Chapter 5 - Why Are FIs Special?

1. Chapter 5 - Why Are FIs Special? Business 4039

2. Negative Externality covenant liquity price risk Name at Lloyd’s reinsurance asset transformer primary security agency costs delegated monitor maturity intermediation time intermediation denomination intermediation Terms & Definitions

3. Why are FIs Special? • This short chapter serves both as a summary of Part I: the Financial Services Sector, and as a transition to Part II: Risk Measurement. • Unlike Chapters 1-3, it is largely conceptual, summarizing the functions of FIs and their importance to society.

4. Uniqueness Recognized • One of the themes dominating FI organization in Canada is the degree to which the specialness of Fis should be enshrined in law and regulatory practice. • Students are encouraged to follow the current debates on this topic in the financial press. Look for: • deposit taking FI regulation • insurance company regulation • securities industry regulation • Bank of Canada policy concerning FIs • CDIC policy concerning FIs • Regulatory activities of liability insurers • international coordination of FI regulation

5. Intermediation Services of FIs • risk transfer, reduction, and monitoring services • liquidity services • maturity intermediation services • transaction services • financial information services

6. Deficit-Saving Economic Unit Surplus-Saving Economic Unit • Borrowers: • borrow large sums (mortgages/commercial/ personal loans) • for long periods of time • complex legal transactions because of the long-term nature of the debt contracts and the need to contractually ensure that the interests of the lender are protected. • Savers: • many of them saving small amounts individually, but large amounts in aggregate • for short periods of time (ie. Need liquidity) • are generally risk averse • don’t have the capacity, time or sophistication to analyze risk or to monitor borrowers Deposit-taking Financial Intermediary

7. Deficit-Saving Economic Unit Surplus-Saving Economic Unit Deposit-taking Financial Intermediary • Deposit-taking FIs: • pool deposits, provide liquidity for depositors, collect/analyze/monitor the financial positions/activities of borrowers, make credit allocation decisions among opportunities to lend/invest, negotiate/monitor/enforce loan agreements. • In this manner the need of both savers and borrowers are met with efficiency. In the absence of FIs failure, confidence in the system is built and this encourages full participation, thereby reducing monetary leakage….currency in circulation is made available for the best competing uses in our society.

8. Covenant • legal clauses in a bond contract that require the issuer of bonds to take or avoid certain actions

9. Price Risk • the risk that the sale price of an asset will be lower than its purchase price.

10. Name at Lloyd’s • the final risk bearer in an insurance contract underwritten in the market organized by Lloyd’s of London.

11. Agency Costs - cost of monitoring • costs relating to the risk that the owners and managers of firms that receive savers’ funds will take actions with those funds contrary to the savers’ best interests.

12. Delegated Monitor • an economic agent appointed to act on behalf of smaller agents in collecting information and/or investing funds.

13. Secondary Claims • example: demand deposit in a deposit-taking FI • it is a financial asset that has characteristics far different than primary securities (bonds, stocks, commercial loans) => often improved liquidity/safety of principal, etc.

14. Maturity Intermediation • a service performed by deposit-taking FIs for secondary asset holders (depositors)....because of ‘pooling’ and ‘diversification’.... • mismatching the maturities of assets and liabilities of the FI.

15. Economies of Scale • FIs provide potential economies of scale in transactions costs...information collection and risk management.

16. Institutional Aspects of Specialness • money supply transmission (banks) • credit allocation (banks, trusts, credit unions, and finance companies) • risk offlay (insurance companies) • intergenerational transfer (pensions, life insurance companies, and deposit-taking FIs) • payment services (banks, trusts, and credit unions) • denomination intermediation (mutual funds, pension funds)

17. Question 5 - 1 What are the major functions of financial intermediaries? • FIs are either brokers or asset/risk transformers. • As brokers, they merely act as agents for savers and investors in investment transactions and for risk generators and absorbers in risk offlay transactions. • As brokers, they provide information and transaction services. • As asset transformers, FIs invest in primary financial securities and issue claims (including contingent claims of insurance) to provide asset transformation and risk offlay.

18. Question 5 - 2 How can FIs afford to issue financial claims that have superior liquidity to securities market claims? • The FI pools the funds of small investors, each of which would have insufficient incentive to monitor the actions of borrowers. In monitoring the aggregated claims, the FI can achieve informational economies of scale. • Liquidity and risk reduction of claims is also increased by pooling into diversified FI portfolios that lower risk of the secondary securities of FI issues relative to the primary securities that the FI purchases.

19. Question 5 - 3 From the perspective of society, apply cost/benefit analysis to government regulation of the FI industry by enumerating the benefits FIs provide to society weighing them against the costs to society. Relate the cost benefit analysis to emerging trends in financial intermediation. Benefits: FIs provide • risk transfer, reduction and monitoring services • liquidity services • maturity intermediation services • transaction services, and • financial information services ...

20. Question 5 - 3 ... From the perspective of society, apply cost/benefit analysis to government regulation of the FI industry by enumerating the benefits FIs provide to society weighing them against the costs to society. Relate the cost benefit analysis to emerging trends in financial intermediation. In transferring risks and funds, they serve either as brokers or as transformers. As brokers, they arrange for the placing of stocks and bonds with ultimate investors. As asset transformers, Fis perform liquidity and maturity intermediation services, pooling small denomination, liquid deposits and actuarial claims into less liquid larger denomination loans. Their interconnection through the payments system provides transactions services. They also provide financial information on deposits, payments, loans and a wide variety of disintermediated assets.

