Chapter 1: Why are Financial Institutions Special? Flashcards
What are five risks common to all FIs?
- Default or credit risk of assets,
- interest rate risk caused by maturity mismatches between assets and liabilities,
- liability withdrawal or liquidity risk,
- underwriting risk, and
- operating risks.
Identify and explain the two functions in which FIs may specialize that would enable the smooth flow of funds from household savers to corporate users.
- The brokerage function: can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs.
- The asset transformation function: is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.
In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.
Explain how FIs act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?
By putting excess funds into FIs, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. In this sense the depositors have delegated the FI to act as a monitor on their behalf. Further, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as business loans, that continually update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate sources and users of funds in the economy.
What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?
- FIs collect and process information more efficiently than individual savers.
- FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds.
- by diversifying the asset base FIs provide secondary securities with lower price-risk conditions than primary securities.
- FIs provide economies of scale in transaction costs because assets are purchased in larger amounts.
- FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.
What are agency costs? How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations?
Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower.
How do large FIs solve the problem of high information collection costs for lenders, borrowers, and financial markets?
One way financial institutions solve this problem is that they develop secondary securities that allow for improvements in the monitoring process.
How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in the securities of corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, for example, offer deposits that can be withdrawn at any time. Yet, the banks make long-term loans or invest in illiquid assets because they are able to diversify their portfolios and better monitor the performance of firms that have borrowed or issued securities. Thus, individual investors are able to realize the benefits of investing in primary assets without accepting the liquidity risk of direct investment.
How do FIs help individual savers diversify their portfolio risks? Which type of FI is best able to achieve this goal?
Money placed in any FI will result in a claim on a more diversified portfolio. Banks lend money to many different types of business, consumer, and government customers. Insurance companies have investments in many different types of assets. Investments in a mutual fund may generate the greatest diversification benefit because of the fund’s investment in a wide array of stocks and fixed income securities.
What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by FIs?
If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets.
What are five areas of institution-specific FI specialness, and which types of institutions are most likely to be the service providers?
- commercial banks and other deposit-taking institutions are key players for the transmission of monetary policy from the central bank to the rest of the economy.
- specific FIs often are identified as the major source of finance for certain sectors of the economy. For example, savings institutions traditionally serve the credit needs of the residential real estate market.
- life insurance and pension funds commonly are encouraged to provide mechanisms to transfer wealth across generations.
- deposit-taking institutions efficiently provide payment services to benefit the economy.
- mutual funds provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as t-bills, bonds, and other securities.
What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide?
Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy, which are considered to be socially important. These may include housing and farming. Presumably the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society.
What are two of the most important payment services provided by FIs? To what extent do these services efficiently provide benefits to the economy?
The two most important payment services are cheque clearing and wire transfer services. Any breakdown in these systems would produce gridlock in the payment system with resulting harmful effects to the economy at both the domestic and potentially the international level.
What is denomination intermediation? How do FIs assist in this process?
Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are sold only in large denominations. Individual savers often invest small amounts in mutual funds. The mutual funds pool these small amounts and purchase a well diversified portfolio of assets. Therefore, small investors can benefit in the returns and low risk which these assets typically offer.
What is negative externality? In what ways does the existence of negative externalities justify the extra regulatory attention received by FIs?
A negative externality refers to the action by one party that has an adverse affect on some third party who is not part of the original transaction.
For FIs, one concern is the contagion effect that can arise when the failure of one FI can cast doubt on the solvency of other institutions in that industry.
