201003123 Management of Financial Intermediation, Professor Lee Jang Woo, Week3 , Essential Material
Part 2 : What Is financial Intermediation?
The nature and variety of financial intermediation.
What are financial Intermediaries?
Definition : As the name suggests, financial intermediaries are entities that intermediate between providers and users of financial captial.
Why do we have Financail intermediations? = What do Fis do that could not be done without them? The answer to this for any firm, financial or nonfinancial,is found in the flow of goods and/or services produced by the firm.After all, a firm not only selects its assets and liabilities but also manages them so as to assure the realization of the potential cash flows.That is the assets appearing on the balance sheet are combined with various kinds of labor inputs to produce the cash flows conventionally attributed to the assets.
1. Brokerage Function of F.I : Brokerage activities of FIs involve the bringing together of transactors in financial claims with complementary needs.
a) Precontract Informational Asymmetry and Brokerage : Precontract information asymmetry involves two kinds of information problems
1)Adverse selection and brokerage : In transactions involving FIs adverse selection problems abound. An F.I like a bank can help deal with this adverse selection problem by performing the brokerage function of credit analysis to sort out borrowers of different credit risks.That is, in this case the broker specializes in credit analysis or develops the skills to process/interpret various types of credit information. This allow it to intermediate between borrowers and lenders and minimize adverse selection problems.
2)Duplicated Screening, Information Reusability and Brokerage : Duplicated screening refers to situations in which individuals can resolve adverse selection at a cost, but there is wasteful expenditure of costly screening resources because multiple individuals end up doing the same screening. An F.I can help avoid such duplication by exploiting the power of information reusability. Savings = 2 X cost X Num(Num-1)
b) Postcontract Informational Asymmetry and Brokerage : In many transactions, one party to the transaction can take actions during the course of the contractual interaction that damage the interest of the other party. The F.I's sepcial skills in monitoring attenuate moral hazard.
2. Qualitative Asset Transformation : Enter the F.I! It purchases the mortgage and finances the purchase with the issuance of a liability called a deposit. The deposit, In contrast to the mortgage,is almost infinitely divisible, highly liquid, and has little default risk. The F.i effectively swaps deposits for mrtgages, thereby modifying the claims held by its clientele. The F.I rewarded for this service with interest rate spread between deposits and mortgages.
1) QAT and risk : But notice that every such asset transformation performed by the FI requires a mismatch with regard to that attribute on the F.I's balance sheet. For example, if the duration fo the F.I's assets and liabilities are perfectly matched, it cannot have altered the duration of the assets of its clients.
3. The variety of Financial Intermediaries
During 1980-2003, The assets of the various types of F.Is and also depicts their growth. Mutual Fund Industry has developed. The shifting market shares of various institutions in the consumer loan market are reflected in the data.
1) Depository Financial Intermediaries
Depository institutions operate withe high leverage, so that even a small return on total assets translates into a high return of equity.
a) Commercial Banks : Commercial bank are widely considered the center of the financial intermediation universe because of their role in administering the community's payments, and also because commercial banks are used to transmit monetary policy impulses originating with the central bank.
The role of commercial banks in the payments system derives from their twin roles as distributor of currency, and as producer and servicer of demand deposits.
b) Thrifts : Savings and loan associations(S&Ls)and mutual savings banks(MSBs), collectively referred to as thrifts, or savings institutions, are depository institutions that were specially chartered to extend residential mortgage finance.In later 1980's, MSBs were damaged by the inflation-induced loss of core deposits, the consequent emergence of interest-rate risk, and the asset-quality problem.
c) Credit Unions : Like thrifts, credit unions specialize in consumer savings and are mutuals.
2)Nondepository Intermediaries
a) Venture Capitalist : Venture capitalists typically provide both capital and expertise that allow entrepreneurs to convert ideas into commercial verntures.
b) Finance companies : Finance companies lend to consumers for auto and home purchases, as well as other purposes, and to businesses for a wide range of applications. Finance ompanies fund themselves by selling commercial paper. The Finance companies do not have access to subsidized funds and are not subject to regulatory restrictions,proscriptions, examinations, and supervision.
c) Insurance companies : Insurance companies hold many of the same kinds of assets found on the balance sheets of commercial banks, but insurer assets are financed for the most part with contingent liabilities.
d) Pensions : The liabilities of defined-contribution pension funds are actuated upon retirement or death of their members, at which time the member's claim is paid out as a lump sum or used to purchase an annuity.
e) Mutual Fund : Open- and closed-end. Closed-end funds have a pre-established number of shares and the fund's initial resources typically are not augmented with the subsequent sale of shares. A closed-end fund is typically traded as a single security on organized exchanges. Open-end is operate by NAV(net asset value) NAV is the estimated liquidation or market value of the fund's assets divided by the number of shares the fund has outstanding. The key financial intermediation services provided by mutual funds include transactions services, screening, and certification. There are three reasons for the current popularity of the funds. First, money-market mutual funds, which were introduced in the 1960s, rapidly became the instrument of choice for circumventing Regulation Q deposit interest rate ceilings. Second, The public has gradually become persuaded of the improbability of consistently "beating"the stock market. Finally, Many investors believe it is as important to diversify across economies(currencies) as it is to diversify across industries.
f) Hedge Fund : Hedge funds are actively managed funds that pursue nontraditional investment strategies. A hedge fund is a private investment pool subject to the terms of an investment agreement between the sponsor of the fund and its investors. Differences between hedge funds and mutual funds persist, however. While mutual fund sales charges and fees are subject to regulatory limits, there are no limits on the fees hedge fund advisers can charge. Also, mutual funds are restricted in their ability to leverage against the value of securities in their portfolio, whereas leveraging and other higher-risk investment strategies are commonplace for hedge fund. Finally, while any investor can open a mutual fund account with $1000 or less, a minimum investment of $1million or more is typically required to become a hedge fund investor.
g) Investment Banking : Like Merrill Lynch, Salomon Brothers, and Morgan Stanley, Specialize in the design and issuance of financial contracts. The often perform the brokerage function of bringing buyers and sellers of securities together.The key intermediation services they provide are transactions services, financial advice, screening and certification, orgination, issuance, and guaranteeing.
3. The role of the government
The US government is far and away the largest financial services provider in the country and arguably in the world.
4. Financial Intermediaries on the Periphery
Gambling - Prominent on the periphery of the financial intermediation universe is the glamorous world of legal and illegal gambling. The more meaningful distinction between insurance and gambling is that the former involves the exchange of a certain cost for relief from an uncertain liability,whereas the latter is the exchange of a certain cost for an uncertain future receipt.
Pawnbroker - pawnbroker is a traditional form of asset-backed lending. the lender typically prefers to be repaid rather than taking ownership and liquidating the collateral or default,
Payday Lending - payday lenders provide unsecured short-term loans to customers.
Title lenders - Title lenders make secured loans rather than unsecured lans.
Loan Sharks - Loan sharking is as lenders who can credibly make illegal or socially unacceptable threats of violence and intimidation in connection with collections.
