LEcture 3 - Financial institutions Flashcards
(31 cards)
- The main functions of financial intermediaries
– Size transformation
– Maturity transformation
– Risk transformation
– Liquidity provision
– Costs reduction
– Provision of a payments system
- SIZE TRANSFORMATION:
(bank) depositors
usually have small sight/saving accounts in comparison with loans required by borrowers
→ if FIs did not exist, depositors would have to pool their funds together to lend them to borrowers
- MATURITY TRANSFORMATION:
savers generally prefer investing their money in safe short-term investment
whereas borrowers prefer long-term loans, to finance
their projects
→ if FIs did not exist, either part (or both) should accept
a non-optimal solution (e.g. borrowers should be
satisfied with short-term loans, or lenders should forego
their money for long periods of time)
- RISK TRANSFORMATION:
depositors are generally not
willing to take great risks when investing their money;
however, borrowers often look for funds in order to
finance risky projects
→ if FIs did not exist, many risky (but profitable) projects
would not be implemented. FIs are willing to take the
risks involved in the borrowers’ activities, if an adequate
compensation for taking such risks is provided
- LIQUIDITY PROVISION:
surplus agents prefer that the assets they invest in be “liquid”, ie easily convertible into cash; on the other hand, borrowers prefer long-term funding to carry out their projects;
- FIs are able to provide liquidity by maintaining a sufficiently large
number of “lenders” (depositors) and ensuring that potential withdrawals (outflows) are covered by cash introduced by new accounts
→ if FIs did not exist, surplus agents would not be willing to hold highly illiquid assets to finance borrowers
- COSTS REDUCTION:
FIs are able to reduce transaction costs, ie
the costs associated with the buying and selling of a financial
instrument (e.g. cost of searching a counterparty, cost of
writing contracts, etc.)
→ because of the reduction of transaction costs, FIs offer lower loan rates relative to direct financing (the total cost of a loan, in terms of interest rate, will be lower)
Why are FIs able to reduce transaction costs?
- Why are FIs able to reduce transaction costs?
– Economies of Scale = Cost savings arising from decreasing unit cost of production as output increases. By increasing the volume of transactions, the cost per unit of transaction decreases
Because FIs engage in numerous transactions, they are able to exploit the benefits of economies of scale
– Economies of Scope
= Cost savings arising from joint production. Let us consider two outputs, Q1 and Q2 and their separate costs, C(Q1) and C(Q2). If the joint cost of producing
the two outputs is expressed by C(Q1,Q2), then economies of
scope are said to exist if:
C(Q1,Q2) < C(Q1) + C(Q2)
Because FIs offer a range of financial services, they are able to exploit the benefits of economies of scope
- PROVISION OF A PAYMENTS SYSTEM:
in modern times, FIs
(especially commercial banks) facilitate payments via a number of non-cash means: cheques, credit/debit cards,
electronic transfers and so on
- However, because of the importance of the payment system
for an economy, appropriate regulation is needed regarding
the activities that FIs are allowed to engage
- Asymmetric Information:
– not everyone has the same information
– everyone has less than perfect information
– some parties to a transaction have ‘inside’ information which is
not made available to both sides of the transaction (asymmetry
in the amount and quality of information)
– Information asymmetries or the imperfect distribution of information among parties can generate adverse selection and
moral hazard
Moral Hazard
– It occurs AFTER the financial transaction has taken place
– The borrower has incentives to engage in undesirable (immoral)
activities making it more likely that will not pay loan back
FIs reduce adverse selection and moral hazard problems, enabling
them to make profits
- Adverse Selection
– It occurs BEFORE the financial transaction has taken place
– It consists in the worst potential borrowers most likely to produce adverse outcomes being the ones most likely to seek loans and be
selected
– This occurs if it is hard to determine the riskiness of each borrower, and one price (interest rate) is set for all potential borrowers – worst
borrowers will be those that most actively look for funds at that price
- Principal-agent problem (also called agency problem):
– It occurs whenever a person (or group of people), called the
agent, makes decisions on behalf of another person (or group of people), called the principal
– Problems arise because the agent often has superior
information and expertise (which may be the reason the
principal employs him/her).
