KINDS OF FINANCIAL INTERMEDIATION

1-1
One of the pre-conditions for the growth of
economy is growth in the Capital formation.




Capital formation refers to an increase in the stocks of
PHYSIAL CAPITAL/REAL OR PRODUCTIVE ASSETS
of an economy.
The process of Capital formation involves three distinct
yet interdependent activities, viz., Savings, Finance and
Investment.
Banks and FIs are engaged in the process of
chanelising Savings from Surplus entities to Deficit
entities/units and help as a catalyst in the Capital
formation and economic development.
This special role/activity of Banks/FIs is known as
Financial Intermediation.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
1-2
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
FIs’ Specialness

1-3
Without FIs: Low level of fund flows.

Information and Monitoring costs : Very High





Economies of scale reduce costs for FIs to screen
and monitor borrowers
Less liquidity
Maturity Mismatch
Substantial price risk
High Default Risk/ Credit Risk
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
1-4
With FIs
FI
Households
Cash
(Brokers)
FI
Corporations
Equity & Debt
(Asset
Transformers)
Deposits/Insurance
Policies
McGraw-Hill/Irwin
Cash
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
1-5
KINDS OF FINANCIAL
INTERMEDIATION
 Banks and FIs actually performs various
kinds
of
intermediation
functions/
transformation services. They are:




Denomination (or Quantum) Intermediation
Default-risk Intermediation
Maturity Intermediation
Liquidity Intermediation
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
KINDS OF FINANCIAL
INTERMEDIATION
 Contd…




1-6
Information Intermediation
Time Intermediation
Risk Pooling and Diversification (Economies of
Scale & Economies of Scope)
Risk Sharing & Asset Transformation
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.


1-7
Kinds of Financial Intermediation
Contd ….
Denomination (or Quantum) Intermediation: is
a kind that occurs when small amounts of savings
from individuals and others are collected and
pooled so as to give loans to others. This helps
small savers to generate higher returns and lower
risks on their portfolios.
Default-risk Intermediation: refers to the
willingness of FIs to make loans to risky borrowers
and, at the same time, issue relatively safe and
liquid securities in order to attract loanable funds
from savers who are risk averse. Generally, the
borrowers from an FI is perceived to be more risky
than the FI itself. Thus FIs assumes the
Default/Credit Risk onto itself and shield the
Primary Savers.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-8
Kinds of Financial Intermediation
Contd…
Maturity Intermediation: refers to the borrowing
of relatively short-term funds from savers, who
often cannot commit their funds over long periods,
and making long-term loans to borrowers who
require a long-term commitment to funds. Thus the
FIs takes over the Maturity Mismatch Risk from
the Primary Savers onto itself and thereby subject
itself to consequent Interest Rate Risk. A Large FI
is better able to bear the risk of mismatching of its
assets and liabilities and manage the consequent
Liquidity Risk and Interest Rate Risk through its
superior access to markets and instruments for
hedging the risks of such loans.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Kinds of Financial Intermediation
Contd….

1-9
Liquidity Intermediation: refers to issuing
of indirect claims to savers/depositors that
are highly liquid while at the same time
accepting relatively less liquid direct claims
from borrowers/investors which may entail
considerable risk of loss and high
transaction costs if these claims are
converted into cash. Thus FIs takes over the
Liquidity & Price Risk from the Primary
savers onto itself.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-10
Kinds of Financial Intermediation
Contd ….
Information Intermediation: refers to the process
by which FIs substitute their skill in gathering and
processing information from financial market place
for that of the savers who frequently have neither
time nor expertise to stay abreast of the market
developments nor access to relevant information
about market conditions and investment
opportunities. The FIs are perceived to possess
“Asymmetric Information” which will facilitate in
taking better decisions on the aspect of routing
money to the investors/borrowers. Information
Asymmetry is a situation in which one party to a
transaction is better informed than the other. This
is in fact one of the causes for existence of a
Financial Intermediary.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-11
Kinds of Financial Intermediation
Contd ….
Inter Generational wealth Transfer or Time
Intermediation: refers to the process by which
FIs, especially Life Insurance Companies and
Pension Funds, provide savers with the ability to
transfer wealth from their youth to old age across
generations. This is of great importance to a
country’s social well-being. For example, pension
funds offer savings plans through which fund
participants accumulate tax exempt savings during
their working years before withdrawing them
during their retirement years. By this act, FIs
assumes on to itself the Longevity Risk (?) and
other financial Risks from that of Primary Savers.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Kinds of Financial Intermediation
Contd ….
1-12

