The Nature of Financial Intermediation

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Key Concepts. Pivotal role of banks and other deposit-taking FIsRapid pace of change in markets, technologies and non-bank competitionInformation costs are responsible for emergence of financial intermediariesFinancial intermediaries deal with:SearchVerificationMonitoringEnforcement costs..

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The Nature of Financial Intermediation

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1. The Nature of Financial Intermediation Business 4039

2. Key Concepts Pivotal role of banks and other deposit-taking FIs Rapid pace of change in markets, technologies and non-bank competition Information costs are responsible for emergence of financial intermediaries Financial intermediaries deal with: Search Verification Monitoring Enforcement costs.

3. Important Terms – Defined … Liquidity and funding risk The threat of insufficient liquidity on the part of the bank for normal operating requirements Settlement/payment risk Is created when one party to a deal pays money or delivers assets before receiving its own cash or assets, hence exposing itself to a potential loss and interest rate risk. Interest rate risk The risk that arises from mismatches in both the volume and maturity of interest-sensitive assets, liabilities and off-balance sheet items Market or price risk The exposure of banks to losses due to market or price fluctuations in well-defined markets Foreign exchange or currency risk The exposure of banks to fluctuations in foreign exchange rates that affect positions held in a particular currency for a customer or the bank. Sovereign risk In which the political or economic conditions in a particular country threaten to interrupt repayment of loans or other debt obligations Operating risk Arising from losses caused by fraud, failure of internal control, or unexpected expenses, as in the case of lawsuits.

4. Financial Intermediation Information is the underlying, core reason for the existence of financial intermediaries. Borrowers do not have the means to search out and contract with lenders. Even if they do, it is an expensive and time consuming and unsystematic process that can be prohibitively expensive. This situation does exist…for example in the case of angel capital.

5. Financial Intermediaries There are many types of financial intermediaries that have evolved over time: Deposit-taking financial intermediaries Banks /Trust companies Credit unions Non-depositor Life and P&C insurance companies Investment dealers Finance Companies Other Mutual funds

6. Uniqueness Recognized One of the themes dominating FI organization in Canada is the degree to which the specialness of Fis should be enshrined in law and regulatory practice. The end result is that financial institutions are among the most heavily regulated and heavily taxed organizations in our society. You are encouraged to follow the current debates on this topic in the financial press. Look for: deposit taking FI regulation insurance company regulation securities industry regulation Bank of Canada policy concerning FIs CDIC policy concerning FIs Regulatory activities of liability insurers international coordination of FI regulation Role of OSFI in supervision

7. Intermediation Services of FIs risk transfer, reduction, and monitoring services liquidity services maturity intermediation services transaction services financial information services denomination intermediation (mutual funds)

10. Price Risk the risk that the sale price of an asset will be lower than its purchase price.

11. Secondary Claims example: demand deposit in a deposit-taking FI it is a financial asset that has characteristics far different than primary securities (bonds, stocks, commercial loans) => often improved liquidity/safety of principal, etc.

12. Maturity Intermediation a service performed by deposit-taking FIs for secondary asset holders (depositors)....because of ‘pooling’ and ‘diversification’.... mismatching the maturities of assets and liabilities of the FI.

13. Securitization The creation of a marketable financial asset through financial innovation…of otherwise illiquid financial assets Eg. MBSs

14. Economies of Scale FIs provide potential economies of scale in transactions costs...information collection and risk management.

