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Chapter 1

Chapter 1 Why Are Financial Intermediaries Special.docx

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FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 1 Why Are Financial Intermediaries Special?  Financial institutions divided into four pillars: chartered banks, trust companies, insurance companies, and investment dealers  Universal bank: FI that is permitted by regulators to offer a full range of financial services  FIs perform essential function of channelling surplus funds (suppliers of funds) to shortage funds (users of funds)  FIs exposed to liability withdrawal, liquidity risk, underwriting risk, and operating cost risk  FIs specialness in provision of services o Information costs – collect information about customers (such as corporations) and to monitor their actions due to relatively large size funds o Liquidity and price risk – provide financial claims to households with superior liquidity attributes and with lower price risk o Transaction cost services – FIs size can result in economies of scale in transaction costs o Maturity intermediation –bare risk of mismatching maturities of assets and liabilities o Transmission of monetary supply – monetary policy actions by country’s central bank affect financial system and economy o Credit allocation –source of financing for a particular sector of the economy o Intergenerational wealth transfers – transfer wealth from one generation to the next o Payment services – payment services such as cheque clearing directly benefits the economy o Denomination intermediation – allows investors to overcome constraints to buying assets imposed by large minimum denomination size FINANCIAL INTERMEDIARIES’ SPECIALNESS  FIs reduce monitoring costs, liquidity costs, and price risk to increase preference of holding financial claims  FIs fulfill two functions: 1. FIs function as brokers – acts as an agent for the saver by providing information and transaction services 2. FIs function as asset transformers – issues financial claims that are more attractive to household savers than the claims directly issued by corporations  FIs purchase primary securities (equities, bonds, and other debt claims) issued by corporations and sell in the form of deposits, insurance policies, and so on  Financial claims on FIs may be considered secondary securities because assets are baked by primary securities issued by commercial corporations that in turn invest in real assets Information Costs  Failure to monitor exposes investors to agency costs, that is the risk firm’s owners will take action with saver’s money contrary to promises contained in covenants of its securities contracts o Arise whenever economic agents enter into contracts with incomplete information and thus costly information collection  FI’s role as delegate monitor o Large number of small savers place funds with a single FI, who invest funds together in direct or primary financial claim issued by firm o FIs as delegate monitor, economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds on their behalf  FI’s role as information producer o Develop new secondary securities to monitor more effectively Liquidity and Price Risk  Financial or secondary claims to households that have superior liquidity attributes compared with those of primary securities through FIs ability to diversify some but not all of their portfolio risk Other Special Services  Potential economies of scale in reduced transaction costs because bid-ask (buy-sell) spreads are lower for assets bought and sold in large quantities  Ability to bare risk of mismatching maturities of assets and liabilities FIN701 Financial Institutions Management OTHER ASPECTS OF SPEICALNESS  Theory of flow of funds points to three principle reasons, along with two other associated reasons: 1. Transmission of monetary policy – Chartered banks and DTIs are conduct through which monetary policy actions affect the rest of the financial sector and economy by controlling level of inflation 2. Credit allocation – Major or only source of finance for a particular sector of the economy predetermined
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