Chapter 4

Financial intermediaries

Financial intermediaries

Deposit taking institutions

Non-deposit taking institutions

Commercial banks and the so-called thrift institutions (thrifts) such as savings and loan associations, mutual savings banks, and credit unions

Contractual savings institutions such as insurance companies and pension funds

Investment Intermediaries including finance companies, mutual funds, and money market mutual funds
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Basic BankingCash Deposit

First National Bank Assets Vault Cash +$100 Liabilities Checkable deposits +$100 First National Bank Assets Reserves Liabilities +$100

+$100 Checkable deposits

Opening of a checking account leads to an increase in the banks reserves equal to the increase in checkable deposits

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Basic BankingCheck Deposit

First National Bank
Assets Cash items in process of collection +$100 Liabilities Checkable deposits +$100

When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves
Second National Bank Assets Liabilities

First National Bank Assets Liabilities

Reserves +$100 Checkable deposits

+$100

Reserves

-$100

Checkable deposits

-$100

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Basic BankingMaking a Profit

First National Bank Assets Liabilities Second National Bank Assets Liabilities

Required reserves
Excess reserves

+$100 Checkable deposits

+$90

+$100

Required reserves
Loans

+$100 Checkable deposits

+$90

+$100

Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long

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How do commercial banks manage their liquidity, assets, and liabilities?

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Liquidity Management: Ample Excess Reserves

Assets Reserves Loans Securities Liabilities $20M Deposits $80M Bank Capital $10M $100M $10M Assets Reserves Loans Securities Liabilities $10M Deposits $80M Bank Capital $10M $90M $10M

If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet

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Liquidity Management: Shortfall in Reserves

Assets Reserves Loans Securities Liabilities $10M Deposits $90M Bank Capital $10M $100M $10M Assets Reserves Loans Securities Liabilities $0 Deposits $90M Bank Capital $10M $90M $10M

Reserves are a legal requirement and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows
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Liquidity Management: Borrowing

Assets Reserves Loans Securities $9M Deposits $90M Borrowing $10M Bank Capital Liabilities $90M $9M $10M

Cost incurred is the interest rate paid on the borrowed funds

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Liquidity Management: Securities Sale

Assets Reserves Loans Securities $9M Deposits $90M Bank Capital $1M Liabilities $90M $10M

The cost of selling securities is the brokerage and other transaction costs

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Liquidity Management: Federal Reserve

Assets Reserves Loans Securities $9M Deposits $90M Borrow from Fed $10M Bank Capital Liabilities $90M $9M $10M

Borrowing from the Fed also incurs interest payments based on the discount rate

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Liquidity Management: Reduce Loans

Assets Reserves Loans Securities $9M Deposits $81M Bank Capital $10M Liabilities $90M $10M

Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount
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Asset Management: Three Goals

Seek the highest possible returns on loans and securities
Reduce risk Have adequate liquidity

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Asset Management: Four Tools

Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets
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Liability Management
Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)

Checkable deposits have decreased in importance as source of bank funds

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Savings and Loan Associations

Chartered by the federal government or by states Most are members of Federal Home Loan Bank System (FHLBS) Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC Regulated by the Office of Thrift Supervision
Assets Mortgage loans for residential housing - Becoming more diversified Liabilities Savings deposits (often called shares) and time and checkable deposits
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Mutual Banks
Approximately half are chartered by states Regulated by state in which they are located Deposit insurance provided by FDIC or state insurance

Assets Mortgage loans for residential housing - Becoming more diversified

Liabilities Savings deposits (often called shares) and time and checkable deposits

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Credit Unions
Tax-exempt Chartered by federal government or by states Regulated by the National Credit Union Administration (NCUA) Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)
Assets Liabilities

Consumer loans

Deposits called shares

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Life insurance companies

Organized in two forms: as stock companies or as mutuals. Regulated by the states Holding long-term assets that are not particularly liquidcorporate bonds and commercial mortgages as well as some corporate stock Two principal forms of life insurance policies: permanent life insurance (such as whole, universal, and variable life) and temporary insurance (such as term)
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Property and Casualty Insurance Companies

o Very much like life insurance companies o Having a greater possibility of loss of funds if major disasters occur Buy more liquid assets than life insurance companies do. o Their largest holding of assets is municipal bonds; they also hold corporate bonds and stocks and government securities

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Pension Funds and Government Retirement Funds

Acquired by contributions from employers or from employees The largest asset holdings of pension funds are corporate bonds and stocks

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Finance companies
Raising funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds Lending these funds to consumers, who make purchases of such items as furniture, automobiles, and home improvements, and to small businesses Some finance companies are organized by a parent corporation to help sell its product
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Finance companies (contd)

Finance companies

Sales finance companies

Consumer finance companies

Business finance companies

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Mutual funds
Acquiring funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds The value of mutual fund shares fluctuates greatly Investments in mutual funds can be risky

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Money Market Mutual Funds

Having the characteristics of a mutual fund but also function to some extent as a depository institution

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Hedge funds
A special type of mutual fund Like mutual funds, hedge funds accumulate money from many people and invest on their behalf Distinction:
Hedge funds have a minimum investment requirement between $100,000 and $20 million Hedge funds usually require that investors commit their money for long periods of time, often several years
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Investigate the structure of financial intermediaries in the UK and other European countries.

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