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Topic 3
Financial
Intermediaries
LOGO
Lecturer: Vu Hai Yen

OPTIONS FOR BORROWERS AND LENDERS

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TYPES OF FINANCIAL TRANSACTIONS

Direct Finance Direct lending gives rise to direct

claims against borrowers.
Primary securities
(stocks, bonds, notes, etc.,
evidencing direct claims
against borrowers)
Borrowers
(DUs)

Lenders (SUs)
Funds

Types of Financial Transactions

Semi-direct Finance Direct lending with the aid of

market makers who assist in the sale of direct claims
against borrowers.
Primary securities
(direct claims
against borrowers)

Borrowers
(DUs)
Proceeds of
security sales
(less fees and
commissions)

Security
brokers,
dealers,
investment
bankers

Primary securities
(direct claims
against borrowers)
Lenders
(SUs)
Funds

Types of Financial Transactions

Indirect Finance Financial intermediation of funds.

Primary securities
(direct claims against

end borrowers in the

form of loan contracts,
stocks, bonds, notes,
etc.)

Secondary Securities

(indirect claims against end

borrowers issued by financial
intermediaries in the form of
deposits, insurance policies,
retirement savings accounts,
etc.)

Financial intermediaries

(banks, friendly and building

societies, insurance companies,
credit unions, investment funds,
finance companies, pension
funds)

End
borrowers
(DUs)
Funds

End
lenders
(SUs)
Funds

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Financial Markets or Intermediaries?

Lenders
Small savers prefer intermediaries like banks and building
societies => accept lower interest rates but reduce transaction
costs
Big lenders buy securities => higher returns

Borrowers
Big borrowers usually issue securities because it is feasible and
at lower interest rate/ high fixed cost of issuing securities
while the deal is large enough
Small borrowers usually use intermediaries => May be difficult
to issue securities due to high level of risk/ high fixed cost of
issuing securities while the deal is small

Financial
intermediaries

Deposit taking
institutions

Commercial banks and the socalled

thrift
institutions
(thrifts) such as savings and
loan associations, mutual
savings banks, and credit
unions

Non-deposit taking
institutions

Contractual savings
institutions
such as insurance
companies and
pension funds

Investment
Intermediaries
including finance
companies, mutual
funds, and money
market mutual
funds

DEPOSITORY INSTITUTIONS
Definition: depository institutions are financial
intermediaries that accept deposits from individuals
and institutions (which then become their liabilities)
and make loans (which then become their assets).
Types:
Commercial Banks
Saving and loan associations
Mutual savings banks
Credit Unions

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DEPOSITORY INSTITUTIONS
Commercial Banks:
Sources of funds (liabilities): issue deposits
Checking deposits: provide check-writing privileges.
Savings deposits: do not provide check-writing
privileges, but allow funds to be withdrawn at any time.
Time deposits: require that funds be deposited for a
fixed period of time, with penalty for early withdrawal.

Uses of funds (assets): make commercial,

consumer, and mortgage loans, buy Government
and municipal bonds.

COMMERCIAL BANKS

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BANK LIABILITIES
(Sources of Bank Funds)
1. Checkable Deposits - (10%)
a. Demand deposits (non-interest-bearing checking)
b. NOW accounts - interest-bearing checking
c. Money market deposit accounts (MMDAs) - money market mutual funds.
2. Nontransaction Deposits (59%) are the Primary source of bank funds
a. Savings accounts (passbook savings)
b. Small-denomination Time Deposits (CDs, certificate of deposits)
c. Large-denomination Time Deposits, over $100,000
3. Borrowings (23%) of bank funds:
a. from other banks - Fed Funds Market - to meet reserve requirements
b. from FRS - discount rate - to meet reserve requirements
c. from parent companies - bank holding companies
d. from corporations and from foreign banks - negotiable CDs and Eurodollar
deposits
4. Bank capital (8%), equity from issuing new stock or capital from retained
earnings. Bank capital is also a cushion against a drop in the value of its
assets, to protect against insolvency, bankruptcy.

