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Chapter One

Why Are Financial Intermediaries Special?

Chapter Outline

Introduction

Financial Intermediaries’ Specialness ? Information Costs

? Liquidity and Price Risk ? Other Special Services

Other Aspects of Specialness

? The Transmission of Monetary Policy ? Credit Allocation

? Intergenerational Wealth Transfers or Time Intermediation ? Payment Services

? Denomination Intermediation

Specialness and Regulation

? Safety and Soundness Regulation ? Monetary Policy Regulation ? Credit Allocation Regulation ? Consumer Protection Regulation ? Investor Protection Regulation ? Entry Regulation

The Changing Dynamics of Specialness ? Trends in the United States ? Future Trends ? Global Issues

Summary

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Solutions for End-of-Chapter Questions and Problems: Chapter One

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, and operating cost risks.

2. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial intermediaries (FIs).

In a world without FIs the users of corporate funds in the economy would have to approach directly the household savers of funds in order to satisfy their borrowing needs. This process would be extremely costly 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. Moreover, 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.

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 generally are averse to purchasing securities directly because of (a) monitoring costs, (b) liquidity costs, and (c) 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. Third, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

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 engaging in the asset transformation function. The 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 brokerages, or they also may offer advisory services which help reduce

information costs, such as full-line firms like Merrill Lynch. The 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 the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.

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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?

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. 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.

6. Explain how financial institutions act as delegated monitors. What secondary benefits

often accrue to the entire financial system because of this monitoring process?

By putting excess funds into financial institutions, individual investors give to the 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. The FI can collect information more efficiently than individual

investors. Further, the FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate sources and users of funds in the economy.

7. What are five general areas of FI specialness that are caused by providing various services

to sectors of the economy? First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, 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.

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 occur when owners or managers 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 firm 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.

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