F446 Chapter 1 Student Handout (8

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Chapter 1: Why are Financial Intermediaries Special?
Financial Intermediaries! Specialness
"ther #spects o$ Specialness
Specialness and %e&ulation
'he Chan&in& (ynamics o$ Specialness
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Financial Intermediaries Specialness: In a simple *orld in *hich $inancial
intermediaries (FIs) do not e+ist, households &eneratin& e+cess sa-in&s (their
income e+ceeds their consumption needs) ha-e a .asic choice/ 'hey could:
(1) Hold cash as an asset
(0) in-est in the securities issued .y corporations
In &eneral, corporations issue securities to $inance their in-estments in real
assets to co-er the &ap .et*een their in-estment plans and their internally
&enerated sa-in&s such as retained earnin&s/ In such a *orld, sa-in&s *ould
$lo* $rom households to corporations/ In return, $inancial claims
(e1uity and de.t securities) *ould $lo* $rom corporations to household sa-ers/
In an economy *ithout FIs, the le-el o$ $und $lo*s .et*een household sa-ers
and the corporate sectors is li2ely to .e 1uite lo*/ 'he reasons *hy include:
(1) Household sa-ers! monitorin& the actions o$ the $irms are e+tremely
costly/ Why? 3onitorin& re1uires considera.le time and e+pense
to collect su$$iciently hi&h 1uality in$romation relati-e to the
a-era&e household sa-er!s in-estment / #s a result, little or
no monitorin& *ould .e done/ # lac2 o$ monitorin& *ould increase
the ris2 o$ ine$$icient corporate mana&ement, *hich *ould reduce the
attracti-eness o$ in-estment/
(0) 'he relati-ely lon&)term nature o$ corporate e1uity and de.t, and the
lac2 o$ a secondary mar2et in *hich households can sell these
securities/ #s a result households may choose to hold cash $or liquidity
reasons/
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(4) 5-en i$ $inancial mar2ets e+isted (*ithout FIs to operate them) *hich
*ould pro-ide the a.ility to trade corporate de.t and e1uity securities
*ith other household sa-ers, in-estors also $ace price risk on the sale o$
securities/ 6rice ris2 is de$ined as .ein& the price at *hich household
in-estors can sell securities on secondary mar2ets such as the 7e*
8or2 Stoc2 5+chan&e may *ell di$$er $rom the price they initially
paid $or the securities/
9ecause o$ the a.o-e reasons plus others e+plained later, in a *orld *here FIs
do e+ist, sa-ers o$ten pre$er to hold the $inancial claims issued .y FIs rather
than those issued .y corporations/
FIs $ul$ill t*o $unctions:
(1) 9ro2era&e $unction: #n FI acts as an a&ent $or the sa-er .y pro-idin&
In$ormation and transaction ser-ices/
(0) #sset)trans$ormation $unction: 'he FI issues $inancial claims that
are more attracti-e to household sa-ers than the claims issued .y
corporation/
(a) 6rimary securities: Financial claims (a&ainst the income
&enerated .y the real assets held .y corporations) issued .y
corporation/
(.) Secondary securities: Financial claims (a&ainst the income
&enerated .y the Financial assets held .y FIs) are issued .y
FIs/ 'hese assets are backed .y the primary securities issued .y
commercial corporations that in turn in-est in real assets/ FIs are
independent mar2et parties that create $inancial products *hose
-alue added to their clients is the Financial o$
$inancial ris2/
FIs $inancial assets are considered to .e more attracti-e to household sa-ers
as a result o$ FIs .ein& .etter at resol-in& the three costs $acin& a sa-er *ho
chooses to in-est directly in corporate securities/ (#&ain, these costs are
(1) :in$ormation cost , (0) li1uidity , and (4) price ris2 /)
