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 Inter enerational !ealth Transfers or Time Intermediation Payment Services "enomination Intermediation Specialness and Regulation Safety and Soundness Re ulation Monetary Policy Re ulation Credit Allocation Re ulation Consumer Protection Re ulation Investor Protection Re ulation #ntry Re ulation The Changing Dynamics of Specialness Trends in the $nited States %uture Trends &lo'al Issues Summary

Solutions for nd!of!Chapter "uestions and #ro$lems% Chapter One () Identify and 'riefly e*plain the five risks common to financial institutions)

"efault or credit risk of assets+ interest rate risk caused 'y maturity mismatches 'et,een assets and lia'ilities+ lia'ility ,ithdra,al or liquidity risk+ under,ritin risk+ and operatin cost risks) -) #*plain ho, economic transactions 'et,een household savers of funds and corporate users of funds ,ould occur in a ,orld ,ithout financial intermediaries .%Is/)

In a ,orld ,ithout %Is the users of corporate funds in the economy ,ould have to approach directly the household savers of funds in order to satisfy their 'orro,in needs) This process ,ould 'e e*tremely costly 'ecause of the up0front information costs faced 'y potential lenders) Cost inefficiencies ,ould arise ,ith the identification of potential 'orro,ers+ the poolin of small savin s into loans of sufficient si1e to finance corporate activities+ and the assessment of risk and investment opportunities) Moreover+ lenders ,ould have to monitor the activities of 'orro,ers over each loan2s life span) The net result ,ould 'e an imperfect allocation of resources in an economy) 3) Identify and e*plain three economic disincentives that pro'a'ly ,ould dampen the flo, of funds 'et,een household savers of funds and corporate users of funds in an economic ,orld ,ithout financial intermediaries)

Investors enerally are averse to purchasin securities directly 'ecause of .a/ monitorin costs+ .'/ liquidity costs+ and .c/ price risk) Monitorin the activities of 'orro,ers requires e*tensive time+ e*pense+ and e*pertise) As a result+ households ,ould prefer to leave this activity to others+ and 'y definition+ the resultin lack of monitorin ,ould increase the riskiness of investin in corporate de't and equity markets) The lon 0term nature of corporate equity and de't ,ould likely eliminate at least a portion of those households ,illin to lend money+ as the preference of many for near0cash liquidity ,ould dominate the e*tra returns ,hich may 'e availa'le) Third+ the price risk of transactions on the secondary markets ,ould increase ,ithout the information flo,s and services enerated 'y hi h volume) 4) Identify and e*plain the t,o functions in ,hich %Is may speciali1e that ena'le the smooth flo, of funds from household savers to corporate users)

%Is serve as channels 'et,een users and savers of funds 'y providin a 'rokera e function and 'y en a in in the asset transformation function) The 'rokera e function can 'enefit 'oth savers and users of funds and can vary accordin to the firm) %Is may provide only transaction services+ such as discount 'rokera es+ or they also may offer advisory services ,hich help reduce information costs+ such as full0line firms like Merrill Lynch) The asset transformation function is accomplished 'y issuin their o,n securities+ such as deposits and insurance policies that are more attractive to household savers+ and usin the proceeds to purchase the primary securities of corporations) Thus+ %Is take on the costs associated ,ith the purchase of securities)

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In ,hat sense are the financial claims of %Is considered secondary securities+ ,hile the financial claims of commercial corporations are considered primary securities6 7o, does the transformation process+ or intermediation+ reduce the risk+ or economic disincentives+ to the savers6

The funds raised 'y the financial claims issued 'y commercial corporations are used to invest in real assets) These financial claims+ ,hich are considered primary securities+ are purchased 'y %Is ,hose financial claims therefore are considered secondary securities) Savers ,ho invest in the financial claims of %Is are indirectly investin in the primary securities of commercial corporations) 7o,ever+ the information atherin and evaluation e*penses+ monitorin e*penses+ liquidity costs+ and price risk of placin the investments directly ,ith the commercial corporation are reduced 'ecause of the efficiencies of the %I) 8) #*plain ho, financial institutions act as dele ated monitors) !hat secondary 'enefits often accrue to the entire financial system 'ecause of this monitorin process6

