CHAPTER 4

FINANCIAL
INTERMEDIATION
 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.
 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
 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, and

 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 to Deficit Units
 From borrowers/spenders’ perspective, financial
intermediaries broaden the range of instruments,
denominations, and maturities that an institution is
able to issue, which significantly reduces borrowing
costs—borrowers can tailor instruments to best fit
their needs.
 Classification And 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:
 depository institutions,

 contractual savings institutions,

 investment-type intermediaries.
Table 4-1
 Depository Institutions
 Types
 Commercial banks
 Thrifts
 savings and loan associations
 mutual savings banks
 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
 Commercial Banks.
 Commercial banks are the largest and most important of all
financial intermediaries.

 Banks have historically been the most diversified in their

activities.

 Liabilities (sources of funds) are

 demand deposits,

 savings accounts,

 time deposits.

 Assets (uses of funds) are

 mortgages,

 government securities,

 business (commercial) loans,

 consumer loans
 Savings and 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
 Mutual Savings Banks (MSBs)

 Credit Unions (CUs)

 Contractual Savings Institutions

 Types

 insurance companies
 private pension funds
 state and local government retirement funds
Table 4-2
 Life Insurance Companies
 Life insurance companies:
 issue policies;

 invest more than two-thirds of the proceeds in

corporate bonds and equities;
 Collect premiums as a continuing source of funds, and

 are typically regulated by the state insurance

commissioner.
 Life insurance policies:
 have a specified cash surrender value--policyholders
can obtain that cash on request.
 Policyholders:
 view the cash value of their policies as untouchable
except in extreme emergency.
 Fire and 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.
 Private Pension Funds and
Government Retirement Funds
 Pension funds manage portfolios more efficiently than individuals by
providing:
 financial expertise,

 economies of scale,

 reduced transactions costs, and

 diversification.

 The U.S. tax code encourages pension plans--income is nontaxable

until retirement.

 Employers withhold the funds from workers' paychecks and send

them (sometimes matched) to a pension fund.

 The retirement fund invests the contributions in

 corporate stocks and bonds and

 U.S. government bonds.

 Investment-Type Financial
Intermediaries
 Types
 stock and bond mutual funds

 Funds seek to maximize various goals (growth, income, etc.)

 Funds specialize in industries (tech, health, etc.)

 finance companies

 sales finance companies

 consumer finance companies
 business finance companies
 money market mutual funds
 invest in highly liquid assets

 These intermediaries provide:

 low transactions costs,

 the financial expertise and experience supplied by mutual fund

management, and
 increased diversification relative to that feasible for a typical
individual.
 Government Regulation Of
The Financial System
 Financial systems are heavily regulated both in
the U.S. and internationally.

 Why?
 to increase information flow to prospective financial
market participants (transaction transparency)
 strengthen the stability of the nation’s financial
system
 improve the central bank's ability to control the
nation’s money supply and credit conditions
 Increasing the Availability
and Accuracy of Information
 A well functioning financial system requires timely and
accurate information.

 Regulation combats the ill effects of

 adverse selection
 moral hazard

 The Securities and Exchange Commission (SEC)

 prevents insider trading of securities, and

 forces corporations to clearly and honestly disclose

financial information (decreases moral hazard).

 Corporations must file periodic audited reports of their assets,

liabilities, sales, and profits.
 Ensuring the Stability of the
Financial Intermediaries
 Asymmetric information and depository institutions (moral
hazard)
 Depository institutions know their true financial conditions.

 Depositors cannot accurately assess their banks’ financial

conditions.

 If bank customers worry about the financial condition of their

bank or the financial system, they may react by withdrawing
their funds.
 A banking panic occurs when large number of bank
customers withdraw their funds, jeopardizing both
unhealthy and healthy banks.
Table 4-3
 The Changing Nature Of
Financial Intermediation
 After the Great Depression of the 1930s, Congress passed the Glass-Steagall
Act, which:
 mandated the separation of commercial banking and investment banking:
 Commercial banks were forbidden to underwrite corporate stocks and
bonds, or to hold common stocks in their portfolios.
 Investment banks were forbidden to accept household deposits or make
business loans.

 The result of this legislation was that financial institutions became highly
specialized.

 In recent decades, deregulation has allowed nearly all financial institutions to

offer nearly any form of financial service.
 Tables 4-2 and 4-4 show
 significant increases in funds held in private retirement accounts and
mutual funds
 significant decline in share of funds held in commercial banks and thrifts

 The Gramm, Leach, Bliley Financial Services Act of 1999, allows

commercial banks to underwrite and distribute securities, sponsor mutual funds,
and sell insurance products.
Tables 4-2 & 4-4
 Benefits and Costs of
Institutional Change
 Benefits
 growth in the role of private pension funds, state and local government
retirement funds, mutual funds and money market mutual funds
 increased range of investment outlets for individuals and firms that
have surplus funds
 expanded range of alternatives open to deficit spenders

 Costs
 increase in the potential for financial instability in the future:

 Increasing portion of assets held in the relatively volatile shares of

stock via pension and mutual funds .

 Changes could tend to make output and employment more

unstable.

 Changes may increase the vulnerability of commercial banks and

thrift institutions to future shocks, such as a collapse of oil prices.