Chapter 1
Why Are Financial
Intermediaries
Special?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Why Are Financial
Intermediaries Special?

Objectives:




Develop the tools needed to measure and
manage the risks of FIs.
Explain the special role of FIs in the financial
system and the functions they provide.
Explain why the various FIs receive special
regulatory attention.
Discuss what makes some FIs more special
than others.
1-2
1-3
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
FIs’ Specialness

Without FIs: Low level of fund flows.

Information costs:



Economies of scale reduce costs for FIs to screen
and monitor borrowers
Less liquidity
Substantial price risk
1-4
1-5
With FIs
FI
Households
Cash
(Brokers)
FI
Corporations
Equity & Debt
(Asset
Transformers)
Deposits/Insurance
Policies
Cash
Functions of FIs

Brokerage function

Acting as an agent for investors:




e.g. Merrill Lynch, Charles Schwab
Reduce costs through economies of scale
Encourages higher rate of savings
Asset transformer:

Purchase primary securities by selling financial
claims to households
• These secondary securities often more marketable
• Transformation of financial risk
1-6
Role of FIs in Cost Reduction

Information costs:

Investors exposed to Agency Costs

Role of FI as Delegated Monitor (Diamond, 1984)
• Shorter term debt contracts easier to monitor than bonds
• FI likely to have informational advantage

FI as information producer
• Monitoring power and control
• Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders
1-7
Specialness of FIs

Liquidity and Price Risk



1-8
Secondary claims issued by FIs have less price
risk
FIs have advantage in diversifying risks
Reduced transaction & information costs


economies of scale
Bid-ask spreads narrower for assets bought and
sold in large quantities.
Other Special Services






1-9
Maturity intermediation
Transmission of monetary policy.
Credit allocation (Areas of special need such as
home mortgages).
Intergenerational transfers or time
intermediation.
Payment services (FedWire and CHIPS).
Denomination intermediation.
Specialness and Regulation

1-10
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.

Negative externalities arise if these services are
not provided.
Regulation of FIs

Important features of regulatory policy:

Protect ultimate sources and users of savings.



1-11
Including prevention of unfair practices such as
redlining and other discriminatory actions.
Primary role:
Ensure soundness of the system as a whole.
Regulation is not costless

Net regulatory burden.
Regulation

1-12
Safety and soundness regulation:

Regulations to increase diversification



Minimum capital requirements
Guaranty funds:



No more than 10 percent of equity to single borrower
Deposit insurance fund (DIF):
Securities Investors Protection Fund (SIPC)
Monitoring and surveillance.

FDIC monitors and regulates DIF participants.
Web Resources

1-13
For information on regulation of depository
institutions and investment firms visit:
FDIC www.fdic.gov
SIPC www.sipc.org
Federal Reserve www.federalreserve.gov
Regulation

1-14
Monetary policy regulation



Federal Reserve directly controls outside
money.
Bulk of money supply is inside money
(deposits).
Reserve requirements facilitate transmission of
monetary policy.
Regulation

1-15
Credit allocation regulation

Supports socially important sectors such as
housing and farming.


Requirements for minimum amounts of assets in a
particular sector or maximum interest rates or fees.
Qualified Thrift Lender Test (QTL)
• 65 percent of assets in residential mortgages

Usury laws and Regulation Q (abolished)
Regulation

Consumer protection regulation



Community Reinvestment Act (CRA).
Home Mortgage Disclosure Act (HMDA).
Effect on net regulatory burden


1-16
FFIEC processed info on as many as 31 million
mortgage transactions in 2006.
Potential extensions of regulations such as
CRA to other FIs such as insurance
companies in light of consolidation and trend
toward universal banking.
Regulation

Investor protection regulation


1-17
Protections against abuses such as insider
trading, lack of disclosure, malfeasance, breach
of fiduciary responsibility.
Key legislation


Securities Acts of 1933, 1934.
Investment Company Act of 1940.
Regulation

1-18
Entry regulation


Level of entry impediments affects profitability
and value of charter.
Regulations define scope of permitted activities.


Financial Services Modernization Act of 1999.
Affects charter value and size of net regulatory
burden.
Web Resources

For more information on regulation of
depository institutions visit:
www.ffiec.gov
www.federalreserve.gov
www.fdic.gov
www.occ.treas.gov
1-19
1-20
Changing Dynamics of Specialness

Trends in the United States



Decline in share of depository institutions.
Increases in investment companies.
May be attributable to net regulatory burden
imposed on depository FIs.


Financial Services Modernization Act
Ethics issues and weakening of public trust
Future Trends
1-21
Further weakening of public trust and
confidence in FIs may encourage
disintermediation
 Increased merger activity within and across
sectors



Citicorp and Travelers, UBS and Paine Webber
More large scale mergers such as J.P. Morgan
and Chase, and Bank One
Growth in Online Trading
 Amendment of SEC 144A


Private placement market effects
Equity Trading on the Internet
1-22
Global Issues
Increased competition from foreign FIs at
home and abroad
 Mergers involving world’s largest banks
 Mergers blending together previously
separate financial services sectors

1-23
World’s Largest Banks ($Billions)
Bank
Barclays Bank (UK)
UBS (Switzerland)
Mitsubishi UFJ (Japan)
HSBC Holdings (UK)
Citigroup (USA)
BNP Paribas (France)
Credit Agricole Groupe (France)
Royal Bank of Scotland (UK)
Bank of America (USA)
1-24
Assets
1,591.5
1,567.6
1,508.5
1,502.0
1,494.0
1,484.1
1,380.6
1,337.5
1,291.8
Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co. Institute
OCC
SEC
SIPC
Wall Street Journal
Thompson Fin. Sec. Data
1-25
www.thebanker.com
www.federalreserve.gov
www.fdic.gov
www.ffiec.gov
www.ici.com
www.occ.treas.gov
www.sec.gov
www.sipc.org
www.wsj.com
www.thompson.com