FINANCIAL INSTITUTION

AND MARKET

Asit Mohanty
Financial Intermediaries

INDIRECT FINANCE
 
Financial
Intermediaries
 
BORROWERS
 Government
SAVERS Business
  Households
Households
Business

 Objective : To intermediate funds from savers to Borrowers in the most risk free manner
 Financial Institutions…. Intermediaries

 ..…are the markets in the economy that help to match

one person’s saving with another person’s investment.
 . . . move the economy’s scarce resources from savers
to borrowers.
 . . . are opportunities for savers to channel unspent
funds into the hands of borrowers.
 Institutions that allow savers and borrowers to interact
are called financial intermediaries.
 Financial Intermediaries.. Intermediaries perform
six basic functions
1.Denomination Intermediation
 - Small amount of savings from individuals and others are pooled so
as to give loans of varying size
2. Default Risk intermediation
 - Willingness to give loans to risky borrowers without hurting the
returns to savers
3. Maturity intermediation
 - Ability to create loans whose maturities may mismatch with the deposit
maturity profile
4. Liquidity intermediation
 - Claims from savers that are highly liquid while loans to borrowers
are relatively less liquid
5. Information intermediation
 - Ability to gather and process information from the financial
marketplace far more effectively than the individual saver
6. Currency intermediation
 - Ability to lend cross-currency
Fund transfer from savers to borrowers
---Direct and Indirect Finance

 The Indirect Finance :

 The intermediary borrows funds from the savers and
then using this fund makes loans to the borrower
spenders.

 Direct Finance :
 borrowers borrow gets fund directly from the lenders
in the financial markets, by selling them securities
( also called financial instruments). These are assets
who buys them and liabilities to those who
sell( issue) them.
INDIRECT FINANCE & DIRECT FINANCE

INDIRECT FINANCE
 
Financial
Intermediaries
 
BORROWERS
 Government
SAVERS Business
  Households
Households
DIRECT FINANCE
Business
 
Financial Markets
 
Direct and Indirect Finance

INDIRECT FINANCE
Financial
Intermediaries

This is the where

‘trouble’ starts
Borrowers Spenders
Lender Savers DIRECT FINANCE House holds
House holds Financial funds Business Firms
Business Firms
funds Govt.
Markets

Monetary Policy, Regulation, Risk management,

Effective Hedging etc…
RIGHT TIME TO REVIEW THE PEDAGOGY
 Financial Markets
 Money market
 Foreign Exchange Market
 Debt market
 Stock Market
 Derivatives Market
 Private Equity Market  
 Over The Counter (OTC)
 Exchange Traded
- Primary / secondary
 Primary vs Secondary Market
 Primary/Direct Securities : Are securities issued directly by the
end user to the lender in the financial markets . These can be of the
following types :
 Equity / ordinary shares
 Debentures/ bonds

 Secondary /Indirect Securities: Financial Instruments issued by

financial intermediaries and not by the end user of the fund.
Example
 units issued by mutual fund….. Invested in Financial Market
 policies issued by insurance companies ….. Invested in Financial
Market
 Deposits of banks are examples of indirect securities…..invested in
financial market or Banks raise fund financial market in order to lend to
Borrowers
 Indirect securities issued to retail investors generate funds that are then
forwarded by the financial intermediary to the end user of the fund.
 Saving and Investment in the National Income
Accounts
 Recall: GDP is both total income in an
economy and the total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX
 Assume a closed economy:
Y=C+I+G
 National Saving or Saving is equal to:
Y-C-G=I=S
Saving and Investment in the National Income
Accounts

 National Saving or Saving is equal to:

Y - C - G = I = S or
S = (Y - T - C) + (T - G)
where “T” = taxes net of transfers
 Two components of national saving:
Private Saving = (Y - T - C)
Public Saving = (T - G)
 Saving and Investment
 Private Saving is the amount of income that
households have left after paying their taxes
and paying for their consumption.
 Public Saving is the amount of tax revenue
that the government has left after paying for its
spending.
 For the economy as a whole, saving must be
equal to investment.
 The Market For Loan able Funds
 Financial markets coordinate the economy’s
saving and investment in
The Loan able Funds Market
 The Supply of Loan able Funds comes from
people who have extra income that they want
to loan out.
 The Demand for Loan able Funds comes from
those who wish to borrow to make
investments.
The Market For Loanable Funds
Interest
Rate

Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply

Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply

Demand

Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

 The Market For Loan able Funds
Interest
Rate
Supply

Movement to
equilibrium is
5% consistent with
principles of supply
and demand.