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F446 Chapter 1 Student Handout (8
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In$ormation Costs: Household sa-ers must monitor the actions o$ $irms in a
timely and completely a$ter purchasin& securities/ Failure to do so e+poses
in-estors to a&ency costs, the ris2 that the $irm!s o*ners or mana&ers
*ill ta2e actions *ith the sa-er!s money contrary to the promises contained in
the co-enants o$ its securities contracts/ #&ency costs arise *hene-er
economic a&ents enter into contracts in a *orld o$ Incomepete in$ormation
and thus costly in$ormation collection/
FIs assist sa-ers .y:
(1) ;roupin& a lar&e num.er o$ small sa-ers $unds to&ether, *hich
(a) increases the incenti-e to collect in$ormation since there is more
at sta2e
(.) lo*ers the a-era&e cost o$ collectin& in$ormation (per in-estin&
sa-er)
(0) FIs may de-elop ne* secondary securities that ena.le households to
monitor these ne* securities more e$$ecti-ely/
(a) 9an2 loans (.an2 assets) are also &enerally shorter)term de.t
contracts that allo*s the .an2 to e+ercise more monitorin& po*er
and control o-er the .orro*er/
(.) 'he in$ormation the FI &enerates re&ardin& the $irm is $re1uently
updated as its loan rene*al decisions are made/
FIs e$$ecti-ely reduce the de&ree o$ in$ormation imper$ection and asymmetry
.et*een the ultimate suppliers and users o$ $unds in the economy/
<i1uidity and 6rice %is2: "$ten, FIs pro-ide $inancial or secondary claims to
households that ha-e superior li1uidity attri.utes compared to those o$ the
primary corporate securities/
5+: 9an2s and thri$ts issue transaction deposit contracts *ith a $i+ed princi)
pal -alue (and o$ten a &uaranteed interest rate) that can .e *ithdra*n
Immdeately on demand .y household sa-ers/
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FIs such as depository institutions can o$$er hi&hly li1uid and lo* price)ris2
contracts to sa-ers *hile in-estin& in relati-ely illi1uid and hi&her price)ris2
securities issued .y corporations/
FIs can diversify a*ay some .ut not all o$ their port$olio ris2s/ #s lon& as the
returns on di$$erent in-estments are not per$ectly positi-ely correlated, .y
.y e+ploitin& the .ene$its o$ si=e , FIs di-ersi$y a*ay si&ni$icant amounts o$
port$olio ris2 > especially the ris2 speci$ic to the indi-idual $irm issuin&
any &i-en security/

"ther Special Ser-ices:
(1) %educe transaction cost (&roupin& small household in-estment $unds
to&ether reduces the a-era&e transaction cost per sa-er? .id)as2 (sell)
.uy) spreads are normally lo*er $or assets .ou&ht and sold in lar&e
1uantities)
(0) 3aturity Intermediation (FIs can .etter .ear the ris2 o$ mismatchin&
the maturities o$ their assets and lia.ilities than can household sa-ers)
"ther #spects o$ Specialness: 'he theory o$ the $lo* o$ $unds point to three
principal reasons $or .elie-in& that FIs are special, alon& *ith t*o other
associated reasons/ In reality, academics, policyma2ers, and re&ulators identi$y
other areas o$ specialness relatin& to certain speci$ic $unctions o$ FIs or &roups
o$ FIs/
'he 'ransmission o$ 3onetary 6olicy: 'he hi&hly li1uid nature o$ .an2 and
thri$t (depository institution) deposits has resulted in their acceptance .y the
pu.lic as most *idely used medium o$ e+chan&e in the economy/
9ecause the lia.ilities o$ depository institutions are a si&ni$icant component o$
the money supply that impacts the rate o$ in$lation, they play a 2ey role in the
transmission o$ monetary policy/
Credit #llocation: FIs are the ma@or and sometimes the only source o$
$inancin& $or a particular sector o$ the economy/ 6olicyma2ers in the Anited