9y puttin e*cess funds into financial institutions+ individual investors ive to the %Is the responsi'ility of decidin ,ho should receive the money and of ensurin that the money is utili1ed properly 'y the 'orro,er) In this sense the depositors have dele ated the %I to act as a monitor on their 'ehalf) The %I can collect information more efficiently than individual investors) %urther+ the %I can utili1e this information to create ne, products+ such as commercial loans+ that continually update the information pool) This more frequent monitorin process sends important informational si nals to other participants in the market+ a process that reduces information imperfection and asymmetry 'et,een the ultimate sources and users of funds in the economy) :) !hat are five eneral areas of %I specialness that are caused 'y providin various services to sectors of the economy6

%irst+ %Is collect and process information more efficiently than individual savers) Second+ %Is provide secondary claims to household savers ,hich often have 'etter liquidity characteristics than primary securities such as equities and 'onds) Third+ 'y diversifyin the asset 'ase %Is provide secondary securities ,ith lo,er price0risk conditions than primary securities) %ourth+ %Is provide economies of scale in transaction costs 'ecause assets are purchased in lar er amounts) %inally+ %Is provide maturity intermediation to the economy ,hich allo,s the introduction of additional types of investment contracts+ such as mort a e loans+ that are financed ,ith short0term deposits) ;) 7o, do %Is solve the information and related agency costs ,hen household savers invest directly in securities issued 'y corporations6 !hat are a ency costs6

A ency costs occur ,hen o,ners or mana ers take actions that are not in the 'est interests of the equity investor or lender) These costs typically result from the failure to adequately monitor the activities of the 'orro,er) If no other lender performs these tasks+ the lender is su'<ect to a ency costs as the firm may not satisfy the covenants in the lendin a reement) 9ecause the %I invests the funds of many small savers+ the %I has a reater incentive to collect information and monitor the activities of the 'orro,er) 3

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!hat often is the 'enefit to the lenders+ 'orro,ers+ and financial markets in eneral of the solution to the information pro'lem provided 'y the lar e financial institutions6

One 'enefit to the solution process is the development of ne, secondary securities that allo, even further improvements in the monitorin process) An e*ample is the 'ank loan that is rene,ed more quickly than lon 0term de't) The rene,al process updates the financial and operatin information of the firm more frequently+ there'y reducin the need for restrictive 'ond covenants that may 'e difficult and costly to implement) (>) 7o, do %Is alleviate the pro'lem of liquidity risk faced 'y investors ,ho ,ish to invest in the securities of corporations6

Liquidity risk occurs ,hen savers are not a'le to sell their securities on demand) Commercial 'anks+ for e*ample+ offer deposits that can 'e ,ithdra,n at any time) ?et the 'anks make lon 0 term loans or invest in illiquid assets 'ecause they are a'le to diversify their portfolios and 'etter monitor the performance of firms that have 'orro,ed or issued securities) Thus individual investors are a'le to reali1e the 'enefits of investin in primary assets ,ithout acceptin the liquidity risk of direct investment) (() 7o, do financial institutions help individual savers diversify their portfolio risks6 !hich type of financial institution is 'est a'le to achieve this oal6

Money placed in any financial institution ,ill result in a claim on a more diversified portfolio) 9anks lend money to many different types of corporate+ consumer+ and overnment customers+ and insurance companies have investments in many different types of assets) Investment in a mutual fund may enerate the reatest diversification 'enefit 'ecause of the fund@s investment in a ,ide array of stocks and fi*ed income securities) (-) 7o, can financial institutions invest in hi h0risk assets ,ith fundin provided 'y lo,0risk lia'ilities from savers6

"iversification of risk occurs ,ith investments in assets that are not perfectly positively correlated) One result of e*tensive diversification is that the avera e risk of the asset 'ase of an %I ,ill 'e less than the avera e risk of the individual assets in ,hich it has invested) Thus individual investors reali1e some of the returns of hi h0risk assets ,ithout acceptin the correspondin risk characteristics) (3) 7o, can individual savers use financial institutions to reduce the transaction costs of investin in financial assets6

9y poolin the assets of many small investors+ %Is can ain economies of scale in transaction costs) This 'enefit occurs ,hether the %I is lendin to a corporate or retail customer+ or purchasin assets in the money and capital markets) In either case+ operatin activities that are desi ned to deal in lar e volumes typically are more efficient than those activities desi ned for small volumes)

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!hat is maturity intermediation6 !hat are some of the ,ays in ,hich the risks of maturity intermediation are mana ed 'y financial intermediaries6