Demand

$1,200 Loanable Funds

The Market For Loanable Funds

 The supply and demand for loanable funds

depends on the real interest rate. Movement
to equilibrium is the process of determining
the real interest rate in the economy.
 Saving represents the supply of loanable
funds, while investment represents demand.
Government Policy That Affects The Economy’s Saving
and Investment

 Policies that influence the loanable funds market:

 Taxes and Saving
 Taxes and Investment
 Government Deficits
 Observe how policy affects equilibrium, interest rates
and funds.
Government Policy That Affects The Economy’s Saving
and Investment

 Taxes on savings reduce the incentive to

save. A tax decrease would alter the
incentive for households to save at any given
interest rate and would affect the supply of
loanable funds resulting in the:
 Supply curve shifting to the right.
 Equilibrium interest rate would drop.
 Quantity demanded for funds would rise.
The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

Decrease in Taxes
5% on savings increases
the incentive to save
affecting the supply
of loanable funds

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

5%

4%

Demand

$1,200 $1,300 Loanable Funds

Government Policy That Affects The Economy’s
Saving and Investment

 A Tax Break on investment would increase

the incentive to borrow if an investment tax
credit were given.
 An investment tax credit would:
 Alter
the demand for loanable funds.
 Cause the demand curve to shift to the right.
 Result in higher interest rate and greater saving.
The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

Tax Break on
investment would
increase the
incentive to borrow
5% altering the demand
for loanable funds.

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

6%
5%

Demand

$1,200 $1,300 Loanable Funds

Government Policy That Affects The Economy’s
Saving and Investment

 Government Deficit:
 When the government spends more than it
receives in tax revenues
 The budget deficit:
 Altersthe supply curve, reducing supply.
 Causes the supply to shift to the left.
 Results in Crowding Out.
Government Policy That Affects The Economy’s
Saving and Investment

 When the government borrows to finance

its deficit, it reduces the supply of
loanable funds available to finance
investment by households and firms.
 This deficit borrowing “crowds out” the
private borrowers who are trying to finance
investments.
The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

Government
borrowing to finance
its budget deficit,
5% reduces the supply of
loanable funds.

Demand

$1,200 Loanable Funds

The Market For Loanable Funds
Interest
Rate
Supply

6%
5%

Demand

$1,000 $1,200 Loanable Funds

 Theory and Structure of Interest rates
 As discussed, Market interest Rate is determined by the factors that
control the supply and demand for loan able funds” …. Loanable Funds
Theory
 Demand for Loanable Funds
 Household demand
 Business demand
 Government …To meet Deficit
 Foreign demand ….. Country A issues securities to investors of country B
 Supply of Loanable Funds
 Household sector is the largest followed by Government and Business
Sector
 At ‘equilibrium interest rate’, Supply = Demand of Loanable Funds
Theory and Structure of Interest rates …..Fisher Effect
 Fisher Effect …Offers an additional explanation to the loanable funds
theory
Nominal Interest rate
- Compensates for reduced Purchasing Power
- Provides a premium for foregoing present consumption
ir = in - E(i)

where
ir is Real interest rate
in is nominal interest rate
E(i) is expected inflation rate
Since ir cannot be negative , higher inflation tends to push up interest rates
Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of interest rates in foreign countries
 Conclusion
 Financial Intermediaries through financial
markets and instruments…. coordinate
borrowing and lending and thereby help
allocate the economy’s scarce resources
efficiently.
 The price in the loanable funds market -
interest rate… Price discovery-process - is
governed by the forces of supply and demand
of funds.
More on Interest Rates
 Interest Rates Determined by