15. Institutional Aspects of Special-ness money supply transmission (banks) credit allocation (banks, trusts, credit unions, and finance companies) risk offlay (insurance companies) intergenerational transfer (pensions, life insurance companies, and deposit-taking FIs) payment services (banks, trusts, and credit unions) denomination intermediation (mutual funds, pension funds)

16. Rationale for Regulation Relevance of Negative Externalities Failure to provide essential intermediation services, or the breakdown in provision of these services can be costly to both surplus savings economic units and deficit-spending economic units Such failures can have negative implications for the government, social stability and for the standard of living in an economy Financial crisis in one country can have contagion effects in other countries The foregoing negative externalities are the underlying reason for the extra regulatory attention paid to financial institutions. This extra attention gives rise to net regulatory burden (the difference between the private costs of regulations and the private benefits for the producers of financial services)

17. Types of FI Regulation Safety and soundness regulation Monetary policy regulation Credit allocation regulation Consumer protection regulation Investor protection regulation Entry and chartering regulation

18. Safety and Soundness Regulation Purpose: To protect depositors and borrowers against the risk of FI failure. Layers of Protection: Diversification regulation (no more than 10% of a portfolio can be invested in one security/asset) – banks cannot have loans exceeding 25% of total equity capital to any one company or borrower. Minimum capital requirements Guaranty funds (CDIC, CIPF) to meet insolvency losses to small claimholders Monitoring and surveillance (OSFI for example)

19. Monetary Policy Regulation In classical central bank theory, the central bank can control the quantity of bank deposits (D) using changing reserve requirements (R). Where: (r) = desired ratio of cash reserves (R) = quantity of bank reserves outstanding Today, banks in Canada are not subject to reserve requirements – however, they are all highly cognizant of the need for liquidity reserves – reserves are costly – and required reserves are seen as a ‘tax’ However, the Bank of Canada does stand ready to inject liquidity if necessary to prevent technical insolvency. The Bank of Canada does use moral suasion and through changes in the overnight lending rate, affect the level of short-term interest rates in the country – thereby taking preemptive action to try to control inflation.

20. Credit Allocation Regulation Lending to socially important sectors of society such as: Small business Farming Poor - Housing Consists of price (maximum rates that can be charged) and quantity restrictions (amount of foreign assets) Canada does not use this type of regulation however, because of the imposition of private costs on our FIs. Canada does take other actions to encourage/support/subsidize lending to important sectors of the economy by creating programs that lower the risk to the FI or by providing the service itself: Government providing the service Business Development Bank of Canada Export Development Canada FedNor Northern Ontario Heritage Fund Government programs to lower the cost to private FIs All of the foregoing government crown corporations and departments work jointly on projects and programs that also involve some private sector involvement either in financing or administration CMHC Student loan programs Government (both federal and provincial programs) guarantees for loans to farming, forestry

21. Consumer Protection Regulation 2001 – Bill C-8 – created the Financial Consumer Agency of Canada Provides consumer information on bank accounts and investment products Examines and imposes fines on FIs that violate consumer protection laws Privacy laws at the provincial levels Pressure on FIs to: Provide lending to small business Provide banking services to low-income Canadians

22. Investor Protection Regulation Provincial securities acts govern: Insider trading Information disclosure requirements through prospectus and continuous reporting requirements for seasoned issues SROs indirectly provide protection, and if they didn’t government would step in to impose regulation: Know-your client rules and enforcement of other types of compliance

23. Trends in Canada Gradual movement to universal banking through increasingly permissive regulations and competitive/strategy moves over time by FIs More frequent review and renewal of governing legislation including deregulation and an increasingly welcoming environment for foreign FIs Leveling of the playing field through uniform requirements for banks and insurance companies Access to the payment system extended beyond banks to life insurance and underwriting firms Incentives for credit union merger and growth Continuing limits on chartered banks to sell insurance through branches (except for credit insurance) and retail consumer leasing Completion of the demutualization process for life insurers – giving these key FIs (SunLife, Canada Life, Mutual Life (Clarica)) access to capital Extension of products lines by Investment Dealers and Insurance Companies into savings products, chequing products, wrap accounts, etc. Continued develop of fee-based income (off-the-balance sheet) sources of income for banks Continued pursuit of international presence by Canadian banks Consolidation (merger) in the life insurance sector Takeover of other pillars by banks (TD took over Central Guaranty Trust in 1992 and Canada Trust in 2000) and all banks have a brokerage arm since the 1980s (RBC, CIBC Wood Gundy, etc)

