An Overview of the Financial System

Chapter: 2

Concept of Financial Intermediation

Indirect Finance: Funds are move from lenders to borrowers by a financial intermediary that stands between the lender savers and the borrower spenders and helps transfer funds from one to the other. A financial intermediary borrows funds from the lendersaver and then uses these funds to make loans to borrower- spender. Financial intermediation: The process of indirect finance using financial intermediaries called financial intermediation is the primary route for moving funds from lender to borrowers. Financial intermediaries are a far more important source of financing for corporation than securities markets.

Benefits of Financial intermediation

Financial Intermediation has following benefits: 1. Lower Transaction Cost. 2. Reduce the Exposure of Investors to Risk. 3. Deal with Asymmetric Information Problem.

Transaction Cost
Transaction Cost: Is the time and money spent in carrying out financial transaction. Financial intermediaries can reduce transaction costs because: I. They have developed expertise in lowering them. II. Their large size allows them to take advantage of economies of scale. Economies of Scale: The reduction in transaction costs per dollar of the transaction as the size of transaction increases. III. It provides its customers with liquidity services. Liquidity Service: Services that make it easier for customers to conduct transaction. IV. Depositors can earn interest on checking and savings accounts and still convert them into goods and services whenever necessary.

Risk Sharing
The other benefit of financial intermediation is they reduce the exposure of investors to risk as: I. Financial intermediaries reduce risk through the process of risk sharing. II. Financial intermediaries share risk at low cost enabling them to earn a profit on the spread between the returns they earn on risky assets and the payment they make on the assets they have sold. III. Financial intermediaries help individuals to diversify and thereby lower the amount of risk to which they are exposed.

Risk Sharing
Risk: Is uncertainty about the returns investors will earn on assets. Risk Sharing: Financial intermediaries create and sell assets with risk characteristics that people are comfortable with and then use the funds they acquire by selling these asset to purchase other assets that may have for more risk. Asset Transformation: Risk sharing is also called as asset transformation as risky assets are turned into safer assets for investors. Diversification: Entails investing in a collection of assets whose returns do not always move together with the result overall risk is lower than for individual assets.

Asymmetric Information
Financial intermediaries alleviate the problem of asymmetric information. Asymmetric Information: Inequality of information means one party often does not know enough about the other party to make accurate decision. This creates two problems: 1. Adverse Selection. 2. Moral Hazard. Adverse Selection: Is the problem created by asymmetric information before the transaction occurs. Moral Hazard: Is the problem created by asymmetric information after the transaction occurs.

 Disintermediation: Funds are move from lenders to borrowers directly without involvement of any financial intermediary. Disintermediation involves the problems of: Transaction Cost. Investment Risk. Asymmetric Information. This make difficult for small savers and borrower to raise funds they needed. Financial intermediaries play an important role in the economy as they provide: Liquidity Service. Promote Risk Sharing. Solve Information Problem. By this financial intermediaries allow small savers and borrowers to benefit from the existence of financial markets. This would be difficult in the case of disintermediation.

Intermediation and Disintermediation

Types of Financial Intermediaries

Financial intermediaries are divided into three categories: 1. Depository Institutions. 2. Contractual Saving Institutions. 3. Investment Intermediaries.

1. Depository Institutions
Depository Institutions: Are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include: 1. Commercial Banks and Thrift Institutions (thrifts). 2. Saving and Loans Associations. 3. Mutual Saving Banks. 4. Credit Unions.

Commercial Banks
These financial intermediaries raise funds primarily by issuing: 1. Checkable Deposits: Deposits on which checks can be written. 2. Saving Deposits: Deposits that are payable on demand but do not allow their owner to write checks. 3. Time Deposits: Deposits with fixed terms to maturity. They use these funds to make commercial, consumer and mortgage loans and to buy U.S government Securities and municipal bonds. They are the largest financial intermediaries and have the most diversified portfolios of assets.

Savings and Loan Associations (S&Ls) and Mutual Savings Banks

These depository institutions obtain funds primarily through: 1. Saving Deposits\ Shares. 2. Time Deposits. 3. Checkable Deposits. These institutions were constrained in their activities in the past and mostly made mortgage loans for residential housing. These restrictions have been loosen over time so that the distinction between these depository institutions and commercial banks has blurred and they become more alike and now are more competitive with each other.

Credit Unions
These financial institutions are typically very small cooperative lending institutions organized around a particular group: Union Members Employees of a particular firm and so forth. These acquire funds from deposits called Shares. They primarily make consumer loans.

Contractual Saving Institutions

Contractual Saving Institutions: Are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Unlike depository institution they do not have to worry about losing funds quickly as they can predict with accuracy about the benefits they will pay in the coming years. Unlike depository institutions liquidity of assets is not as important consideration for them. They invest their funds primarily in long term securities such as corporate bonds, stocks and mortgages.

Contractual Savings Institutions are: 1. Life Insurance Companies. 2. Fire and Causality Insurance Companies. 3. Pension Funds and Government retirement Funds.

Life Insurance Companies

Life Insurance Companies insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force. They these funds mainly to buy corporate bonds and mortgages. They also purchase stocks but are restricted in the amount they can hold. They are amount the largest of the contractual saving institutions.

Fire and casualty Insurance Companies

These companies insure their policyholders against loss from theft, fire and accidents. Like life insurance companies they receive funds through premiums for their policies. They have a greater possibility of loss of funds if major disaster occurs as compare to life insurance companies. Unlike life insurance companies they use their funds to buy more liquid assets. Their largest holding of assets is municipal bonds. They also hold corporate bonds and stocks and U.S government securities.

Pension Funds and Government Retirement Funds

Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and employees, who either have a contribution automatically deducted from their paychecks or contribute voluntarily. The larges asset holdings of pension funds are corporate bonds and stocks.

Investment Intermediaries
This category of financial intermediaries includes: 1. Finance Companies. 2. Mutual Funds. 3. Money Market Mutual Funds.

Finance Companies
Finance companies raise funds by selling commercial paper and by issuing stocks and bonds. Commercial Paper: Is a short term debt instrument. They lend these funds to consumers, who make purchases of such items as furniture, automobiles and home improvements and to small business. Some finance companies are organized by a parent corporation to help sell its product.

Mutual Funds
Mutual funds acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow share holders to: Pool their resources so that they can take advantage of lower transaction cost when buying large blocks of stocks or bonds. Hold more diversified portfolios. Shareholders can sell or redeem shares at any time but the value of these shares will be determined by the value of the mutual funds holdings of securities. Investment in mutual funds can be risky because the mutual funds shares value fluctuates greatly.

Money Market Mutual Funds

Money markets mutual funds have the characteristics of mutual funds and also function to some extent as depository institution as they offer deposit type accounts. They sell shares to acquire funds. These funds are used to buy money market instruments that are safe and very liquid. Interest on these assets is paid out to the shareholders. Shareholders can write checks against the value of their shareholdings. Shares in a money market mutual fund function like checking account deposits that pay interest.

Investment Banks
Unlike an investment bank or financial intermediary it does not take in deposits and then lend them out. Investment bank is an intermediary that helps a corporation issue securities by: I. It advises the corporation on which type of securities to issue stocks or bonds. II. It helps sell or underwrite the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. III. It also acts as a deal makers helping corporations acquire other companies through mergers or acquisitions.

Table 3 Primary Assets and Liabilities of Financial Intermediaries