 Real Rate of Interest

 Expected Inflation
 Default Risk
 Maturity Risk
 Illiquidity Risk
More on Interest Rates

 Real Rate of Interest

 Compensates for the lender’s lost
opportunity to consume.
More on Interest Rates

 Default Risk
 For most securities, there is some risk that
the borrower will not repay the interest
and/or principal on time, or at all.
 The greater the chance of default, the
greater the interest rate the investor
demands and the issuer must pay.
 More on Interest Rates

 Expected Inflation
 Inflation erodes the purchasing power of money.
 Example: If you loan someone $1,000 and they pay it back one year
later with 10% interest, you will have $1,100. But if prices have
increased by 5%, then something that would have cost $1,000 at the
outset of the loan will now cost $1,000(1.05) = $1,050.
 More on Interest Rates

 Maturity Risk

 If interest rates rise, lenders may find that

their loans are earning rates that are lower
than what they could get on new loans.
 The risk of this occurring is higher for longer
maturity loans.
 More on Interest Rates
 Illiquidity
 Bonds/Loan that are easy to sell without
losing value are more liquid.
 Illiquid Bonds have a higher interest rate to

compensate the lender for the inconvenience

of being “stuck.”
Determination of Rates

kk== k*
k* ++IRP
IRP++ DRP
DRP++ MP
MP++ ILP
ILP

k = the nominal, or observed rate

on security
k* = real rate of interest
IRP = Inflation Risk Premium
DRP = Default Risk Premium
MP = Maturity Premium
ILP = Illiquidity Premium
 Term Structure of Interest Rates

 Term Structure
 Relationship between long and short
term interest rates
 Yield (Interest Rate) curve
 Yield Curve
8.00%

7.50%
33month
month
7.00% T-Bill
T-Bill

6.50%

6.00%

5.50%

5.00%
June 10, 2010
4.50%

4.00%

3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
 Yield Curve
8.00%

7.50%

7.00%
66month
month
6.50% T-Bill
T-Bill
6.00%

5.50%

5.00%
June 10, 2010
4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
 Yield Curve
8.00%

7.50% 11year
year
7.00%
T-Bill
T-Bill

6.50%

6.00%

5.50%

5.00% June 10, 2010

4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
 Yield Curve
8.00% 22year
year
T-Note
T-Note
7.50%

7.00%

6.50%

6.00%

5.50%

5.00%
June 10, 2010
4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
 Yield Curve
8.00%

7.50%

7.00%

6.50%

6.00%

5.50% 33year
year
T-Note
T-Note
5.00%
June 10, 2010
4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
 Yield Curve
8.00%

7.50%

7.00%

6.50%
55year
year
6.00% T-Bond
T-Bond
5.50%

5.00%
June 10, 2010
4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Treasury Yield Curve
8.00%

7.50%

7.00%

6.50%

6.00%

5.50%

5.00%
June 10, 2010
4.50%

4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Treasury Yield Curve
8.00%

7.50%

7.00%

6.50%

6.00%

5.50%

5.00%
June 10, 2010
4.50% June 10, 2009
June 10, 2008
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
The ‘Lemons’ Problem

 George Akerlof: ‘The Market for ‘Lemons’: Quality, Uncertainty

and the Market Mechanisms (1970)

 Potential buyer of a used car can’t tell whether the car he wants to
buy is a good car that will run well ‘peach’ or a ‘lemon’ that will give
him continuous grief

 The owner of the car is more likely to know whether the car is a
‘lemon’ or a ‘peach’

 The ‘used car’ market will then function poorly if the buyer pays
average price for bad used car
The ‘Lemons’ Problem
Life Insurance :

 Suppose that there are two groups among the population, smokers and non-smokers.
 An insurer selling life policies can't tell who is what, so they set premium at the
average level and each pay the same premiums, while people buying insurance know
whether they are smokers or not,
 Non-smokers, on the average, are more likely to live longer, while smokers, on the
average, are more likely to die younger. So the life policy is a better buy for the
smokers' beneficiaries.