24. Entry Regulation Chartering/federally-licensing for business, banks – Bank Act Minimum requirements to create FIs.

25. Chapter 1 The Nature of Financial Intermediation Problem Solutions

26. Saunders Questions Chapter 1 Question 1 Identify and briefly explain the five risks common to financial institutions. Default or credit risk of assets Interest rate risk caused by maturity mismatches between assets and liabilities Liability withdrawal or liquidity risk Underwriting risk Operating cost risk

27. Saunders Questions Chapter 1 Question 2 Explain how economic transactions between household savers of funds and corporate users of fund would occur in a world without financial intermediaries. Without FIs the users of corporate funds would have to approach directly (find/search) the household savers of funds in order to satisfy their borrowing needs. This would be extremely costly and inefficient because of the up-front information costs faced by potential lenders. Cost inefficiencies would arise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities, and the assessment of risk and investment opportunities Lenders would have to monitor the activities of borrowers over each loan’s life span. The net result would be an imperfect allocation of resources in an economy.

28. Saunders Questions Chapter 1 Question 3 Identify and explain three economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries. Investors are generally averse to purchasing securities directly because of: Monitoring costs Liquidity costs 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 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. The price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

29. Saunders Questions Chapter 1 Question 4 Identify and explain the two functions in which FIs may specialize that enable the smooth flow of funds from household savers to corporate users. FIs serve as conduits between users and savers of funds by providing a brokerage function and by in engaging in asset transformation function. 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 brokerage, or they may also offer advisory services which help reduce information costs.

30. Saunders Questions Chapter 1 Question 4 … Identify and explain the two functions in which FIs may specialize that enable the smooth flow of funds from household savers to corporate users. FIs serve as conduits between users and savers of funds by providing a brokerage function and by in engaging in asset transformation function. 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 primary securities of corporations. FIs thus, take on the costs associated with the purchase of securities.

31. Saunders Questions Chapter 1 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? Primary securities The 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. 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

32. Saunders Questions Chapter 1 Question 6 Explain how financial institutions act as delegated monitors. Delegated Monitor Depositors of excess funds in FIs give 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. FI Economies as a Delegated Monitor and Overall Benefits The FI can collect information more efficiently than individual investors FIs can use this information to create new products, such as commercial loans, that continually update the information pool. This more frequent monitoring process sends important information signals to other participants in the market, a process that reduces imperfection and asymmetry between the ultimate sources and users of funds in the economy.

33. Saunders Questions Chapter 1 Question 7 What are the five general areas of FI specialness that are caused by providing various services to sectors of the economy? FI Specialness 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 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.

34. Saunders Questions Chapter 1 Question 8 How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations? What are agency costs? Agency Costs Agency costs arise because of the possibility that owners and managers may 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 borrower 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.

35. Saunders Questions Chapter 1 Question 9 What often is the benefit to the lenders, borrowers, and financial markets in general of the solution to the information problem provided by the large financial institutions? One benefit to the solution process is the development of new secondary securities that allow even further improvements in the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. The renewal process updates the financial and operating information of the firm more frequently, thereby reducing the need for restrictive bond covenants that may be difficult and costly to implement.

36. Saunders Questions Chapter 1 Question 10 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. Commercial banks, for example, offer deposits that can be withdrawn at any time. …yet, the banks make long-term loans or invest in illiquid assets (mortgages and long-term bonds) 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.

37. Saunders Questions Chapter 1 Question 11 How do FIs help individual savers diversify their portfolios risks? Which type of financial institution is best able to achieve this goal? Money placed in any financial institution will result in a claim on a more diversified portfolio. Banks lend money to many types of corporate, consumer, and government customers, and insurance companies have investments in many different types of assets. Investment in a mutual fund may generate the greatest diversification (depending on the type of fund) benefit because of the fund’s investment in a wide array of stocks and fixed income securities.

