Role of FIs
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Why study Financial Markets and
Institutions?
• They are the cornerstones of the overall financial
system in which financial managers operate
• Individuals use both for investing
• Corporations and governments use both for
financing
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Overview of Financial Markets
• Primary Markets versus Secondary Markets
• Money Markets versus Capital Markets
• Foreign Exchange Markets
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Primary Markets versus Secondary
Markets
• Primary Markets
• markets in which users of funds (e.g. corporations,
governments) raise funds by issuing financial
instruments (e.g. stocks and bonds)
• Secondary Markets
• markets where financial instruments are traded among
investors (e.g. NYSE, NASDAQ)
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Money Markets versus Capital Markets
• Money Markets
• markets that trade debt securities with maturities of one year or less (e.g.
CD’s, U.S. Treasury bills)
• Capital Markets
• markets that trade debt (bonds) and equity (stock) instruments with
maturities of more than one year
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Foreign Exchange Markets
• “FX” markets deal in trading one currency for another
(e.g. dollar for yen)
• The “spot” FX transaction involves the immediate
exchange of currencies at the current exchange rate
• The “forward” FX transaction involves the exchange of
currencies at a specified date in the future and at a
specified exchange rate
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Derivative Security Markets
• The markets in which derivative securities trade.
• Derivative Security
• An agreement between two parties to exchange a standard quantity of an
asset at a predetermined price on a specified date in the future.
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Overview of Financial Institutions
• Institutions that perform the essential
function of channeling funds from those
with surplus funds to those with
shortages of funds (e.g. banks, thrifts,
insurance companies, securities firms and
investment banks, finance companies,
mutual funds, pension funds)
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Flow of Funds in a World without FIs:
Direct Transfer
Financial Claims
(Equity and debt
instruments)
Users of Funds
(Corporations)
Suppliers of
Funds
(Households)
Cash
Example: A firm sells shares directly to investors without
going through a financial institution.
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Flow of Funds in a world with FIs: Indirect
transfer
FI
(Brokers)
Users of Funds
Cash
Suppliers of Funds
FI
(Asset
transformers)
Financial Claims
(Equity and debt securities)
Cash
Financial Claims
(Deposits and insurance policies)
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Types of FIs
• Commercial banks
• depository institutions whose major assets are loans
and major liabilities are deposits
• Thrifts
• depository institutions in the form of savings and loans,
credit unions
• Insurance companies
• financial institutions that protect individuals and
corporations from adverse events
(continued)
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• Securities firms and investment banks
• financial institutions that underwrite securities and
engage in securities brokerage and trading
• Finance companies
• financial institutions that make loans to individuals and
businesses
• Mutual Funds
• financial institutions that pool financial resources and
invest in diversified portfolios
• Pension Funds
• financial institutions that offer savings plans for
retirement
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Services Performed by Financial
Intermediaries
• Monitoring Costs
• Liquidity and Price Risk
• Transaction Cost Services
• Maturity Intermediation
• Denomination Intermediation
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Services Provided by FIs Benefiting the
Overall Economy
• Money Supply Transmission
• Credit Allocation
• Intergenerational Wealth Transfers
• Payment Services
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Risks Faced by Financial Institutions
• Interest Rate Risk
• Foreign Exchange Risk
• Market Risk
• Credit Risk
• Liquidity Risk
• Off-Balance-Sheet Risk
• Technology Risk
• Operational Risk
• Country or Sovereign Risk
• Insolvency Risk
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Regulation of Financial Institutions
• FIs provide vital financial services to all
sectors of the economy; therefore, their
regulation is in the public interest
• In an attempt to prevent their failure and
the failure of financial markets overall
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Globalization of Financial Markets and
Institutions
• Financial Markets became more global as
the value of stocks traded in foreign
markets soared
• Foreign bond markets have served as a
major source of international capital
• Globalization also evident in the
derivative securities market
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Factors Leading to Significant Growth in
Foreign Markets
• The pool of savings from foreign investors has
increased
• International investors have turned to US and other
markets to expand their investment opportunities
• Information on foreign investments and markets is
now more accessible (e.g. internet)
• Some mutual funds allow ability to invest in foreign
securities with low transaction costs
• Deregulation has enhanced globalization of capital
flows
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The Role of Financial Markets
1. Liquidity:
•
•
Ensure owners can buy and sell financial instruments cheaply.
Keeps transactions costs low.
2. Information:
•
Pool and communication information about issuers of financial
instruments.
3. Risk sharing:
•
Provide individuals a place to buy and sell risk.
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Financial Institutions
• Firms that provide access to the financial markets, both
• to savers who wish to purchase financial instruments directly and
• to borrowers who want to issue them.
• Also known as financial intermediaries.
• Examples: banks, insurance companies, securities firms, and pension funds.
• Healthy financial institutions open the flow of resources, increasing the
system’s efficiency.
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The Role of Financial Institutions
• To reduce transaction costs by specializing in the issuance of
standardized securities.
• To reduce the information costs of screening and monitoring
borrowers.
• They curb asymmetries, helping resources flow to most productive uses.
• To give savers ready access to their funds.
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• Financial intermediation and leverage in the US have shifted away
from traditional banks and toward other financial institutions less
subject to government regulations.
• Brokerages, insurers, hedge funds, etc.
• These have become known as shadow banks.
• Provide services that compete with banks but do not accept deposits.
• Take on more risk than traditional banks and are less transparent.
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• The rise of highly leveraged shadow banks, combined with
government relaxation of rules for traditional banks, permitted a
rise of leverage in the financial system as a whole.
• This made the financial system more vulnerable to shocks.
• Rapid growth in some financial instruments made it easier to
conceal leverage and risk-taking.
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• The financial crisis transformed shadow banking.