 Premiums set according to average risk will not be sufficient to cover claims because
buyers will be selected for higher risk (buyers carrying less risk are less likely to
purchase insurance.)

 So the insurer end up selecting only the ‘lemons’ as its clients. May lead to failure of
the business and drive the insurer out of the market completely.

 If the insurance company knew who smokes and who doesn't, it could set rates
differently for each group and there would be no adverse selection
Problem of lemons…
 Lemons Problem is also important for Financial Market

 The lender ( net savers) doesn’t have exact idea about the risk of lending
to the borrower. However, the borrower knows about the risk associated
with him. Therefore, the lender will charge average rate of interest to the
borrower.

 At average rate of Interest , borrowing will be more attractive to sub prime

borrower than the prime borrower.

 This implies, the rate of interest supposed to be charged (Risk Based

Pricing) is higher than this average rate of Interest.

 If the borrower defaults because of high probability of default, then the

lender will stop lending.

 Hence, there is a need of the financial Intermediary.

 Information Asymmetry & Lemons
 

One party not having sufficient knowledge about the

other party involved in a transaction to make an
accurate decision

 
 
 Adverse Selection

 Asymmetric information problem which is there before

the transaction occurs leads to adverse selection

 Belief: Potential bad credit risks are the ones who most
actively seek out loans

 Fear of ‘adverse selection’ prevents intermediaries from

lending, even though there may be credit-worthy
borrowers out there
 Moral Hazard & Lemons’ in
Banking and Financial markets
 Moral Hazard’ arises after the transaction occurs
 ‘end use’ of borrowed funds is used foe some other purpose
 Reduces the probability of the loan being repaid…Default
Probability goes up
 Hence the intermediary may decide not to lend
 Lenders unable to distinguish between firms with high risk and
low risk
 Lenders will only get the ‘price’ that reflects the average quality
 The ‘good’ firms will not want to come to the market at the average
price, only the ‘bad’ firms will!
 Hence the market will not function well
 Tools to help solve the
‘Adverse Selection’ problem

 If buyers can distinguish between a

‘peach’ and a ‘lemon’, they will be
willing to pay appropriate value for the ‘peach’
…and the market will grow

 How do we achieve this?

 Tools to solve the ‘Adverse Selection’ problem

 An independent ‘credit rating’ Agency

 Govt. regulation:
- Stringent accounting standards and disclosure norms
- Make information available at ‘zero’ cost
 Financial Intermediation:

- Firms with average to low financial performance (low credit rating) end up
with ‘Indirect finance’ and incur a higher cost of intermediation
- And … Firms with good financial performance (high credit rating)
pursue ‘direct finance’ and hence incur a lower cost of borrowing
 In developing countries, ‘financial intermediation’, i.e. indirect
finance, is pursued more often (why?)
 Moral Hazard in Debt
Instruments
Borrower takes on projects that are riskier is perceived by the
lender

Tools to help solve moral hazard in debt contracts

 Debt to be proportionate to net-worth of the borrower

 Obtain Financial Collateral / Mortgage

 Restrictive covenants to avoid undesirable end use of funds

The Nature and role of Financial
intermediary….Other Roles
1. Removes Moral Hazard
2. Price Discovery
3. Product Information : If a bank has lend money to a
borrower, it implies borrower has both ability/willingness to
repay….hence a net saver can access that borrower through
direct finance.
4. Small Size Ticket: Individuals who are net savers can’t lend
to Big Ticket Borrower directly….. Financial Intermediary…pool
the small size funds in order to finance the big borrower
 Categories of Financial Intermediaries
 Depository Institutions
 Commercial Banks

 Cooperative Banks

 Credit Societies

 Non Depository Institutions

 Financial Companies
 Development Financial Institutions(DFI)
 Housing Finance Companies
 NBFC…….Leasing, Hire Purchase
 Contractual Institutions
 Insurance Companies

 Pension Funds

 Mutual Funds
Categories of Financial Intermediaries
Depository Institutions
 They are financial intermediaries which are allowed to accept deposits from
individuals and institutions and make loans.
 Strictly speaking, depository institutions or banks should be able to repay
the deposits taken, on demand and hence they should confine their
investments to outlets of very liquid nature.
Non Depository Institutions:
Development Financial Institutions ( DFIs) :
 These DFIs could be state level or national level.
State Level : State Finance Corporation , State Industrial Development
Corporation
 National level : Small Industries development Bank of India( SIDBI), Export
Import bank of India ( EXIM Bank), Industrial Investment bank of India ( IIBI) and
National Bank for Agricultural and Rural Development ( NABARD), Industrial
Finance Corporation of India ( IFCI), National Housing Bank ( NHB) etc.

