Lesson 1: Why are Financial Institutions special?

Question 1

What are five risks common to all financial institutions?

Answer 1

Five risks common to all financial institutions include:

1. credit risk (default of assets)
2. interest rate risk - caused by maturity mismatches between assets and liabilities
3. liquidity risk (liability withdrawal)
4. underwriting risk (for example through the sale of securities or the issue of various types of credit guarantees)
5. operating risks - due to the use of real resources (labour and technology

Question 2

Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions

Answer 2

In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs.

In this economy, the level of fund flows between household savers and the corporate sector is likely to be quite low. There are several reasons for this. Once they have lent money to a firm by buying its financial claims, households need to monitor, or check, the actions of that firm. They must be sure that the firm’s management neither absconds with nor wastes the funds on any projects with low or negative net present values.

Such monitoring actions are extremely costly for any given household because they require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver’s investments. Given this, it is likely that each household would prefer to leave the monitoring to others. In the end, little or no monitoring would be done. The resulting lack of monitoring
would reduce the attractiveness and increase the risk of investing in corporate debt and equity.

The net result would be an imperfect allocation of resources in an economy.

Question 3

Identify and explain three economic disincentives that would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world
without financial institutions

Answer 3

Investors generally are averse to directly purchasing securities because of:

1. monitoring costs
2. liquidity costs
3. price risk

Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be available.
Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

Question 4

Identify and explain the two functions FIs perform that would enable the smooth flow of
funds from household savers to corporate users. (PHOTO)

Answer 4

FIs serve as conduits between users and savers of funds by providing a brokerage functionand by engaging in an
asset transformation function

When acting as a pure broker, a FI acts as an agent for the saver by providing information and transaction services. For example, full-service securities firms like Merrill Lynch carry out investment research and make investment recommendations for their retail (household) clients as well as conduct the purchase or sale of securities at better prices and with greater efficiency than household savers could achieve by trading on their own. This efficiency results in reduced costs of trading, or economies of scales. Similarly, independent insurance brokers identify the best types of insurance policies household savers can buy to fit their savings and retirement plans. In fulfilling a brokerage function, the FI plays an extremely important role by reducing transaction and information costs or imperfections between households and corporations.

Thus, the FI encourages a higher rate of savings than would otherwise exist. 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.

Question 5

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?

Answer 5

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

Question 6

Explain how financial institutions act as
delegated monitors.
What secondary benefits often accrue to the entire financial system because of this monitoring process? (Part 1)

Answer 6

By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is
used properly by the borrower. This agglomeration of funds resolves a number of problems.
First, the large FI now has a much greater
incentive to collect information and monitor
actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collectiontend to enhance the advantages to savers of using FIs rather than directly investing themselves

Question 7

Explain how financial institutions act as
delegated monitors.
What secondary benefits often accrue to the entire financial system because of this monitoring process? (Part 2)

Answer 7

Second, the FI can collect information more efficiently than individual investors. The FI can use this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs.

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 providers and users of funds in the economy.

In conclusion, by acting as a delegated monitor and as an information producer, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.

Question 8

What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?

Answer 8

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. A dimension of FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers.

Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts. By investing in a portfolio of long-
and short-term assets that have variable-and fixed-rate components, the FI can reduce maturity risk exposure by using liabilities that have similar variable-and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products.

Question 9

What are five general areas of FI specialness

that are caused by providing various services to sectors of the economy?

Answer 9

1. FIs collect and process
   information more efficiently than individual savers.
2. FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds.
3. By diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities.
   4.FIs provide economies of scale in transaction costs because assets are purchased in larger amounts.
   5.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.