21. Question 5 - 3... FIs institutional functions in society include: • Money supply transmission (banks) • credit allocation (banks, trusts, credit unions and finance companies) • risk offlay (insurance companies) • intergenerational transfers (pensions, life insurance companies and deposit-taking Fis) • payment services (banks, trusts and credit unions) • denomination intermediation (mutual funds, pension funds)

22. Question 5 - 3 ... Costs: The main cost to society of these services beyond the interest, fees and commissions that are visible for each transaction stems from the system of regulation. Direct clearers have access to Bank of Canada borrowing. Deposit-taking FI’s retail liabilities are guaranteed by CDIC (or provincial government deposit guarantee corporations.) Considerable cost (that must be borne eventually by service users and/or taxpayers) is associated with the preparation of regulatory agency filings, government audits, and staffing of regulatory bodies. The move to risk-adjusted deposit insurance premiums for deposit insurance and self-regulatory organizations - rather than government organizations - to regulate the FI industry are part of a trend to allocate more fairly the costs of FI specialness and increase the efficiency of monitoring.

23. Question 5 - 4 From the perspective of the FI, apply cost benefit analysis to the FI industry. Relate this cost benefit analysis to emerging trends in financial intermediation. Benefits: FIs can be very profitable: witness the record bank profits in recent years. The level of profitability is related to the efficiency with which the FI provides existing and develops new services and the degree to which current FIs are protected from competition from exiting competitors and new entrants. Costs: Government safety nets and protective regulations are not without costs. Deposit-taking FIs pay hefty deposit insurance premiums. The costs of on-site inspections are borne by the FI. Accounting, auditing and administrative expenses are associated with various regulatory filings.

24. Question 5 - 4 ... From the perspective of the FI, apply cost benefit analysis to the FI industry. Relate this cost benefit analysis to emerging trends in financial intermediation. In FI industries with free entry and exit (such as P&C insurance or credit unions), the cost-benefit analysis can be easily observed in the extent to which firms enter and exit the industry. In other industries where ease of entry is curtailed by legal, high investment, reputational capital or regulatory constraints (e.g., banking and life insurance) the tradeoff must be inferred from such measures as FI profitability and market performance of shares.

25. Question 5 - 5 If financial markets operated perfectly and costlessly, financial intermediaries would not exist. State whether you agree or disagree and why. • This is a very open ended question, depending largely on definitions of “perfectly and costlessly.” • If FI services were provided to the public for nothing, then the FI would not exist, the statement is clearly true. • If the sentence is taken to mean, “if markets for existing securities were efficient, Fis would not exist” the statement would be wrong. • If “perfection” implies financial market completeness, then the payoffs of securities in every future state of the world would be priced in financial markets. In that case, fully informed rationale individuals could purchase disintermediated claims that would fully offset any future risk and make risk offlay through Fis redundant.

26. Question 5 - 6 FIs are among the most heavily regulated firms in private industry. Explain why. • To justify such regulation, advocates usually argue that Fis provide special functions or services and that major disturbances to, or interferences with, these functions can lead to adverse effects on the rest of the economy - what economists call negative externalities. • Example: if a major FI were to fail, the results - if not correctly dealt with -- could include loss of confidence in the FI system in general, contraction of the money supply, reduction in credit allocation and real economic losses.

27. Question 5 - 7 How would financial and economic transactions differ if there were no FIs? • If there were no FIs, fund flows between the funds providers and the funds users would be less because the monitoring costs would be prohibitive for retail investors. The resulting lack of monitoring would reduce the attractiveness and increase the risk of investing in household and corporate debt and equity. In the absence of FIs, the risk generating household or business would have two choices: either accept the risks as a fact of life or seek out (and individually contract with) risk absorbers (ie. Households, or businesses that are more risk tolerant than the risk generator). These increased risks and/or costs would restrain the flow of funds.

28. Question 5 - 8 Why may investors be averse to holding primary securities directly? • Investors may be averse to holding primary securities directly because of: a. monitoring costs b. liquidity costs; and c. price risk • The relative long term nature of corporate debt and equity increases both the liquidity costs and price risk of direct securities holdings. If an investor wants to liquidate a position at any given point in time, he or she may find that the price may be temporarily below the “true market value” of the security. • Moreover the costs of liquidation, (in terms of fees, commissions

29. Question 5 - 8 ... Why may investors be averse to holding primary securities directly? • Moreover the costs of liquidation, (in terms of fees, commissions, search costs, time), may be prohibitive. An FI can economize on both of these costs by maintaining a portfolio of securities and pooling diverse transactions to create volume discounts and internal hedging opportunities (I.e., when one investor wants to liquidate another may want to invest.)

30. Question 5 - 9 What is meant by maturity intermediation? • If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by mismatching their asset and liability maturities. That is, the FI can offer the relatively short term liabilities desired by households (say, in the form of bank deposits) and also satisfy the demand for long term loans (say, for home mortgages). By investing in a portfolio of long and short term assets and liabilities, the FI can both reduce risk exposure through diversification and manage risk exposure by centralizing its hedging activities.

31. Question 5 - 10 • This apparent decline of banks and insurance companies’ assets is only relative. • Actual assets have been growing both in nominal and real (inflation adjusted) terms. • The growth, however, has been less than that of mutual funds and pension funds. Reasons for this trend include: • the aging population, which has an increasing proportion of its financial assets in funds to support retirement • increasing investor sophistication and desire to tailor investment profiles to personal risk return preferences has led to increasing interest in mutual funds. • Increased availability of disintermediated instruments as opposed to claims of deposit-taking FIs and insurance companies that must bear the costs of regulatory burden. • Stock and bond market booms have contributed to make mutual funds look attractive relative to fixed interest returns of bank deposits.