Lecture 3: Financial institutions Flashcards
The main functions of financial intermediaries
Size transformation Maturity transformation Risk transformation Liquidity provision Costs reduction Provision of a payments system
Size transformation
(bank) depositors usually have small sight/saving accounts in comparison with loans required by borrowers.
In general, lenders tend to want to lend smaller amount of funds than borrowers generally wish to borrow. Financial intermediaries are able to collect together the small amounts made available by lenders and parcel these into the larger amounts required by borrowers.
Maturity transformation
savers generally prefer investing their money in safe. Short-term investment whereas borrowers prefer long-term loans, to finance their projects. A financial intermediary such as a commercial bank typically accepts investors’ funds on a short-term basis of less than a year and transforms these liabilities into longer term assets such as loans. The process of converting short-term liabilities into longer-term assets is known as maturity transformation.
One of the most important reasons why financial institutions are able to perform maturity transformation is that they deal with a large number of deficit and surplus agents. This means that their inflow and outflow of funds is fairly predictable, so they can operate with a relatively low level of liquid reserves.
Risk transformation
Depositors are generally not willing to take great risks when investing their money, however borrowers often look for funds in order to finance risky projects. o Effective risk reduction is achieved by making a relatively large number of small loans rather than a small number of large loans. In addition, a financial intermediary will tend to lend funds to different sectors of the economy, so that it will not be unduly affected by problems in any particular sector. A financial intermediary can obtain information on the purpose of the loan and better relate the size of the loan to the ability to repay. In addition, a financial intermediary is likely to be more skilled in charging an appropriate rate of interest to compensate for the risk involved.
Liquidity provision
surplus agents prefer that the assets they invest in be “liquid” i.e. easily convertible into cash; on the other hand, borrowers prefer long-term funding to carry out their projects. FIs are able to provide liquidity by maintaining a sufficiently large number of “lenders” (depositors) and ensuring that potential withdrawals (outflows) are covered by cash introduced by new accounts.
Costs reductions
FIs are able to reduce transaction costs, i.e. the costs associated with the buying and selling of a financial instrument (i.e., cost of searching a counterparty, cost of writing contracts, etc.)
Why are FIs able to reduce transaction costs?
Why are FIs able to reduce transaction costs?
Economic of Scale: Cost savings arising from decreasing unit cost of production as output increases. By increasing the volume of transactions, the cost per unit of transaction decreases.
Because FIs engage in numerous transactions, they are able to exploit the benefits of economies of scale.
Economies of Scope: Cost savings arising from joint production. Let us consider two outputs, Q1 and Q2 and their separate costs, C(Q1) and C(Q2). If the joint cost of producing the two outputs is expressed by C(Q1,Q2), then economies of scope are said to exist if:
C(Q1,Q2) < C(Q1) + C(Q2)
Because FIs offer a range of financial services, they are able to exploit the benefits of economies of scope
Provision of payments system:
o In modern times, financial intermediaries (especially commercial banks) facilitate payments via a number of non-cash means: cheques, credit/debit cards, electronic transfers and so on.
o However, because of the importance of the payment system for an economy, appropriate regulation is needed regarding the activities that financial intermediaries (FIs) are allowed to engage.
Issues in a financial system without financial intermediaries
Asymmetric Information:
o Not everyone has the same information
o Everyone has less than perfect information
o Some parties to a transaction have ‘inside’ information which is not made available to both sides of the transaction (asymmetry in the amount and quality of information)
o Information asymmetries or the imperfect distribution of information among parties can generate adverse selection and moral hazard.
Adverse selection
o It occurs BEFORE the financial transaction has taken place
o It consists in the worst potential borrowers most likely to produce adverse outcomes being the ones most likely to seek loans and be selected
o This occurs if it is hard to determine the riskiness of each borrower, and one price (interest rate) is set for all potential borrowers – worst borrowers will be those that most actively look for funds at that price
Moral hazard
o It occurs AFTER the financial transaction has taken place
o The borrower has incentives to engage in undesirable (immoral) activities making it more likely that will not pay loan back.
o FIs reduce adverse selection and moral hazard problems, enabling them to make profits
e.g. o Suppose you have made a loan of £1,000 to another friend, Joe, who has asked you for the loan so he can purchase a computer and set himself up in business as a graphic designer. Once you have made the loan there is a risk that Joe will not use the money for what he claimed he was going to use it for, but instead use it to bet on the horses.
Principal agent problem (also called agency problem)
o It occurs whenever a person (or group of people), called the agent, makes decisions on behalf of another person (or group of people), called the principal
o Problems arise because the agent often has superior information and expertise (which may be the reason the principal employs him/her).
o The agent can choose his behaviour after the contract has been established, and because of this the agent is often able to conceal the outcome of a contract. Agency problems also arise because the agent cannot be efficiently or costlessly monitored
→ possible moral hazard problem
The remedy to issues in a financial system
Principal-agent problem and the role of banks:
o In order to reduce agency problem, lenders can insert clauses in debt contracts that limit the discretionary use of the funds by the borrowers – this is hard to achieve for individual lenders
o FIs (in particular, banks) have more expertise than individual investors – they also have more contractual power which they use to decrease the informational asymmetries between them and the borrowers
o FIs can act as delegated monitors with respect to possible moral hazard of the borrowers
Delegated Monitoring:
o Since monitoring borrowers is costly, it is efficient for depositors to delegate the task of monitoring to specialised agents such as banks.
o Banks can act as delegated monitors as:
o they can diversify among different investment projects
o they can finance a large number of borrowers
Financial institutions
o Central banks o Deposit institutions o Insurance companies o Mutual funds/unit trusts o Investment companies/investment trusts o Pension funds
Central banks
o Implementation of monetary and exchange rate policy o Management of national debt o Supervision of banking sector -capital adequacy - liquidity - risk profile o Lender of last resort o Banker to government and commercial banks