If net 'orro,ers and net lenders have different optimal time hori1ons+ %Is can service 'oth sectors 'y matchin their asset and lia'ility maturities throu h on0 and off0'alance sheet hed in activities and fle*i'le access to the financial markets) %or e*ample+ the %I can offer the relatively short0term lia'ilities desired 'y households and also satisfy the demand for lon 0term loans such as home mort a es) 9y investin in a portfolio of lon 0and short0term assets that have varia'le0 and fi*ed0rate components+ the %I can reduce maturity risk e*posure 'y utili1in lia'ilities that have similar varia'le0 and fi*ed0rate characteristics+ or 'y usin futures+ options+ s,aps+ and other derivative products) (5) !hat are five areas of institution0specific %I specialness+ and ,hich types of institutions are most likely to 'e the service providers6

%irst+ commercial 'anks and other depository institutions are key players for the transmission of monetary policy from the central 'ank to the rest of the economy) Second+ specific %Is often are identified as the ma<or source of finance for certain sectors of the economy) %or e*ample+ SALs and savin s 'anks traditionally serve the credit needs of the residential real estate market) Third+ life insurance and pension funds commonly are encoura ed to provide mechanisms to transfer ,ealth across enerations) %ourth+ depository institutions efficiently provide payment services to 'enefit the economy) %inally+ mutual funds provide denomination intermediation 'y allo,in small investors to purchase pieces of assets ,ith lar e minimum si1es such as ne otia'le C"s and commercial paper issues) (8) 7o, do depository institutions such as commercial 'anks assist in the implementation and transmission of monetary policy6

The %ederal Reserve 9oard can involve directly the commercial 'anks in the implementation of monetary policy throu h chan es in the reserve requirements and the discount rate) The open market sale and purchase of Treasury securities 'y the %ed involves the 'anks in the implementation of monetary policy in a less direct manner) (:) !hat is meant 'y credit allocation re ulation6 !hat social 'enefit is this type of re ulation intended to provide6

Credit allocation re ulation refers to the requirement faced 'y %Is to lend to certain sectors of the economy+ ,hich are considered to 'e socially important) These may include housin and farmin ) Presuma'ly the provision of credit to make houses more afforda'le or farms more via'le leads to a more sta'le and productive society) (;) !hich intermediaries 'est fulfill the inter enerational ,ealth transfer function6 !hat is this ,ealth transfer process6

Life insurance and pension funds often receive special ta*ation relief and other su'sidies to assist in the transfer of ,ealth from one eneration to another) In effect+ the ,ealth transfer process

allo,s the accumulation of ,ealth 'y one eneration to 'e transferred directly to one or more youn er enerations 'y esta'lishin life insurance policies and trust provisions in pension plans) Often this ,ealth transfer process avoids the full mar inal ta* treatment that a direct payment ,ould incur) (=) !hat are t,o of the most important payment services provided 'y financial institutions6 To ,hat e*tent do these services efficiently provide 'enefits to the economy6

The t,o most important payment services are check clearin and ,ire transfer services) Any 'reakdo,n in these systems ,ould produce ridlock in the payment system ,ith resultin harmful effects to the economy at 'oth the domestic and potentially the international level) ->) !hat is denomination intermediation6 7o, do %Is assist in this process6

"enomination intermediation is the process ,here'y small investors are a'le to purchase pieces of assets that normally are sold only in lar e denominations) Individual savers often invest small amounts in mutual funds) The mutual funds pool these small amounts and purchase ne otia'le C"s ,hich can only 'e sold in minimum increments of B(>>+>>>+ 'ut ,hich often are sold in million dollar packa es) Similarly+ commercial paper often is sold only in minimum amounts of B-5>+>>>) Therefore small investors can 'enefit in the returns and lo, risk ,hich these assets typically offer) -() !hat is negative externality6 In ,hat ,ays do the e*istence of ne ative e*ternalities <ustify the e*tra re ulatory attention received 'y financial institutions6

A ne ative e*ternality refers to the action 'y one party that has an adverse affect on some third party ,ho is not part of the ori inal transaction) %or e*ample+ in an industrial settin + smoke from a factory that lo,ers surroundin property values may 'e vie,ed as a ne ative e*ternality) %or financial institutions+ one concern is the conta ion effect that can arise ,hen the failure of one %I can cast dou't on the solvency of other institutions in that industry) --) If financial markets operated perfectly and costlessly+ ,ould there 'e a need for financial intermediaries6

