FINANCIAL INTERMEDIARIES

AND FINANCIAL INNOVATION

Chapter # 2
Part 1

Purpose of the chapter

The main purpose f this chapter is to

introduce financial intermediaries.

Financial intermediaries include:

Commercial Banks
Savings and loan Associations
Investment Companies
Insurance Companies
Pension Funds

Financial Institutions
Business entities include nonfinancial and financial

enterprises. Nonfinancial enterprises provide following

services:
Nonfinancial enterprises manufacture products or provide

nonfinancial services
Financial enterprises provide following services:
Transforming financial assets acquired through the market

and transforming them into different and most widely used

asset. This function is performed by financial intermediaries,
the most important type of financial institution.

Contd..
Exchanging the financial asset on behalf of

customer
Exchanging the financial asset on their own account
Assisting in the creation of FA for their customers
and then selling those FA to other market
participants
Providing investment advise
Managing the portfolios of other market
participants

Contd..
Financial Intermediaries also include depository

institutions (commercial banks, savings and loan

associations, savings bank and credit unions) which
acquire bulk of the funds of customers by offering their
liabilities to them in the forms of deposits; insurance
companies; pension funds; and finance companies.
Financial intermediaries also provide services like

underwriting.

Contd
Typically the FI that provide underwriting services

also provide brokerage/dealer services.

Some nonfinancial enterprises also have subsidiaries

that provide financial services. These FI are also

called Captive Finance Companies. For example
General Motors acceptance corporation (a subsidiary
of GM)

Role of Financial Intermediaries

FI obtain funds by issuing financial claims against

themselves to market participants and then invest those

funds.
The investment made by FI can be loan or security. These
investments are called direct investment.
The participants who hold those financial claims have said
to made indirect investment.
Example: Commercial Banks, Investment Companies
(Pooling of Funds)

Contd.. Functions of Financial

Intermediaries
FI provide four basic functions:
1. Maturity Intermediation: In our example of
commercial banks two things should be noticed:

The maturity of at least a portion of the deposits

accepted is typically short term. (certain types of
deposits are payable on demand and others have
specific maturity date, but most are less than two
years).

Contd..
Maturity of the loans made by the commercial

banks may be considerably longer than two

years.
The commercial bank by issuing it own financial claim in

essence transforms a longer-term asset into a shorter-term

one by giving the borrower a loan for the length of the
time sought and the investor/depositor a FA for the desired
investment horizon. This function of Financial
Intermediary is called maturity intermediation.

Contd..
2.

Reducing Risk via Diversification: FI convert more

risky funds into less risky funds.

3.

Reducing the costs of contracting and information

processing: Investors purchasing FA should take time to
develop skills necessary to understand how to evaluate
an investment.
Once skills are developed, investors should apply those
skills to the analysis of specific FA that are candidates
for purchase (or subsequent sale).

Contd..
Investors who want to make a loan to a consumer or

business will need to write the loan contract (or hire an

attorney to do so).
In addition o the opportunity cost of time to process
the information about the FA and its issuer, there is
cost of acquiring this information. All these costs are
called information processing costs.

Contd..
4.

Providing a payment mechanism: Although most

transactions made today are not done with cash. Instead
payments are made using checks, credit cards, debit
cards, and the electronic transfer of funds. These
methods of making payments is called payment
mechanisms, are provided by certain financial
intermediaries.

Part 1 Complete
Part 2 Starts below

Overview of Asset/Liability Management

for Financial Institutions
OBJECTIVE:
To know why managers of FI invest in particular types

of financial assets and the types of investment

strategies they employ.
To know the problem of asset/liability management.

Contd..
The nature of the liability dictates which strategy is

adopted.
Depository Institutions
Depository institutions buy money and sell money.
Banks BUY money by borrowing from depositors or other
sources of funds.
And they SELL money by lending it to businesses and
individuals.
The difference between the buying and selling value is
called SPREAD.
The cost of the funds and the return on the funds sold is
expressed in terms of interest rate per unit of time.

Nature of the Liabilities

By liabilities of FI we mean the amount and timing of

the cash outlays that must be made to satisfy the

contractual terms of the obligations issued.
The liabilities of any FI can be categorized according to

four types, mentioned below:

Liability Type

Amount of Cash
Outlays

Timings of Cash
Outlays

Type I

Known

Known

Type II

Known

Uncertain

Type III

Uncertain

Known

Type IV

Uncertain

Uncertain

Contd..

Type I Liabilities

Both the amount and timings are known with certainty.

Example: a liability requiring FI to pay $50,000 six

months from now will be a good example. (Principal +

Interest). Where interest rate is always fixed.
Type I liabilities are not just sold by depository

institutions but also by life insurance companies.

EXAMPLE: Life insurance companies have obligation to

fulfill under this contract for some of money called

PREMIUM, it will guarantee an interest rate up to some
specified maturity date.

Contd..

Type II Liabilities

In type II liabilities the amount of the cash

outlay is known, but the timings are uncertain.

EXAMPLE: Life insurance policy. (will be

discussed in chapter 7).

In this type for an annual premium, a life

insurance company agrees to make specified $

$ payment to the policy beneficiaries/holders
upon the death of the insured.

Contd..

Type III Liabilities

In this type timing of the cash outlay is known but the

amount is uncertain.
EXAMPLE: FI issue an obligation in which the interest
rate adjusts periodically according to some interest rate
benchmark.
Depository Institutions issues:
CD: Have stated maturity and Interest rate fluctuate over

the life of the deposit.

3-years floating rate certificate of deposit: Interest rate

adjusts every 3-months and is benchmarked against the

Treasury Bill rate plus 1 percentage point. And matures
after 3 years.

Contd..

Type IV Liabilities

There are numerous insurance products and pension

obligations that present uncertainty to both the

amount and the timings of the cash outlay.
EXAPMPLE: Automobile and home insurance

policies in which amount/payment and timings are

uncertain.
Also retirement benefits depends on the total number

of employment years and this will affect the cash

outlay.

Contd..

Liquidity Concerns

Because of the uncertainty about the timings and amount of

the cash outlays, a FI must be prepared to fulfill/satisfy the

financial obligations.
EXAMPLE: If the depositor request the withdrawal of the
funds prior of the maturity date. The deposit accepting
institution will grant this request will take an early withdrawal
penalty.
In certain type of investment companies the shareholders have

the right to redeem their shares at any time.

Regulations and Taxation: Numerous regulations ad tax

considerations influence the investment policies that FI pursue.

Financial Innovation
Categorization of Financial Innovation: Since 1960s there

is significant surge in Financial Innovation. Here are just 3

ways to categorize the innovations suggested by Economic
Council of Canada.
Market Broadening Instruments: which increase the liquidity

of the markets and the availability of the funds by attracting new

investors and offering new opportunities for the borrowers.
Risk Management Instruments: which relocate financial risk
to those who are less averse to them or who have better
diversification.
Arbitraging Instruments and Processes: which enable the
investors and borrowers to take advantage of the differences in
cost and return between markets, which reflect differences in the
perception of the risk, as well as in information, taxations and
regulations.

THE END =D