– The agent can choose his behaviour after the contract has been established, and because of this the agent is often able to
conceal the outcome of a contract. Agency problems also arise
because the agent cannot be efficiently or costlessly monitored
→ possible moral hazard problem
- Principal-agent problem and the role of banks:
– In order to reduce agency problem, lenders can insert clauses in
debt contracts that limit the discretionary use of the funds by
the borrowers – this is hard to achieve for individual lenders
– FIs (in particular, banks) have more expertise than individual
investors – they also have more contractual power which they
use to decrease the informational asymmetries between them
and the borrowers
– FIs can act as delegated monitors with respect to possible moral
hazard of the borrowers
Issues in a financial system – The
remedy
- Delegated Monitoring
- Since monitoring borrowers is costly, it is
efficient for depositors to delegate the task of
monitoring to specialised agents such as
banks. - Banks can act as delegated monitors as:
- they can diversify among different investment
projects - they can finance a large number of borrowers
Financial institutions
- Central banks
- Deposit institutions
- Insurance companies
- Mutual funds/unit trusts
- Investment companies/investment trusts
- Pension funds
Central banks
- Implementation of monetary and exchange rate
policy - Management of national debt
- Supervision of banking sector
-capital adequacy - liquidity
- risk profile
- Lender of last resort
- Banker to government and commercial banks
Deposit institutions
- This type of financial institutions take deposits
from units in surplus (savers: they have funds in
excess with regard to their consumption needs)
and lend the money gathered to units in deficit
(borrowers: they need funds to satisfy their need
for investment/consumption) - Main types of deposit institutions
- commercial banks
- savings institutions (building societies)*
Bank capital
- Assets – Liabilities = Net Worth
- This is bank capital.
- It is the value of the bank to its owners.
- Bank capital is roughly 9% of assets
- Ratio of Debt to Equity is about 10 : 1
- That’s substantial leverage!
Performance measure
- Return on Assets (ROA)
ROA = Net profit after taxes/Total Bank Assets - Return on Equity (ROE)
ROE = Net profit after taxes/Bank Capital
Deposit institutions main risks
- Default risk: risk that borrowers go bankrupt
- Funding risk (interest rate risk): risk that adverse movements
in interest rates reduce or wipe out completely net interest
income - Regulatory risk: risk coming from new regulation (e.g.
constraints on quantity and/or riskiness of loans) - Liquidity risk: because deposits are mostly in short-term and
are transformed into long-term investments, large amount of
simultaneous withdrawals can cause bankruptcy of deposit
institution – bank runs (Northern Rock)
Deposits institutions – role in the
payments system
- Banks are deposit taking institutions (DTIs) and are also
known as monetary financial institutions (MFIs) - Monetary financial institutions play a major role in a country’s
economy as their deposit liabilities form a major part of a
country’s money supply and are therefore very relevant to
Governments and Central Banks for the transmission of
monetary policy - Banks’ deposits function as money; as a consequence an
expansion of bank deposits results in an increase in the stock
of money circulating in an economy - All other things being equal, the money supply, that is the
total amount of money in the economy, will increase if
interest rate drops.
Insurance companies
- Insurance companies are non-deposit institutions, and as
a result they do not participate in the payments system - Insurance companies carry out the intermediation
function by gathering funds from policy holders
(premiums) and investing them in the capital markets - In exchange for the premiums paid, insurance companies
provide policy holders with compensation should a
particular event occur
- How to calculate the premiums?
– PREMIUM = f(L,P)
– The premium paid by policy-holders depends on the
likelihood of the insured-event occurring (L) and on the
magnitude of the payment of the insurance company to
the policy holder should the event occur (P)
– The larger L or P, the larger the premium paid by the policy
holders
* The premiums are pooled by the insurance company and the
money invested in capital markets – when payments are to be
made, the money is withdrawn from the funds gathered
through the premiums
