Chapter 1

Why Are Financial

Intermediaries
Special?

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 Why Are Financial 1-2

Intermediaries Special?

 Objectives:
 Explain the special role of FIs in the financial
system and the functions they provide.
 Explain why the various FIs receive special
regulatory attention.
 Regulations governing the FIs
 An overview of the financial system

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 1-3

Without FIs

Equity & Debt

Households Corporations
(net savers) (net borrowers)
Cash
 Information costs>High monitoring cost
 Less liquidity> Better to hold cash
 Substantial price risk> Sale price might be lower than
purchase price
WITHOUT FIS: LOW LEVEL OF FUND FLOWS

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 1-4

With FIs

FI
(Brokers)
Households Corporations

Cash FI Equity & Debt

(Asset
Transformers)
Deposits/Insurance Cash
Policies

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 1-5

Functions of FIs
 Brokerage function
 Acting as an agent for investors:e.g. Merrill
Lynch
 Reduce cost of trading through economies of
scale
 Encourages higher rate of savings>Reducing
transaction and information cost
 Asset transformer:
 Purchase primary securities by selling financial
claims to households
 These secondary securities often more
marketable>Deposits, insurance policies
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 1-6

Role of FIs in Cost Reduction

 Information costs:
 Investors exposed to Monitoring costs: A part of
Agency Costs> Costs relating to the risk that
the owners or mangers of firms will take action
contrary to the best interest of the savers
 Role of FI as Delegated Monitor (Diamond, 1984)

• The aggregation of funds by FI provide higher incentive to

monitor
• Development of new securities>Shorter term loan contracts
easier to monitor than bonds

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 1-7

Specialness of FIs

 Liquidity and Price Risk

 Secondary claims issued by FIs have less
price risk
 FIs have advantage in diversifying risks
 Reduced transaction & information costs
 economies of scale

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 1-8

Other Special Services

 Maturity intermediation>Fixed Deposit Vs Loan
 Transmission of monetary policy< Inflation>
Discount rate (bank rate), Open market operation,
Reserve requirements.
 Credit allocation >Areas of special need such as
industry, agriculture, micro-credit, home mortgages
 Intergenerational transfers or time
intermediation>Transfer of wealth between youth
and old age: life insurance, pension fund
 Payment services >Check clearing, wire transfers
 Denomination intermediation>Buying large
denomination corporate debt.

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 1-9
Specialness and Regulation
 FIs receive special regulatory attention.
Reasons:
 Special services provided by FIs in general.

 Institution-specific functions such as money

supply transmission (banks), credit allocation

(thrifts, farm banks), payment services
(banks,thrifts), etc.
FAILURE OF FI TO PROVIDE THESE
SERVICES CAN BE COSTLY BOTH TO
SOURCES (HOUSEHOLDS) AND USERS
(FIRMS).

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 1-10
Unavailable in
the book Why Highly Regulated?

 Safeguarding Depositors’ Interest

 Restricting Concentration of Wealth

 Stopping Misuse of Power

 Stopping Illegal Transactions

 Helping in recovering Loans/Advances

 Avoiding Failures

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 1-11

Regulatory Body of Financial System

Central Bank (Bangladesh Bank) is the

financial supervisor and regulator for
non-security portion ； and
Securities and Exchange Commission
(SEC) plays the role of supervisor and
regulator for security portion of the
financial market

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 1-12

Nature of Regulations/Controls

 Macroeconomic Controls: to maintain overall control

over the level of aggregate economic activity both in
the internal and external sector ; for example reserve
requirements, credit and deposit ceilings, interest rate
controls, restrictions on foreign investment etc.

 Allocative Controls: to influence the allocation of

financial resources in favor of priority activities. This
includes selective credit programs, compulsory
investment requirements, preferential interest rates
etc.

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 1-13

Regulations of Financial Sectors

 Structural Controls: to control the structure of

the financial system ; the category includes
entry and merger controls, geographic
restrictions, limits on range of activities etc.

 Organizational Controls: to ensure smooth

functioning and integrity of financial markets
and information exchanges; this includes rules
of market participation, disclosure of market
information, minimum technical standards etc.

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 1-14

Regulations of Financial Sectors

 Protective Controls: to provide adequate protection

to user of financial services, especially consumers and
non-professional investors; this includes information
disclosure to consumers, compensation funds,
ombudsmen to investigate and resolve disputes etc.

 Prudential Controls: to preserve the safety and

soundness of financial institutions and sustain public
confidence in the stability of the financial system as a
whole. The measures include authorization criteria,
minimum capital requirements, limits on the
concentration of risks, Loan Classification, reporting
requirements etc.
etc

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 1-15

Financial
System

Financial Financial Financial

Instruments Institutions Markets

Financial system is the setup within which funds are

transferred from surplus to deficit economic unit
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 1-16

Financial Instruments

 Financial Instruments are the evidences of

financial claims of holders against issuers.
 Two types: Primary and Secondary

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 1-17

Financial Institutions

Banking Non-Bank
Institutions Institutions

NCB Leasing Companies

Mutual Fund
SPB
House Building Fin.
PCB Investment Companies
Stock Exchanges
FCB
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 1-18

Financial Markets
 Where financial instruments are bought and sold
 Two types: Money market and Capital market

 Security and non-security markets

 Security : Regulator> Securities and

Exchange Commission (SEC)

 Primary (New Issue) Market

 Secondary Market: Stock Exchange, OTC

markets
 Non-Security: Regulator> Bangladesh Bank

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 1-19
Group Assignment 1

 Draw a flow chart showing the financial

system of Bangladesh.

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