an overview of the financial system...chapter 2

7/29/2019 An Overview of the Financial System...Chapter 2

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An Overview of the Financial

System

Chapter: 2


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Concept of Financial Intermediation

Indirect Finance: Funds are move from lenders toborrowers by a financial intermediary that standsbetween the lender savers and the borrower spendersand helps transfer funds from one to the other.

A financial intermediary borrows funds from the lender-saver and then uses these funds to make loans toborrower- spender.

Financial intermediation: The process of indirect financeusing financial intermediaries called financialintermediation is the primary route for moving fundsfrom lender to borrowers.

Financial intermediaries are a far more important sourceof financing for corporation than securities markets.


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Benefits of Financial intermediation

Financial Intermediation has following

benefits:

1. Lower Transaction Cost.

2. Reduce the Exposure of Investors to Risk.

3. Deal with Asymmetric Information Problem.


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TransactionCost

Transaction Cost: Is the time and money spent in carrying outfinancial transaction.

Financial intermediaries can reduce transaction costs because:

I. They have developed expertise in lowering them.

II. Their large size allows them to take advantage of economies ofscale.

Economies of Scale: The reduction in transaction costs per dollar ofthe transaction as the size of transaction increases.

III. It provides its customers with liquidity services.

Liquidity Service: Services that make it easier for customers to

conduct transaction.IV. Depositors can earn interest on checking and savings accounts

and still convert them into goods and services whenevernecessary.


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Risk Sharing

The other benefit of financial intermediation is theyreduce the exposure of investors to risk as:

I. Financial intermediaries reduce risk through theprocess of risk sharing.

II. Financial intermediaries share risk at low costenabling them to earn a profit on the spreadbetween the returns they earn on risky assets andthe payment they make on the assets they have sold.

III. Financial intermediaries help individuals to diversifyand thereby lower the amount of risk to which theyare exposed.


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Risk Sharing

Risk: Is uncertainty about the returns investors will earnon assets.

Risk Sharing: Financial intermediaries create and sellassets with risk characteristics that people are

comfortable with and then use the funds they acquire byselling these asset to purchase other assets that mayhave for more risk.

Asset Transformation: Risk sharing is also called as assettransformation as risky assets are turned into safer assetsfor investors.

Diversification: Entails investing in a collection of assetswhose returns do not always move together with theresult overall risk is lower than for individual assets.


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Asymmetric Information

Financial intermediaries alleviate the problem ofasymmetric information.

Asymmetric Information: Inequality of informationmeans one party often does not know enough about the

other party to make accurate decision. This creates two problems:

1. Adverse Selection.

2. Moral Hazard.

Adverse Selection: Is the problem created by asymmetricinformation before the transaction occurs.

Moral Hazard: Is the problem created by asymmetricinformation after the transaction occurs.


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Intermediation and Disintermediation Disintermediation: Funds are move from lenders to borrowers directly

without involvement of any financial intermediary. Disintermediation involves the problems of:

Transaction Cost.

Investment Risk.

Asymmetric Information.

This make difficult for small savers and borrower to raise funds theyneeded.

Financial intermediaries play an important role in the economy as theyprovide:

Liquidity Service.

Promote Risk Sharing. Solve Information Problem.

By this financial intermediaries allow small savers and borrowers tobenefit from the existence of financial markets. This would be difficultin the case of disintermediation.


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Types of Financial Intermediaries

Financial intermediaries are divided into three

categories:

1. Depository Institutions.

2. Contractual Saving Institutions.

3. Investment Intermediaries.


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1. Depository Institutions

Depository Institutions: Are financialintermediaries that accept deposits from

individuals and institutions and make loans.

These institutions include:

1. Commercial Banks and Thrift Institutions

(thrifts).

2. Saving and Loans Associations.3. Mutual Saving Banks.

4. Credit Unions.


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Commercial Banks

These financial intermediaries raise funds primarily byissuing:

1. Checkable Deposits: Deposits on which checks can bewritten.

2. Saving Deposits: Deposits that are payable on demandbut do not allow their owner to write checks.

3. Time Deposits: Deposits with fixed terms to maturity.

They use these funds to make commercial, consumer

and mortgage loans and to buy U.S governmentSecurities and municipal bonds.

They are the largest financial intermediaries and havethe most diversified portfolios of assets.