38. Saunders Questions Chapter 1 Question 12 How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers? Diversification of risk occurs with investments in assets that are not perfectly positively correlated. One result of extensive diversification is that the average risk of the asset base of an FI will be less than the average risk of the individual assets in which it has invested. Thus, individual investors realize some of the returns of high-risk assets without accepting the corresponding risk characteristics.

39. Saunders Questions Chapter 1 Question 13 How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets? By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are designed to deal in large volumes typically are more efficient than those activities designed for small volumes.

40. Saunders Questions Chapter 1 Question 14 What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial intermediaries? If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. The FI can offer relatively short-term liabilities desired by households and also satisfy the demand for long-term loans such as home mortgages. 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 utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps and other derivative products.

41. Saunders Questions Chapter 1 Question 15 What are the five areas of institution-specific FI specialness, and which types of institutions are most likely to be the service providers? Chartered Bank – key players for transmission of monetary policy Depository FIs such as banks, trusts, financial acceptance and credit unions provide financing for consumers and corporations. For example, Canada Mortgage and Housing Corporation provides mortgage insurance for residential mortgages. Life insurance and pension funds provide mechanisms to transfer wealth across generations. Depository financial institutions, insurance companies and brokerage firms provide payment services Mutual funds provide denomination intermediation. (Brokerage/investment firms may as well, as in the case of T-bills)

42. Saunders Questions Chapter 1 Question 16 How do deposit-taking institutions such as chartered banks assist in the implementation and transmission of monetary policy? The Bank of Canada can involve banks directly in the implementation of monetary policy through changes in the target Overnight Rate. The open market sale and purchase of Government of Canada securities by the Bank of Canada involves the banks in the implementation of monetary policy in a less direct manner.

43. Saunders Questions Chapter 1 Question 17 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.

44. Saunders Questions Chapter 1 Question 18 Which financial intermediaries best fulfill the intergenerational wealth transfer function? What is this wealth transfer process? Life insurance and pension funds often receive special taxation relief and other subsidies to assist in the transfer of wealth from one generation to another. In effect, the wealth transfer process allows the accumulation of wealth by one generation to be transferred directly to one or more younger generations by establishing life insurance policies and trust provisions in pension plans. Often this wealth transfer process avoids the full marginal tax treatment that a direct payment would incur.

45. Saunders Questions Chapter 1 Question 19 What are two of the most important payment services provided by financial institutions? 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.

46. Saunders Questions Chapter 1 Question 20 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 money market securities which can only be sold in minimum increments of $100,000, but which often are sold in million dollar packages. Similarly, commercial paper often is sold only in minimum amounts of $100,000. Therefore small investors can benefit in the returns and low risk which these assets typically offer.

47. Saunders Questions Chapter 1 Question 21 What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions? 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 example, in an industrial setting, smoke from a factory that lowers surrounding property values may be viewed as a negative externality. For financial institutions, 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.

48. Saunders Questions Chapter 1 Question 22 If financial markets operated perfectly and costlessly, would there be a need for financial intermediaries? To a certain extent, financial intermediation exists because of financial market imperfections. If information is available costlessly to all participants, savers would not need intermediaries to act as either their brokers or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections.

49. Saunders Questions Chapter 1 Question 23 What is mortgage redlining? Mortgage redlining occurs when a lender specifically defines a geographic area in which it refuses to make any loans. The term arose because of the area often was outlined on a map with a red pencil.

50. Saunders Questions Chapter 1 Question 24 Why are FIs among the most regulated sectors in the world? When is net regulatory burden positive? FIs are required to enhance the efficient operation of the economy. Successful financial intermediaries provide sources of financing that fund economic growth opportunity that ultimately raises the overall level of economic activity. Moreover, successful financial intermediaries provide transaction services to the economy that facilitate trade and wealth accumulation.