To a certain e*tent+ financial intermediation e*ists 'ecause of financial market imperfections) If information is availa'le costlessly to all participants+ savers ,ould not need intermediaries to act as either their 'rokers or their dele ated monitors) 7o,ever+ if there are social 'enefits to intermediation+ such as the transmission of monetary policy or credit allocation+ then %Is ,ould e*ist even in the a'sence of financial market imperfections) -3) !hat is mort a e redlinin 6

Mort a e redlinin occurs ,hen a lender specifically defines a eo raphic area in ,hich it refuses to make any loans) The term arose 'ecause of the area often ,as outlined on a map ,ith a red pencil)

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!hy are %Is amon the most re ulated sectors in the ,orld6 !hen is net re ulatory 'urden positive6

%Is are required to enhance the efficient operation of the economy) Successful financial intermediaries provide sources of financin that fund economic ro,th opportunity that ultimately raises the overall level of economic activity) Moreover+ successful financial intermediaries provide transaction services to the economy that facilitate trade and ,ealth accumulation) Conversely+ distressed %Is create ne ative e*ternalities for the entire economy) That is+ the adverse impact of an %I failure is reater than <ust the loss to shareholders and other private claimants on the %I2s assets) %or e*ample+ the local market suffers if an %I fails and other %Is also may 'e thro,n into financial distress 'y a conta ion effect) Therefore+ since some of the costs of the failure of an %I are enerally 'orne 'y society at lar e+ the overnment intervenes in the mana ement of these institutions to protect society2s interests) This intervention takes the form of re ulation) 7o,ever+ the need for re ulation to minimi1e social costs may impose private costs to the firms that ,ould not e*ist ,ithout re ulation) This additional private cost is defined as a net re ulatory 'urden) #*amples include the cost of holdin e*cess capital andCor e*cess reserves and the e*tra costs of providin information) Althou h they may 'e socially 'eneficial+ these costs add to private operatin costs) To the e*tent that these additional costs help to avoid ne ative e*ternalities and to ensure the smooth and efficient operation of the economy+ the net re ulatory 'urden is positive) -5) !hat forms of protection and re ulation do re ulators of %Is impose to ensure their safety and soundness6

Re ulators have issued several uidelines to insure the safety and soundness of %IsD a) ') c) d) -8) %Is are required to diversify their assets) %or e*ample+ 'anks cannot lend more than (> percent of their equity to a sin le 'orro,er) %Is are required to maintain minimum amounts of capital to cushion any une*pected losses) In the case of 'anks+ the 9asle standards require a minimum core and supplementary capital of ; percent of their risk0ad<usted assets) Re ulators have set up uaranty funds such as 9I% for commercial 'anks+ SIPC for securities firms+ and state uaranty funds for insurance firms to protect individual investors) Re ulators also en a e in periodic monitorin and surveillance+ such as on0site e*aminations+ and request periodic information from the %Is) In the transmission of monetary policy+ ,hat is the difference 'et,een inside money and outside money6 7o, does the %ederal Reserve 9oard try to control the amount of inside money6 7o, can this re ulatory position create a cost for the depository financial institutions6

Outside money is that part of the money supply directly produced and controlled 'y the %ed+ for e*ample+ coins and currency) Inside money refers to 'ank deposits not directly controlled 'y the %ed) The %ed can influence this amount of money 'y reserve requirement and discount rate policies) In cases ,here the level of required reserves e*ceeds the level considered optimal 'y the %I+ the ina'ility to use the e*cess reserves to enerate revenue may 'e considered a ta* or cost of providin intermediation) -:) !hat are some e*amples of credit allocation re ulation6 7o, can this attempt to create social 'enefits create costs to the private institution6

The qualified thrift lender test .ETL/ requires thrifts to hold 85 percent of their assets in residential mort a e0related assets to retain the thrift charter) Some states have enacted usury la,s that place ma*imum restrictions on the interest rates that can 'e char ed on mort a es andCor consumer loans) These types of restrictions often create additional operatin costs to the %I and almost certainly reduce the amount of profit that could 'e reali1ed ,ithout such re ulation) -;) !hat is the purpose of the 7ome Mort a e "isclosure Act6 !hat are the social 'enefits desired from the le islation6 7o, does the implementation of this le islation create a net re ulatory 'urden on financial institutions6