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Savings and Loan Associations (S&Ls) and

Mutual Savings Banks

These depository institutions obtain funds primarilythrough:

1. Saving Deposits\ Shares.

2. Time Deposits.

3. Checkable Deposits. These institutions were constrained in their activities in the

past and mostly made mortgage loans for residentialhousing.

These restrictions have been loosen over time so that the

distinction between these depository institutions andcommercial banks has blurred and they become more alikeand now are more competitive with each other.


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Credit Unions

These financial institutions are typically very

small cooperative lending institutions

organized around a particular group:

Union Members

Employees of a particular firm and so forth.

These acquire funds from deposits called

Shares.

They primarily make consumer loans.


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Contractual Saving Institutions Contractual Saving Institutions: Are financial intermediaries

that acquire funds at periodic intervals on a contractual basis.

Unlike depository institution they do not have to worry aboutlosing funds quickly as they can predict with accuracy aboutthe benefits they will pay in the coming years.

Unlike depository institutions liquidity of assets is not asimportant consideration for them.

They invest their funds primarily in long term securities suchas corporate bonds, stocks and mortgages.

Contractual Savings Institutions are:

1. Life Insurance Companies.

2. Fire and Causality Insurance Companies.

3. Pension Funds and Government retirement Funds.


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Life Insurance Companies

Life Insurance Companies insure people againstfinancial hazards following a death and sellannuities (annual income payments uponretirement).

They acquire funds from the premiums that peoplepay to keep their policies in force.

They these funds mainly to buy corporate bondsand mortgages.

They also purchase stocks but are restricted in theamount they can hold.

They are amount the largest of the contractualsaving institutions.


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Fire and casualty Insurance Companies

These companies insure their policyholdersagainst loss from theft, fire and accidents.

Like life insurance companies they receive fundsthrough premiums for their policies.

They have a greater possibility of loss of funds ifmajor disaster occurs as compare to life insurancecompanies.

Unlike life insurance companies they use theirfunds to buy more liquid assets.

Their largest holding of assets is municipal bonds.

They also hold corporate bonds and stocks and U.S

government securities.


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Pension Funds and Government Retirement

Funds

Private pension funds and state and localretirement funds provide retirement income in theform of annuities to employees who are covered by

a pension plan. Funds are acquired by contributions from

employers and employees, who either have acontribution automatically deducted from their

paychecks or contribute voluntarily. The larges asset holdings of pension funds are

corporate bonds and stocks.


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Investment Intermediaries

This category of financial intermediaries

includes:

1. Finance Companies.

2. Mutual Funds.

3. Money Market Mutual Funds.


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Finance Companies

Finance companies raise funds by selling

commercial paper and by issuing stocks and bonds.

CommercialPaper: Is a short term debt instrument.

They lend these funds to consumers, who make

purchases of such items as furniture, automobiles

and home improvements and to small business.

Some finance companies are organized by a parentcorporation to help sell its product.


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Mutual Funds

Mutual funds acquire funds by selling shares to manyindividuals and use the proceeds to purchase diversifiedportfolios of stocks and bonds.

Mutual funds allow share holders to:

Pool their resources so that they can take advantage of

lower transaction cost when buying large blocks of stocksor bonds.

Hold more diversified portfolios.

Shareholders can sell or redeem shares at any time but

the value of these shares will be determined by the valueof the mutual funds holdings of securities.

Investment in mutual funds can be risky because themutual funds shares value fluctuates greatly.


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Money Market Mutual Funds

Money markets mutual funds have the characteristics ofmutual funds and also function to some extent asdepository institution as they offer deposit typeaccounts.

They sell shares to acquire funds.

These funds are used to buy money market instrumentsthat are safe and very liquid.

Interest on these assets is paid out to the shareholders.

Shareholders can write checks against the value of theirshareholdings.

Shares in a money market mutual fund function likechecking account deposits that pay interest.


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Investment Banks

Unlike an investment bank or financial intermediary itdoes not take in deposits and then lend them out.

Investment bank is an intermediary that helps acorporation issue securities by:

I. It advises the corporation on which type of securities toissue stocks or bonds.

II. It helps sell or underwrite the securities by purchasingthem from the corporation at a predetermined priceand reselling them in the market.

III. It also acts as a deal makers helping corporationsacquire other companies through mergers oracquisitions.


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Table 3 Primary Assets and Liabilities of Financial

Intermediaries

an overview of the financial system...chapter 2

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