Chapter 1
Why Are Financial
Intermediaries
Special?
K. R. Stanton
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Why Are Financial
Intermediaries Special?

1-2
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.
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1-3
Without FIs
Equity & Debt
Households
Corporations
(net savers)
(net borrowers)
Cash
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FIs’ Specialness

1-4
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
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1-5
With FIs
FI
Households
Cash
(Brokers)
FI
Corporations
Equity & Debt
(Asset
Transformers)
Deposits/Insurance
Policies
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Cash
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Functions of FIs

1-6
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
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Role of FIs in Cost Reduction

1-7
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
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Specialness of FIs

Liquidity and Price Risk




1-8
Secondary claims issued by FIs have less price
risk
FIs have advantage in diversifying risks
S&L debacle of 1980s linked to inadequate
diversification of S&Ls
Reduced transaction & information costs

economies of scale
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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.
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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.
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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.
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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
FDIC: Bank Insurance Fund (BIF), Savings
Association Insurance Fund (SAIF)
Securities Investors Protection Fund (SIPC)
Monitoring and surveillance.
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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
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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.
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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)
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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 2002.
Potential extensions of regulations such as
CRA to other FIs such as insurance
companies.
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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.
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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.
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Web Resources

1-19
For more information on regulation of
depository institutions visit:
www.ffiec.gov
www.federalreserve.gov
www.fdic.gov
www.occ.treas.gov
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1-20
Changing Dynamics of Specialness

Trends in the United States





Decline in share of depository institutions.
Increases in pension funds and investment
companies.
May be attributable to net regulatory burden
imposed on depository FIs.
Technological changes affect delivery of
financial services and regulatory issues
Potential for regulations to be extended to
hedge funds

Result of Long Term Capital Management disaster
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Future Trends
1-21
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 and First Chicago
Growth in Online Trading
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Global Issues
1-22
Increased competition from foreign FIs at
home and abroad
 Mergers involving world’s largest banks
 Mergers blending together previously
separate financial services sectors

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World’s Largest Banks
1-23
Bank
Assets
($Millions)
Citigroup (USA)
1,097,000
Mizuho Financial Group (Japan)
945,688
UBS (Switzerland)
825,000
Sumitomo Mitsui Fin. (Japan)
802,674
Deutsche Bank (Germany)
794,984
Bank of Tokyo-Mitsubishi (Japan)
789,495
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Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co. Institute
OCC
SEC
SIPC
Wall Street Journal
Thompson Fin. Sec. Data
McGraw-Hill/Irwin
1-24
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.tfibcm.com
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.