Chapter 2. Financial Intermediaries & Financial Innovation

1. Chapter 2. Financial Intermediaries & Financial Innovation • financial institutions • role of financial intermediaries • asset/liability management • financial innovation

2. I. Financial Institutions • provide financial services • transforming financial assets (own one type, issue another type) • trade financial assets • create & sell assets on behalf of others • investment advice & management

3. depository institutions • acquire funds mostly from deposits • nondepository institutions • acquire funds from other sources

4. II. Role of Financial Intermediaries • raise funds FOR direct investment • their assets • stock, bonds, loans • raise funds BY indirect investment • issue their own liabilities • accept deposits, • sell insurance policies • sell mutual funds shares

5. indirect investments allow investors • choice of desired maturity • maturity intermediation • diversification w/ small amount of capital • lower transactions costs • alternative payment mechanisms

6. III. Asset/liability Managment • liabilties = claims on financial institution • liabilities differ in the certainty about their amount and timing

7. Type I Liabilities • timing and amount is certain • fixed rate bank CD • GIC (guaranteed investment contract) (principal and fixed interest payment due on specified date)

8. Type II Liabilities • amount is certain, timing is not • term life insurance policy (amount of policy is known, but timing of death is not)

9. Type III Liabilities • amount not certain, but timing is • variable rate bank CD (know the maturity date, but not size of interest payment)

10. Type IV Liabilities • amount and timing uncertain • auto insurance policy • property insurance policy (how much is the damage? when will damage occur?)

11. type of liabilities issued determines the types of assets bought & held • long-term or short-term? • risk?

12. IV. Financial Innovation • creation of new financial assets • new ways to use financial assets • dramatic in past 30 years

13. why does it happen? • changing times/ new risks • increased volatility in -- interest rates -- stock prices -- exchange rates led to development of derivatives

14. advances in technology • rapid flow of information • rapid calculation of risks and prices • rapid trading • competition among institutions • for products • for strategies

15. circumvent regulations, tax laws • NOW accounts in 1970s • “selling short against the box” • sophistication of market professionals • devise & use complex securities • price complex securities

16. Asset securitization • take individual loans • pool them together • issue & sell securities w/ cash flow back by the loan pool payments

17. old way: • bank originates mortgage • bank holds mortgage & collects payments until loan is paid • new way: • bank originates mortgage • bank sells mortgage to Fannie Mae • bank gets fee for servicing mortgage • Fannie Mae issues securities

18. advantages • bank capital not tied up in loans • institutions specialize in part of process • pool of loans is diversified (less risk) • loans are more liquid • easier to get • cheaper to get