Financial Intermediation

Question 1

Why do suppliers not sell directly to consumers?

Answer 1

Convenience of an intermediary: minimises transaction costs, takes care of

Question 2

Outline the different layers of intermmedation in the case of food

Answer 2

Distributors, wholesalers
Then to processors
Then to grocery stores

Question 3

Outline the benefits of having an intermediary

Answer 3

Intermediaries can:
Absorb differences in timing (have the funds ready when you want it because of inventories)

Absorb differences in quantity (merge different sums of money together to create a loan, for instance)

Repackage product (Repackaging loans, creating new securities out of loans)

Specialize in product information (FI’s evaluate credit risks)

Question 4

Outline functions unique to financial intermediaries

Answer 4

Helps diversify default risks

Can leverage residual risk onto equity

Question 5

Outline dysfunctions unique to financial intermediaries

Answer 5

Maturity transformation: they typically led longer than they borrow, thereby resulting in interest rate risk.
Equation for IRR: delta NW/A = delta i (Dl-Da), where Dl is the duration of liabilities, and Da is the duration of assets.

(For clarification on the concept duration, go back to bonds in chapter 5)

Therefore, a rise in interest rates can potentially lead to negative net worth depending on Dl and Da.

Question 6

How can interest rate risk be eliminated?

Answer 6

Matching of Dl and Da to hedge against the interest rate change.

Maximizing Dl would be optimal to reduce the reduction in net worth in the event of an interest rate hike.

Question 7

Role of CBs in the financial intermediation process?

Answer 7

Pre-1961: Involved extensive maturity transformation since all deposits had 0 maturity.
Since 1961, CDs allow CB intermediation to be maturity balanced.
Since 1983, CBs have relied heavily on MMDAs (0 maturity, 6 per month) to balance short term loans such as commercial and industrial loans.

Question 8

Give some examples of thrift institutions

Answer 8

Savings and Loan Associations, Savings Banks, and Credit Unions

Question 9

Describe the balance sheet composition of a typical thrift institution in the 1950s-70s

Answer 9

Specialize in:
Non M1 deposits: savings, CDs, MMDAs
Long term Loans: S& Ls - 30 year fixed rate mortgages

For savings banks: bonds, mortgages, mostly state chartered

Question 10

Describe the evolution of mortgage intermediation

Answer 10

Pre-1930s:
Some mortgages balloon loans, interest for 3 - 5 years, then all due at once. (Many, however, were already amortized 30 year loans)

1929-32:
30% deflation, high U
Defaults on home, business loans increased, which increased bank, thrift failures as a direct result (since many were involved in the mortgage business)

1932: Federal Home Loan Act
Created Federal Savings and Loan Associations
- Less specialized in home mortgages, collected passbook savings
- Made amortized home loans up to m = 30 years, got tax advantage
After 1934, these associations insured by the FSLIC (Fed S & L Insurance Corporation)

Question 11

Advantages of amortized loans?

Answer 11

For borrower:
Constant, predictable payment
Buyer builds equity, owns house
Buyer keeps value of all improvements

For lender
House unlikely to depreciate faster due to the consistency of payments
Buyer bears primary consequence of poor maintenance
Buyer bears most of the price fluctuation risk
Safe from credit risk if:
20% down payment
20% max (Principal + interest/income ratio)

Question 12

What does duration measure?

Answer 12

The extent of a bond’s price change in relation to the current interest rate.

Duration is always less than m/2, decreases as i rises.

Question 13

If a commercial bank with leverage ratio 5:1 experiences a 10% increase in its assets, its equity will increase by…

Answer 13

5*1.1 = 5.5.
5.5-4=1.5
(1.5-1=0.5 
0.5*100=50%
Equity increases by 50%.

Question 14

The BHC of the commercial bank would experience a ___ percentage increase in its assets

Answer 14

Since equity increases by 50%, and BHC assets = CBs equity, a 50% increase in equity would correspond to a 50% increase in BHC assets, thereby increasing the BHC’s equity by a much larger percentage.

Say the BHC’s leverage ration = 2:1.
2*1.5=3.
Equity increases by 100%, since 3-1 = 2 = new equity, which is double the original value of equity.

Therefore, any change in CB equity corresponds to the same change in a BHC’s asset value, which magnifies the BHC’s equity value.

Question 15

Why are thrifts particular vulnerable to increases in the interest rate?

Answer 15

Because -delta i (Dl-Da) = change in net worth, and usually, Da»> Dl, resulting in decreases in value of net worth if interest rates increase substantially.

Question 16

Describe the thrift crisis of the 1980s

Answer 16

Interest rates increased due to Volcker central bank policy.
Caused decreases in thrift asset value, whereas liabilities remained somewhat the same (remember that price change = D delta i).
Net worth doomed to go negative due to borrowing short lending long policy.

1980s:
Zombie thrifts dead but going through the motions of life.
Regulators delayed resolving insolvencies thru 80s.
Provoked S and Ls to take big risks to recover losses.

1989:
Crisis finally ended with the failure of the FSLIC (Federal Savings and Loan insurance corp.), massive cost to taxpayers
Banks GSE becoming the new mortgage intermediaries.