The 7M"A ,as passed 'y Con ress to prevent discrimination in mort a e lendin ) The social 'enefit is to ensure that everyone ,ho qualifies financially is provided the opportunity to purchase a house should they so desire) The re ulatory 'urden has 'een to require a ,ritten statement indicatin the reasons ,hy credit ,as or ,as not ranted) Since (==>+ the federal re ulators have e*amined millions of mort a e transactions from more than :+:>> institutions each calendar quarter) -=) !hat le islation has 'een passed specifically to protect investors ,ho use investment 'anks directly or indirectly to purchase securities6 &ive some e*amples of the types of a'uses for ,hich protection is provided)

The Securities Acts of (=33 and (=34 and the Investment Company Act of (=4> ,ere passed 'y Con ress to protect investors a ainst possi'le a'uses such as insider tradin + lack of disclosure+ outri ht malfeasance+ and 'reach of fiduciary responsi'ilities) 3>) 7o, do re ulations re ardin 'arriers to entry and the scope of permitted activities affect the charter value of financial institutions6

The profita'ility of e*istin firms ,ill 'e increased as the direct and indirect costs of esta'lishin competition increase) "irect costs include the actual physical and financial costs of esta'lishin a 'usiness) In the case of %Is+ the financial costs include raisin the necessary minimum capital to receive a charter) Indirect costs include permission from re ulatory authorities to receive a charter) A ain in the case of %Is this cost involves accepta'le leadership to the re ulators) As these 'arriers to entry are stron er+ the charter value for e*istin firms ,ill 'e hi her)

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!hat reasons have 'een iven for the ro,th of investment companies at the e*pense of FtraditionalG 'anks and insurance companies6

The recent ro,th of investment companies can 'e attri'uted to t,o ma<or factorsD a) Investors have demanded increased access to direct securities markets) Investment companies and pension funds allo, investors to take positions in direct securities markets ,hile still o'tainin the risk diversification+ monitorin + and transactional efficiency 'enefits of financial intermediation) Some e*perts ,ould ar ue that this ro,th is the result of increased sophistication on the part of investorsH others ,ould ar ue that the a'ility to use these markets has caused the increased investor a,areness) The ro,th in these assets is inar ua'le) Recent episodes of financial distress in 'oth the 'ankin and insurance industries have led to an increase in re ulation and overnmental oversi ht+ there'y increasin the net re ulatory 'urden of FtraditionalG companies) As such+ the costs of intermediation have increased+ ,hich increases the cost of providin services to customers) !hat are some of the methods ,hich 'ankin or ani1ations have employed to reduce the net re ulatory 'urden6 !hat has 'een the effect on profita'ility6

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Throu h re ulatory chan es+ %Is have 'e un chan in the mi* of 'usiness products offered to individual users and providers of funds) %or e*ample+ 'anks have acquired mutual funds+ have e*panded their asset and pension fund mana ement 'usinesses+ and have increased the security under,ritin activities) In addition+ le islation that allo,s 'anks to esta'lish 'ranches any,here in the $nited States has caused a ,ave of mer ers) As the si1e of 'anks has ro,n+ an e*pansion of possi'le product offerin s has created the potential for lo,er service costs) %inally+ the emphasis in recent years has 'een on products that enerate increases in fee income+ and the entire 'ankin industry has 'enefited from increased profita'ility in recent years) 33) !hat characteristics of financial products are necessary for financial markets to 'ecome efficient alternatives to financial intermediaries6 Can you ive some e*amples of the commoditi1ation of products ,hich ,ere previously the sole property of financial institutions6

%inancial markets can replace %Is in the delivery of products that .(/ have standardi1ed terms+ .-/ serve a lar e num'er of customers+ and .3/ are sufficiently understood for investors to 'e comforta'le in assessin their prices) !hen these three characteristics are met+ the products often can 'e treated as commodities) One e*ample of this process is the mi ration of over0the0 counter options to the pu'licly traded option markets as tradin volume ro,s and tradin terms 'ecome standardi1ed) 34) In ,hat ,ay has Re ulation (44A of the Securities and #*chan e Commission provided an incentive to the process of financial disintermediation6

Chan in technolo y and a reduction in information costs are rapidly chan in the nature of financial transactions+ ena'lin savers to access issuers of securities directly) Section (44A of the S#C is a recent re ulatory chan e that ,ill facilitate the process of disintermediation) The private placement of 'onds and equities directly 'y the issuin firm is an e*ample of a product that historically has 'een the domain of investment 'ankers) Althou h historically private placement assets had restrictions a ainst tradin + re ulators have iven permission for these assets to trade amon lar e investors ,ho have assets of more than B(>> million) As the market ro,s+ this minimum asset si1e restriction may 'e reduced)

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