitoring

• costs relating to the risk that the owners and
  managers of firms that receive savers funds will
  take actions with those funds contrary to the
  savers best interests.

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Delegated Monitor

• an economic agent appointed to act on behalf of
  smaller agents in collecting information and/or
  investing funds.

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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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Economies of Scale

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

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Institutional Aspects of Specialness

• 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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Question 5 - 1

• What are the major functions of financial
  intermediaries?
• FIs are either brokers or asset/risk
  transformers.
• As brokers, they merely act as agents for savers
  and investors in investment transactions and for
  risk generators and absorbers in risk offlay
  transactions.
• As brokers, they provide information and
  transaction services.
• As asset transformers, FIs invest in primary
  financial securities and issue claims (including
  contingent claims of insurance) to provide asset
  transformation and risk offlay.

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Question 5 - 2

• How can FIs afford to issue financial claims that
  have superior liquidity to securities market
  claims?
• The FI pools the funds of small investors, each
  of which would have insufficient incentive to
  monitor the actions of borrowers. In monitoring
  the aggregated claims, the FI can achieve
  informational economies of scale.
• Liquidity and risk reduction of claims is also
  increased by pooling into diversified FI
  portfolios that lower risk of the secondary
  securities of FI issues relative to the primary
  securities that the FI purchases.

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Question 5 - 3

• From the perspective of society, apply
  cost/benefit analysis to government regulation of
  the FI industry by enumerating the benefits FIs
  provide to society weighing them against the
  costs to society. Relate the cost benefit
  analysis to emerging trends in financial
  intermediation.
• Benefits FIs provide
• risk transfer, reduction and monitoring services
• liquidity services
• maturity intermediation services
• transaction services, and
• financial information services
• ...

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Question 5 - 3 ...

• From the perspective of society, apply
  cost/benefit analysis to government regulation of
  the FI industry by enumerating the benefits FIs
  provide to society weighing them against the
  costs to society. Relate the cost benefit
  analysis to emerging trends in financial
  intermediation.
• In transferring risks and funds, they serve
  either as brokers or as transformers. As
  brokers, they arrange for the placing of stocks
  and bonds with ultimate investors. As asset
  transformers, Fis perform liquidity and maturity
  intermediation services, pooling small
  denomination, liquid deposits and actuarial
  claims into less liquid larger denomination
  loans. Their interconnection through the
  payments system provides transactions services.
  They also provide financial information on
  deposits, payments, loans and a wide variety of
  disintermediated assets.

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Question 5 - 3...

• FIs institutional functions in society include
• Money supply transmission (banks)
• credit allocation (banks, trusts, credit unions
  and finance companies)
• risk offlay (insurance companies)
• intergenerational transfers (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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Question 5 - 3 ...

• Costs The main cost to society of these
  services beyond the interest, fees and
  commissions that are visible for each transaction
  stems from the system of regulation. Direct
  clearers have access to Bank of Canada borrowing.
  Deposit-taking FIs retail liabilities are
  guaranteed by CDIC (or provincial government
  deposit guarantee corporations.) Considerable
  cost (that must be borne eventually by service
  users and/or taxpayers) is associated with the
  preparation of regulatory agency filings,
  government audits, and staffing of regulatory
  bodies.
• The move to risk-adjusted deposit insurance
  premiums for deposit insurance and
  self-regulatory organizations - rather than
  government organizations - to regulate the FI
  industry are part of a trend to allocate more
  fairly the costs of FI specialness and increase
  the efficiency of monitoring.

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Question 5 - 4

• From the perspective of the FI, apply cost
  benefit analysis to the FI industry. Relate this
  cost benefit analysis to emerging trends in
  financial intermediation.
• Benefits FIs can be very profitable witness
  the record bank profits in recent years. The
  level of profitability is related to the
  efficiency with which the FI provides existing
  and develops new services and the degree to which
  current FIs are protected from competition from
  exiting competitors and new entrants.
• Costs Government safety nets and protective
  regulations are not without costs.
  Deposit-taking FIs pay hefty deposit insurance
  premiums. The costs of on-site inspections are
  borne by the FI. Accounting, auditing and
  administrative expenses are associated with
  various regulatory filings.

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Question 5 - 4 ...