States and a num.er o$ other countries ha-e identi$ied residential
real estate as needin& special su.sidies/
Inter&enerational Wealth 'rans$ers or 'ime Intermediation: <i$e insurance
and pension $unds are o$ten especially encoura&ed, -ia special ta+ation relie$
and other su.sidy mechanisms, to ser-ice and accommodate the a.ility o$
sa-ers to trans$er *ealth .et*een youth and old a&e and across &enerations/
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6ayment Ser-ices: (epository institutions pro-ide e$$icient payment ser-ices
such as chec2)clearin& and *ire trans$er o$ $unds *hich directly .ene$its the
economy/
(enomination Intermediation: 9ecause they are sold in -ery lar&e
denominations, many assets are either out o$ reach o$ indi-idual sa-ers, or
*ould result in sa-ers! holdin& hi&hly undi-ersi$ied asset port$olios/ 9y
.undlin& to&ether small in-estment $unds $rom households, .oth o$ these
pro.lems ha-e .een &reatly reduced .y .oth money mar2et and de.t)e1uity
mutual $unds/ Such indirect access to these lar&er denomination assets may also
allo* small sa-ers to &enerate hi&her returns on their port$olios/
Specialness and %e&ulation: FIs are re&ulated to protect a&ainst a disruption in
the pro-ision o$ the ser-ices pre-iously discussed, *hich *ould impose lar&e costs
on the economy and society/ %e&ulation is an attempt to enhance the social
*el$are .ene$its and miti&ate the social costs o$ the pro-ision o$ FI ser-ices/ 'he
pri-ate costs o$ re&ulation $or the producers o$ $inancial ser-ices is called the net
regulatory burden, *hich can .e de$ined as the di$$erence .et*een the pri-ate costs
o$ re&ulations and the pri-ate .ene$its $or the producers o$ $inancial ser-ices/ 'he
si+ types o$ re&ulation are:
Sa$ety and Soundness %e&ulation: 'hese mechanisms are intended to ensure
the sa$ety and soundness o$ the FI and thus to maintain the credi.ility o$ the FI
in the eyes o$ its .orro*ers and lenders/ 'hese mechanisms include:
(1) (i-ersi$ication o$ assets (e+: .an2s are re1uired not to ma2e loans
e+ceedin& B 1C: D o$ their o*n e1uity capital $unds to any one company
or .orro*er)
(0) 3inimum le-el o$ FI capital or e1uity $unds
(4) ;uaranty $und insurance ((IF, SI6C, and state &uaranty $unds)
(4) %e&ulator monitorin& and sur-eillance (production o$ $inancial state)
ments alon& *ith on)site e+amination)
(E) Costs $or those .ein& re&ulated (employee time re1uirements in-ol-ed
*ith the re&ulators! in$ormation re1uirements)
Ho*e-er, the hi&her the net re&ulatory .urden on FIs, the more Ine$$iciency
they produce any &i-en set o$ $inancial ser-ices $rom a pri-ate (FI) o*ner!s
perspecti-e/
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3onetary 6olicy %e&ulation: 'his re&ulation concerns the special role .an2s
play in the transmission o$ monetary policy $rom the Federal %eser-e to the rest
o$ the economy/
'he Federal %eser-e directly controls only the "utside money , the 1uantity o$
notes and coin in the economy, *hereas the .ul2 o$ the money supply consists o$
deposits called Inside money /
%e&ulators commonly impose $ormal controls (reser-e re1uirements) to meet
the li1uidity and transaction needs o$ the FI!s customers/ FIs o$ten -ie*
re1uired reser-es as similar to a ta+ and a positi-e cost o$ underta2in&
intermediation ($or speci$ics, &o to
***/$ederalreser-e/&o-FmonetarypolicyFreser-ere1/htm)
Credit #llocation %e1uirement: 'his re&ulation supports the FI!s lendin& to
socially important sectors such as housin& and $armin& / 'hese re&u)lations may
re1uire an FI to hold a minimum amount o$ assets in one particular sector o$ the