• The largest US brokerages failed, merged, or converted themselves into
traditional banks to gain access to funding.
• The crisis has encouraged the government to scrutinize any
financial institution that could, by risk taking, pose a threat to the
financial system.
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The Structure of the Financial Industry
• We can divide intermediaries into two broad categories:
• Depository institutions,
• Take deposits and make loans
• What most people think of as banks
• Non-depository institutions.
• Include insurance companies, securities firms, mutual fund companies, etc.
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The Structure of the Financial Industry
1. Depository institutions take deposits and make loans.
2. Insurance companies accept premiums, which they invest, in
return for promising compensation to policy holders under
certain events.
3. Pension funds invest individual and company contributions in
stocks, bonds, and real estate in order to provide payments to
retired workers.
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The Structure of the Financial Industry
4. Securities firms include brokers, investment banks,
underwriters, and mutual fund companies.
•
•
•
Brokers and investment banks underwrite stocks and bonds to
corporate customers, trade them, and advise customers.
Mutual-fund companies pool the resources of individuals and
companies and invest them in portfolios.
Hedge funds do the same for small groups of wealthy investors.
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The Structure of the Financial Industry
5. Finance companies raise funds directly in the financial markets
in order to make loans to individuals and firms.
•
Finance companies tend to specialize in particular types of loans, such
as mortgage, automobile, or business equipment.
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The Structure of the Financial Industry
6. Government-sponsored enterprises are federal credit agencies
that provide loans directly for farmers and home mortgagors.
•
•
Guarantee programs that insure loans made by private lenders.
Provides retirement income and medical care through Social Security
and Medicare.
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Figure 3.2: Flow of Funds through Financial
Institutions
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• Most people need to borrow to buy a house.
• Mortgage payment will be your biggest monthly expense so shop
around.
• Many offers are from mortgage brokers - firms that have access to
pools of funds earmarked for use as mortgages.
• Who offers your mortgage is not important - get the best rate you
can.
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Functions of Financial Institutions
• Financial intermediaries channel funds between borrowers and lenders.
• Intermediation  transforming assets
– the function of transforming assets or liabilities into other assets or
liabilities
• Liabilities – deposits
• Assets – loans
– this is the principal activity of most financial institutions.
– intermediation improves social welfare by channeling resources to their
most effective use
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Contd...
• Facilitate the acquisition/payment of goods & services via lower transactions
costs
– Chequing services provided by banks improve economic efficiency.
• Facilitate the creation of a “portfolio”
– A portfolio is a collection of financial assets
– The financial system provides economies of scale & scope
• Economies of Scope: cost savings that stem from engaging in complementary activities.
• Economies of Scale: obtained when the unit cost of an operation decreases as more of it
is done.
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Contd...
• Ease liquidity constraints
• Reallocate consumption/savings patterns
• Often the liquidity required to make certain purchases is not in line with the
immediate flow of income available to individuals. Eg. Credit Card
• The ability to influence the allocation of consumption and investment is
probably the most important function of intermediation.
• Provide security
• Intermediation provides a host of services that reduce or shift risk.
• Financial institutions can also influence the riskiness of financial
transactions [contracts and insurance].
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Contd...
• Reduce asymmetric information problem
• Moral hazard
• the individual perceives as beneficial actions that are deemed undesirable by another.
• Adverse selection
• decision making that results from the incentive for some people to engage in a transaction that is
undesirable to everyone else
• Banks have a comparative advantage in offering specialized services that help reduce this
problem.
• Banks can also take advantage of this asymmetric information problem, with dire
consequences.
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Adverse Selection
Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes
ones most likely to seek loans and be selected
1.
are
Moral Hazard
1. After transaction occurs
2.
Hazard that borrower has incentives to engage in undesirable (immoral) activities making it
more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling
them to make profits
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•Brokerage an “agency” function
– Brokers are agents who bring would-be buyers and sellers together so
transactions can be made.
– Intermediation provides value-added but there are potential “externalities”.
One intermediary’s actions can have consequences for the entire system.
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• Banks are particularly adept at intermediation because they can
perform the necessary functions more cheaply than most
institutions.
• Technological change and deregulation have narrowed the
comparative advantage of banks.
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Function of Financial Markets
1. Allows transfers of funds from person
or business without investment
opportunities to one who has them
2. Improves economic efficiency
Source: Mishkin, Frederic S. and Apostolos Serletis, The Economics of Money, Banking and Financial Markets, 2nd Canadian Edition,
Pearson Addison Wesley, 2004
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Role of Financial Intermediaries
Transaction Costs and Economies of Scale –
Transaction costs = the time and money spent in carrying out financial
transactions.
Financial intermediaries help reduce transaction costs by taking advantage of
economies of scale. Example: a bank can use the same loan contract again and
again, thereby reducing the costs of making each individual loan.
2. Risk Sharing and Diversification - Risk = uncertainty about the returns investors
will receive on any particular asset. By purchasing a large number of different
assets issued by a wide range of borrowers, financial intermediaries use
diversification to help with risk sharing.
Example: by lending to a large number of different businesses, a bank might see a
few of its loans go bad; but most of the loans will be repaid, making the overall
return less risky.
1.
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3. Adverse Selection and Moral Hazard - Financial intermediaries also
use their expertise to screen out bad credit risks and monitor
borrowers. They thereby help solve two problems related to
imperfect information in financial markets.
Adverse Selection = refers to the problem that arises before a loan
is made because borrowers who are bad credit risks tend to be
those who most actively seek out loans. Financial intermediaries
can help solve this problem by gathering information about
potential borrowers and screening out bad credit risks.
Moral Hazard = refers to the problem that arises after a loan is
made because borrowers may use their funds irresponsibly.
Financial intermediaries can help solve this problem by monitoring
borrowers’ activities.
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