Risk Pooling & Diversification (Economies of Scale &
Economies of Scope):

FIs also engage in risk pooling and take advantage of
Economies of Scale in their activities. Economies of scale
refers to decreasing of costs of overall operation and
performance by virtue of large size of operations. By
deploying resources in loans and other assets
like
investments with a wide variety of risk-return
characteristics, the benefits of financial diversification are
achieved, enhancing the safety of funds supplied by
savers.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Kinds of Financial Intermediation
Contd ….
1-13

Risk Pooling & Diversification (Economies of Scale &
Economies of Scope):

Most small savers cannot adequately diversify their limited
funds among different types of investments. However, an
FI can pool the funds of many small savers and efficiently
diversify, achieving Economies of Scope, across many
different investments, lowering risks of all savers.
Economies of Scope refers to decreasing of costs of
overall operation and performance as well as increasing
the overall revenues by virtue of using/optimising the same
existing resources including human resources (often
underutilised) for various complementary and related
operations.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Kinds of Financial Intermediation
Contd ….


1-14
Risk Sharing & Asset Transformation:
Another benefit made possible by the low transaction costs
of FIs is that they can help reduce the exposure of
investors to risk—that is, uncertainty about the returns
investors will earn on assets. FIs do this through the
process known as risk sharing: They create and sell assets
with risk characteristics that people are comfortable with,
and the intermediaries then use the funds they acquire by
selling these assets to purchase other assets that may
have far more risk. Low transaction costs allow financial
intermediaries to share risk at low cost, enabling them to
earn a profit on the spread between the returns they earn
on risky assets and the payments they make on the assets
they have sold.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Kinds of Financial Intermediation
Contd ….
1-15

Risk Sharing & Asset Transformation: (Contd…)

This process of risk sharing is also sometimes referred to
as asset transformation or risk transformation because, in
a sense, risky and illiquid assets (Primary securities like
equity, debt securities, loans and mortgages) are turned
into safer and liquid assets (Secondary securities like
deposits and insurance policies) for investors. Hence FIs
are called as Asset Transformers or Risk Transformers.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Flow of Funds in a world with FIs : 1-16
Indirect Transfer/Financing
Users of Funds
Cash
FI
(Brokers)
FI
(Asset
transformers)
Financial Claims
(Equity and debt securities, loans
and mortgages etc.)
PRIMARY SECURITIES
McGraw-Hill/Irwin
Suppliers of Funds
1-16
Cash
Financial Claims
(Deposits and insurance policies)
SECONDARY SECURITIES
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Risks incurred by FIs while performing1-17
the role of Financial Intermediation




As Banks & FIs perform the various services described
above, they assume many types of risks.
Specifically, all FIs hold some assets that are potentially
subject to default or credit risk (such as loans, stocks or
bonds).
Further, FIs tend to mismatch the maturities of their
Balance Sheet Assets and Liabilities to a greater or lesser
extents and are thus exposed to liquidity risk and interest
rate risk.
Moreover, all FIs are exposed to some degree of liability
withdrawal or liquidity risk, depending on the type of claims
they have sold to liability holders.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Risks incurred by FIs while performing1-18
the role of Financial Intermediation



Finally, all FIs are exposed to operating cost risk because
the production of financial services requires the use of real
resources and back-office support systems (labour and
technology combined to provide services).
Other risks FIs face include Off-Balance-Sheet risk,
technology risk, country or sovereign risk and insolvency
risk.
We shall study all these risks in detail in the course on risk
management in banking.
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.