BANK ASSETS
(Uses of Bank Funds)
1. Reserves (1%):
Deposits kept on account at the Fed (all banks have an
account at the Fed)
Vault cash on hand at bank, stored in the vault overnight.
2. Securities (22%):
3. Loans (72%):
Most bank profits come from Loans. Loans make up 72%
of bank assets:
a. Commercial loans to businesses
b. real estate loans (mortgages, home improvement loans,
etc.)
c. consumer loans (credit card, automobiles)
d. interbank loans, Federal Funds market
e. other loans
4. Other Assets (5%): Property, plant and equipment. Buildings,
office equipment, computer systems, etc.

Banks
Retail Banks: offer banking services to individuals,
households and small firms

Assets: ~50% are loans

Liabilities: ~50% are deposits & mainly in domestic currency
Provide wide range of financial services
Be heavily involved in national payments systems

Wholesale Banks: offer a range of specialist services

largely to firms
Liabilities are denominated by foreign currencies
Liabilities are mainly time deposits hold few liquid assets
Specialize in one particular type of banking activity

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DEPOSITORY INSTITUTIONS
Savings and Loan Associations (S&Ls): has traditionally
specialized in mortgage lending
Sources of funds: issue deposits.
Uses of funds: make loans, mainly mortgage loans.
Mutual Savings Banks: like S&Ls, but structured as
mutuals, meaning that the depositors own the bank.
Sources of funds: issue deposits.
Uses of funds: make loans, mainly mortgage loans.
Credit Unions: Set up to serve small groups: union members,
employees of a particular firm, etc.
Sources of funds: issue deposits
Uses of funds: make loans, mainly consumer loans
S&Ls, mutual savings banks, and credit unions are called
thrift institutions.

Commercial banks are the largest type of

depository institution.
Thrift institutions have declined in importance, but
still remain significant.
Mutual funds and money market mutual funds
have grown spectacularly.

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CONTRACTUAL SAVING INSTITUTIONS

Definition: contractual savings institutions as a group
that acquire funds at periodic, or regular, intervals on
a contractual basis.
Types:
Life Insurance Companies (Long term
insurance companies)
Fire (Property) and Casualty Insurance
Companies (General insurance companies)
Pension Funds

INSURANCE COMPANIES
Engaged in two distinct forms of business:
Long-term Insurance (life insurance)
General Insurance (non-life insurance)
All provide insurance against financial loss
An agreement to compensate policyholders in event
of specified event occurring within a specified time.
Level of premium depends on likelihood or Risk of
event occurring, level of compensation or benefit to
be paid.

RISKS ARE FACED BY INSURANCE COMPANIES

Asymmetric information: the insured has the better
information since he knows his activities and the risks
involved in much greater detail than the insurance
company does.
Adverse selection: This arises when the riskiest clients
express the strongest demand for insurance products.
The insurance company does not normally have the
information to distinguish very accurately between
customers of different degrees of risk the contracts
that are actually written are dominated by high-risk
clients.
Moral hazard. This arises when people become less
careful about their actions precisely because they are
insured

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How does insurance company deal with risks

Risk screening: identify groups of clients having
differing degrees of risk Charge them risk-based
premium
Deductible Amount: the amount of loss which the
insurer is not required to pay in the event of claim
reduce Moral Hazard behavior
Restrictive Covenants: a term in a contract to
restrict the behavior of insured.
Eg. The car insurance becomes invalid if the
insured uses the car for sporting activities

Pension Funds
Sources of fund: Receive contributions from employees
of companies and governments.
Uses of fund: Invest money in securities.
Money is paid back to plan members in the form of
endowments.
Pension schemes often take the form of a trust fund.
An employer sets up a trust managed by a trustee for
the benefit of plan members.
Plan assets are separated from the sponsoring
employers and do not appear in its balance sheet.

Pension Scheme
Unfunded

Funded
- Contributions invested
in financial assets

PAYGcurrent employee contribution

used to pay pension to the retired.
(Each generation of workers paying for
predecessors pension. They hope next
generation pay for theirs. No pool of
investible funds created

- Return intended to exceed

rate of inflation

- Risknot sufficient employees

to pay retired.