• From the perspective of the FI, apply cost
  benefit analysis to the FI industry. Relate this
  cost benefit analysis to emerging trends in
  financial intermediation.
• In FI industries with free entry and exit (such
  as PC insurance or credit unions), the
  cost-benefit analysis can be easily observed in
  the extent to which firms enter and exit the
  industry.
• In other industries where ease of entry is
  curtailed by legal, high investment, reputational
  capital or regulatory constraints (e.g., banking
  and life insurance) the tradeoff must be inferred
  from such measures as FI profitability and market
  performance of shares.

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Question 5 - 5

• If financial markets operated perfectly and
  costlessly, financial intermediaries would not
  exist. State whether you agree or disagree and
  why.
• This is a very open ended question, depending
  largely on definitions of perfectly and
  costlessly.
• If FI services were provided to the public for
  nothing, then the FI would not exist, the
  statement is clearly true.
• If the sentence is taken to mean, if markets for
  existing securities were efficient, Fis would not
  exist the statement would be wrong.
• If perfection implies financial market
  completeness, then the payoffs of securities in
  every future state of the world would be priced
  in financial markets. In that case, fully
  informed rationale individuals could purchase
  disintermediated claims that would fully offset
  any future risk and make risk offlay through Fis
  redundant.

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Question 5 - 6

• FIs are among the most heavily regulated firms in
  private industry. Explain why.
• To justify such regulation, advocates usually
  argue that Fis provide special functions or
  services and that major disturbances to, or
  interferences with, these functions can lead to
  adverse effects on the rest of the economy - what
  economists call negative externalities.
• Example if a major FI were to fail, the results
  - if not correctly dealt with -- could include
  loss of confidence in the FI system in general,
  contraction of the money supply, reduction in
  credit allocation and real economic losses.

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Question 5 - 7

• How would financial and economic transactions
  differ if there were no FIs?
• If there were no FIs, fund flows between the
  funds providers and the funds users would be less
  because the monitoring costs would be prohibitive
  for retail investors. The resulting lack of
  monitoring would reduce the attractiveness and
  increase the risk of investing in household and
  corporate debt and equity. In the absence of
  FIs, the risk generating household or business
  would have two choices either accept the risks
  as a fact of life or seek out (and individually
  contract with) risk absorbers (ie. Households, or
  businesses that are more risk tolerant than the
  risk generator). These increased risks and/or
  costs would restrain the flow of funds.

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Question 5 - 8

• Why may investors be averse to holding primary
  securities directly?
• Investors may be averse to holding primary
  securities directly because of
• a. monitoring costs
• b. liquidity costs and
• c. price risk
• The relative long term nature of corporate debt
  and equity increases both the liquidity costs and
  price risk of direct securities holdings. If an
  investor wants to liquidate a position at any
  given point in time, he or she may find that the
  price may be temporarily below the true market
  value of the security.
• Moreover the costs of liquidation, (in terms of
  fees, commissions

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Question 5 - 8 ...

• Why may investors be averse to holding primary
  securities directly?
• Moreover the costs of liquidation, (in terms of
  fees, commissions, search costs, time), may be
  prohibitive. An FI can economize on both of
  these costs by maintaining a portfolio of
  securities and pooling diverse transactions to
  create volume discounts and internal hedging
  opportunities (I.e., when one investor wants to
  liquidate another may want to invest.)

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Question 5 - 9

• What is meant by maturity intermediation?
• If net borrowers and net lenders have different
  optimal time horizons, FIs can service both
  sectors by mismatching their asset and liability
  maturities. That is, the FI can offer the
  relatively short term liabilities desired by
  households (say, in the form of bank deposits)
  and also satisfy the demand for long term loans
  (say, for home mortgages). By investing in a
  portfolio of long and short term assets and
  liabilities, the FI can both reduce risk exposure
  through diversification and manage risk exposure
  by centralizing its hedging activities.

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Question 5 - 10

• This apparent decline of banks and insurance
  companies assets is only relative.
• Actual assets have been growing both in nominal
  and real (inflation adjusted) terms.
• The growth, however, has been less than that of
  mutual funds and pension funds. Reasons for
  this trend include
• the aging population, which has an increasing
  proportion of its financial assets in funds to
  support retirement
• increasing investor sophistication and desire to
  tailor investment profiles to personal risk
  return preferences has led to increasing interest
  in mutual funds.
• Increased availability of disintermediated
  instruments as opposed to claims of
  deposit-taking FIs and insurance companies that
  must bear the costs of regulatory burden.
• Stock and bond market booms have contributed to
  make mutual funds look attractive relative to
  fixed interest returns of bank deposits.