51. Saunders Questions Chapter 1 Question 24 …2 Why are FIs among the most regulated sectors in the world? When is net regulatory burden positive? Conversely, distressed FIs create negative externalities for the entire economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other private claimants on the FI's assets. For example, the financial markets suffer if an FI fails and other FIs also may be thrown into financial distress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions to protect society's interests. This intervention takes the form of regulation.

52. Saunders Questions Chapter 1 Question 24 …3 Why are FIs among the most regulated sectors in the world? When is net regulatory burden positive? However, the need for regulation to minimize social costs may impose private costs to the firms that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs add to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive.

53. Saunders Questions Chapter 1 Question 25 What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness? FIs are required to diversify their assets. For example, federally-regulated FIs must follow OSFI’s Guidelines on Large Exposure Limits. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses. In the case of banks, OSFI standards require a minimum core and supplementary capital of 7 percent of their risk-adjusted assets. Regulators have set up guaranty funds such as CDIC, CIPF to protect individual investors against losses on the insolvency of FIs Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the FIs.

54. Saunders Questions Chapter 1 Question 26 What legislation has been passed specifically to protect investors who use investment banks directly or indirectly to purchase securities? Give some examples of the types of abuses for which protection is provided. While the discussion of a national securities regulator for Canada is under discussion, the regulation of securities dealers is a provincial and territorial responsibility in Canada. Through self-regulating organizations (SRO’s), securities dealers, including mutual funds, are subject to rules affecting possible abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities.

55. Saunders Questions Chapter 1 Question 27 How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions? The profitability of existing firms will be increased as the direct and indirect costs of establishing competition increase. Direct costs include the actual physical and financial costs of establishing a business. In the case of FIs, the financial costs include raising the necessary minimum capital to receive a charter. Indirect costs include permission from regulatory authorities to receive a charter. As these barriers to entry are stronger, the charter value for existing firms will be higher.

56. Saunders Questions Chapter 1 Question 28 What reasons have been given for the growth of investment companies at the expense of “traditional” banks and insurance companies? The recent growth of investment companies can be attributed to two major factors: Investors have demanded increased access to direct securities markets. Investment companies and mutual funds allow investors to take positions in direct securities markets while still obtaining the risk diversification, monitoring, and transactional efficiency benefits of financial intermediation. Some experts would argue that this growth is the result of increased sophistication on the part of investors; others would argue that the ability to use these markets has caused the increased investor awareness. The growth in these assets is inarguable. b. Both the banking and insurance industries have been subject to an increase in regulation and governmental oversight, thereby increasing the net regulatory burden of “traditional” companies. As such, the costs of intermediation have increased, which increases the cost of providing services to customers.

57. Saunders Questions Chapter 1 Question 29 What are some of the methods which banking organizations have employed to reduce the net regulatory burden? What has been the effect on profitability? Through regulatory changes, FIs have begun changing the mix of business products offered to individual users and providers of funds. For example, banks have acquired mutual funds, have expanded their asset and pension fund management businesses, and have increased the security underwriting activities. As the size of banks has grown, an expansion of possible product offerings has created the potential for lower service costs. The emphasis in recent years has been on products that generate increases in fee income, and the entire banking industry has benefited from increased profitability in recent years.

58. Saunders Questions Chapter 1 Question 30 What characteristics of financial products are necessary for financial markets to become efficient alternatives to financial intermediaries? Can you give some examples of the commoditization of products which were previously the sole property of financial institutions? Financial markets can replace FIs in the delivery of products that: (1) have standardized terms, (2) serve a large number of customers, and (3) are sufficiently understood for investors to be comfortable in assessing their prices. When these three characteristics are met, the products often can be treated as commodities. One example of this process is the migration of over-the-counter options to the publicly traded option markets as trading volume grows and trading terms become standardized.

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