The Role of Financial

Intermediaries
Week 03
Chapter 2 – Financial
Intermediation
• Definition of Financial Intermediation
• Transforming financial assets into more widely preferred type of
asset/liability
• Example: Car Loan
• Example: Swap (Bond swap from fixed to floating rate)
• Performed by Financial Institutions
• Many of these intermediation functions are completed with large institutions
• Completed in Financial Markets
Chapter 2 – Financial
Intermediation
• A closer look at Financial Institutions
• Types
• Banks – Commercial, Investment, Savings and Loans, Credit Unions, etc.
• Investment Companies
• Insurance Companies
• Others – Pension Funds, Foundations, etc.
• Functions
• Transforming, Exchanging, and Designing Financial Assets
• Advising and Managing Financial Assets
Chapter 2 – Financial
Intermediation
• Direct Investing with Intermediaries
• Commercial Bank
• Direct Deposit – CD – Promised Payment at the end of the Investment Period
• Dollars are loaned to a borrower (to buy a car) with a different payment schedule

• Indirect Investing with Intermediaries

• Mutual Fund Company (Investment Company)
• Buy mutual fund shares at NAV (no load)
• Company uses funds to buy stocks and bonds
Chapter 2 – Financial
Intermediation
• Four Functions of Intermediation
• Maturity
• Borrow in the long vs. lend in the short
• Risk Reduction (Diversification)
• Eliminate firm specific risk via a portfolio
• Cost Reduction of Information/Contracting
• Share information acquired across large set of individuals
• Payment Mechanisms
• Checks, Credit Cards, Debit Cards, etc.
Chapter 2 – Financial
Intermediation
• Asset/Liability Management for Financial Institutions
• Nature of Business – Buy and Sell Money
• Buy Low, Sell High – Spread
• Nature of Liabilities
• Timing and Amount of Outflow of Cash
• Table 2-1 Page 19
• Liquidity of Claims against Financial Institutions – can obligations be
met with current assets of the institution?
Chapter 2 – Financial
Intermediation
• Growth of Financial Intermediaries through Financial Innovation
• Market Broadening Instruments – attracts new investors
• Zero-Coupon Bonds – TGIRS, LYONS, etc
• Risk Management Instruments
• Options
• Arbitrage Instruments – Price Stability
• Index Assets for direct trade
• Motivation? Risk Transfer or Arbitrage
Chapter 2 – Financial
Intermediation
• Asset Securitization
• Pledging Cash Flows from a set of borrowers to the lenders of the funds…
• Example Mortgage Backed Securities
• Ginnie Mae, Sallie Mae, Freddie Mac…
• Conforming Loans are the security for the Bonds sold to investors and the payment of
the mortgage payment flows to bondholders
• Original Lender to Mortgage does not service loans – just pools loans and sells bonds
• Costs and Benefits? Implications?
Chapter 2 – Financial
Intermediation
• End of Chapter Questions
• #7 – Mutual Funds – Advantages and Disadvantages for Investor
• Advantages
• Risk Reduction – Portfolio
• Cost Reduction for information and transactions
• Record Keeping
• Disadvantages
• Loss of flexibility for individual investor
• Pay gains annually stock appreciation
• Conclusion – Meets the needs of many investors thus the growth…
Chapter 2 – Financial
Intermediation
• End of Chapter Questions
• #8 – Volatility Increases Innovation
• Greater Volatility means Greater Risk
• Greater Risk means Benefits of Risk Transfer Increases
• Financial Innovation is finding an efficient way to transfer risk so greater volatility
increases the benefits of new ways to transfer risk.
• #10 – Asset Securitization and Liquidity
• Liquidity of Market (instruments have a secondary market)
• New Lenders that find “niche” meets their requirements
 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 B
S Money
B
S
S B
B
S Intermediaries B
S
 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
 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.
 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.
 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.
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
 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.
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.
1Table 4-1

3
1Table 4-1

3
 1. Depository Institutions
Types
1.1 Commercial banks
1.2 Savings & loan
associations
1.3 Mutual savings banks
1.4 Credit unions
They:
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.
Figure 4-1
 1.1 Commercial Banks.
• Commercial banks are the largest and most important of
all financial intermediaries.

Assets (uses of funds)

mortgages,
Liabilities (sources of
government securities,
business (commercial)
funds)
loans, demand deposits,
consumer loans savings accounts,
time deposits.
 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.
 Other Institutions

1.3 Mutual Savings Banks (MSBs)

• encourage working class employees to save

1.4 Credit Unions (CUs)

• not-for-profits
• for members
1Table 4-1

3
 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
 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.
 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.
 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.
 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.
1Table 4-1

3
3. Investment-Type Financial
Intermediaries

3.1 Mutual funds

3.2 Finance companies

3.3 Money market mutual funds

 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
 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

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.