 NABARD, SIDBI and NHB are typically refinance institutions i.e they finance
the loans to other financial institutions for specific purpose.
Categories of Financial Intermediaries
Investment Intermediaries
 Mutual funds :
 Pools resources of the net savers and uses that pool of resources to
invest on behalf of these net savers in different financial instruments

 Pension Funds :
 It is a contractual intermediary wherein the net savers have a contract
with the Pension Funds to save for a specified period of time which is
the liability side of the Pension Funds
 Pension funds provide retirement income in the form of annuities to
employees who are covered by a pension plan.
 Insurance Companies
 It is a contractual intermediary

 The savings of the policy holders in terms of insurance premiums are

channelized through this intermediary in order to get this promised sum.
Non Depository Institutions: Other Non Banking
Financial Companies

 They provide a variety of fund -based or non –fund-

based(advisory) services. Most of the funds raised are
in the form of public time deposits . Following are
some of the principal NBFCs:
 Leasing companies
 Hire Purchase and consumer finance companies
 Venture capital funds
Types and classification of Financial Markets
 Short term Market ……Maturity of The Market
 - Call Money Market
 - Treasury Bills Market
 - Commercial Bills and Discount Market
 - Commercial Paper Market
 - Certificate of Deposits Market
 Long term Market ……Maturity of The Market
 - Govt. Securities Market
 - Equity Market

 Derivatives Market …..On the Basis of Future Delivery

 Foreign Exchange Market……On the Basis of Currency
 Mortgages Market……On the Basis of Nature of Asset Class/Claim
 Financial Markets
 Classified according to the characteristics of participants
and securities involved.
 The primary market is where deficit economic units sell
new securities.
 The secondary market is where investors trade previously
issued securities with each other.
 Money Supply Measures
Components of Money Supply
 M1 =Currency with the Public + Demand Deposit money of the Public with
Banks….Narrow money
 M2 = M1+ Post Office Savings Bank Deposits
 M3 = M2 +Time Deposits with Banks…Broad Money
 M4 = M3 +Total Post Office Deposits

Sources of Money Supply …..M3

 Net Bank Credit to Government
 RBI’s net credit to Government
 Other Banks’ Credit to Government
 Bank Credit to Commercial Sector
 Net Foreign Exchange Assets of Banking Sector
 RBI’s net foreign exchange assets (NFA)
 Other banks’ net foreign exchange assets (NFA)
 Money Supply Measures….
Components of Reserve Money…High Powered Money…Monetary Base
 Currency with the Public
 Banker’s Deposits with RBI
 Other’s Deposits with RBI
Sources of Reserve Money
 Net RBI Credit to Government
 RBI Credit to Bank
 RBI Credit to Commercial Sector
 Net Foreign Exchange Assets of RBI

The money multiplier (also called the credit multiplier or the deposit multiplier) is
a measure of the extent to which the creation of money in the banking
system causes the growth in the money supply….(M3) to exceed growth in
the monetary base…. (RM)
 Money Supply Measures….
 M3 = C + TD
 RM = C + R
 M3/RM = (C + TD)/ (C + R) = (C/TD + TD/TD)/ (C/TD + R/TD)
 M3/RM = (1 + c)/(c+ r )
 M3 = (1 + c)/(c+ r )* RM

c is the proportion of their money customers keep as cash,

r is the reserve requirement
Therefore, money multiplier will fluctuate if there is any change in
CRR (6%)…..which is policy variable
c……Secular Decline…Why….
Trend in M3