economy or to set ma+imum interest rates, prices, or $ees to su.sidi=e certain
sectors/
Consumer 6rotection %e&ulation: Con&ress passed the Community %ein-est)
ment #ct and the Home 3ort&a&e (isclosure #ct to pre-ent discrimination in
lendin& / 3any analysts .elie-e that community and consumer protection la*s
are imposin& a considera.le net re&ulatory .urden on FIs *ithout pro-idin&
o$$settin& social .ene$its that enhance e1ual access to mort&a&e and lendin&
mar2ets/ Ho*e-er, as dere&ulation proceeds and the trend to*ard consolidation
and uni-ersal .an2in& continues, it is li2ely that such la*s *ill .e e+tended
.eyond .an2s to other $inancial ser-ice pro-iders/
In-estor 6rotection %e&ulation: 'his area is meant to protect in-estors *ho
either use in-estment .an2s directly to purchase securities, or indirectly to
access securities mar2ets throu&h in-estin& in mutual or pension $unds/ Garious
la*s protect in-estors a&ainst a.uses such as insider tradin&, lac2 o$ disclosure,
outri&ht mal$easance, or .reach o$ $iduciary responsi.ilities/
5ntry %e&ulation: 'he entry and acti-ities o$ FIs are re&ulated (e/&/, ne* .an2
charterin& re&ulations)/ 9arriers to entry and re&ulations pertainin& to the
scope o$ permitted acti-ities affect the charter value o$ an FI and the si=e o$ its
net re&ulatory .urden/
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F446 Chapter 1 Student Handout (8
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'he Chan&in& (ynamics o$ Specialness:
'rends in the Anited States:
(1) Ser-ices pro-ided .y depository institutions (payment ser-ices,
transaction costs ser-ices, and in$ormation costs) ha-e .ecome relati-ely
:less si&ni$icant: as a portion o$ all ser-ices pro-ided .y FIs/
(0) 'he most dramatically increasin& trend is the risin& share o$ in-estment
companies/ In-estment companies di$$er $rom .an2s and insurance
companies in that they &i-e sa-ers Cheaper access to the direct
securities mar2ets/
'hese trends indicate sa-ers ha-e increasin&ly pre$erred that FIs operate
more in the direct securities mar2ets than the traditional trans$ormed
$inancial claims o$$ered .y (depository) FIs durin& the late 1HCCs/ %eco&)
ni=in& this chan&in& trend, the A/S/ Con&ress passed the Financial Ser-ices
3oderni=ation (FS3) #ct, *hich $or the $irst time in IC years allo*ed $or the
creation o$ J$inancial holdin& companiesK that could en&a&e in .an2in&
acti-ities, insurance acti-ities, and securities acti-ities/ /
(4) # ma@or e-ent that chan&ed and reshaped the $inancial ser-ices industry
*as the $inancial crisis o$ the late 0CCCs/ #s FIs ad@usted to re&ulatory
chan&es .rou&ht a.out .y the li2es o$ the FS3 #ct, one result *as a
dramatic increase in the systematic ris2 o$ the $inancial system, caused in
lar&e part .y a shi$t in the .an2in& model $rom that o$ Jori&inate and
Hold:K to Jori&inate and ::(istri.uted:: /K Since the FIs, actin& as
under*riters, *ere not e+posed to the credit, li1uidity, and interest rate
ris2s o$ traditional .an2in&, they had little incenti-e to screen and
monitor acti-ities o$ .orro*ers to *hom they ori&inated loans/ 'hus,
FIs $ailed to act as specialists in ris2 measurement and mana&ement/
'his pro.lem area *as e+acer.ated .y the housin& mar2et .oom and
decline, to&ether *ith the Jsu.prime credit crisis/K What resulted *as a
*orld*ide .rea2do*n in the credit mar2ets, as *ell as an enhanced le-el
o$ e1uity mar2et -olatility/
;lo.al Issues:
(1) FIs must no* compete not only *ith other domestic FIs .ut increasin&ly
*ith $orei&n FIs/
(0) #n increased le-el o$ mer&er acti-ity in-ol-in& the *orld!s lar&est .an2s/
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