-Private sector firms usually

funded schemes

- Public sector firms usually

unfunded

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INVESTMENT COMPANIES

Finance
Companies

Money
Market
Mutual
Funds

Mutual
Funds

FINANCE COMPANIES

Finance Companies: specializes in making loans to

relatively high-risk individuals and businesses
Sources of funds: sell commercial paper,
stocks, bonds.
Uses of funds: make consumer and business
loans.

MONEY MARKET MUTUAL FUNDS

Money Market Mutual Funds: are sort of a combination of

mutual funds and depository institutions.
Sources of funds: sell shares to individuals.
Uses of funds: buy money market instruments.
Shareholders can often write checks against the
value of their shareholdings.

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MUTUAL FUNDS
Mutual Funds: allow individual investors to pool their resources
and thereby hold a more diversified portfolio of assets with lower
transaction costs.
Sources of funds: mobilize money by selling units (i.e.
shares) to (retail) investors.
Uses of funds: invest money in various types of securities
(i.e. bonds and stocks)
Mutual funds: enable savers to pool their (usually small) savings
on an equal basis in order to invest them in tradable securities.
The advantage of mutual funds is that the investments are
picked by professionals; they are very diverse so the risk is
low, and there is potential for long term growth.
Mutual funds in UK: Unit Trusts and Investment Trusts

Advantages of mutual funds compared

to direct individual investments

Reduce transaction cost: Economies of scale

E.g: Bonds and shares have to be bought through a broker
(which might well be an investment bank). The broker
will charge a commission which will decrease with the
size of the deal. On a 100,000 purchase it might charge
0.25% rising to 1% on 10,000 and may be subject to a
minimum, say 25 this penalises small transactions.
By pooling lots of small savings before making large
purchases, the unit trust manager helps reduce
transaction costs.

Advantages of mutual funds compared

to direct individual investments
Reduce risk: portfolio diversification
the unit trust manager spreads ones wealth across
a range of risky assets would normally reduce risk
relative to the rate of return.

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Types of Mutual Funds

Open-ended funds
New shares or units are issued when investors
contribute more money or existing ones are
retired when investors take money out.
The fund value is equal to the current market
value of all its investments.
Closed-ended funds
Number of shares is fixed.
Shares are traded in an exchange whose value
can be above or below the funds net asset value.

HEDGE FUNDS
A hedge fund is an investment fund that can
undertake a wider range of investment and trading
activities than other funds, but which is only open for
investment from particular types of investors specified
by regulators.
A private investment fund with large, unregulated
pool of capital and very experienced investors who
use a range of sophisticated strategies to maximize
returnshedging, leveraging and derivative trading.

HEDGE FUNDS
Is allowed to engage in short-selling
Can trade in derivatives
Aims for an absolute positive rate of return whatever
the state of the markets
Is required to make a little public disclosure of its
activities
Pay its management by results
Consist of a small group of wealthy investors

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SECURITIES MARKET INSTITUTIONS

Specialize in intermediating risks in securities
markets
Types:
Investment Banks
Securities Brokers and Dealers
Organized exchanges

Financial Intermediaries: Assets,

Liabilities, and Management
Unlike a manufacturing company with real assets,
banks have only financial assets
Therefore, banks have financial claims on both
sides of the balance sheet
Credit Risks
Interest Rate Risks

Credit Risks

Banks tend to hold assets to maturity and expect a

certain cash flow
Do not want borrowers to default on loans
Need to monitor borrowers continuously
Charge quality customers lower interest rate on
loans
Detect possible default problems

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Interest Rate Risks

Banks are vulnerable to change in interest rates

Want a positive spread between interest
earned on assets and cost of money (liabilities)
Attempt to maintain an equal balance between
maturities of assets and liabilities
Adjustable rate on loans, mortgages, etc.
minimizes interest rate risks

Balance Sheets of Depository Institutions

All have deposits on the right-hand side of

balance sheet
Investments in assets tend to be short term in
maturity
Do face credit risk because they invest heavily in
nontraded private loans

DISCUSSION
Can financial intermediaries help savers reduce
risk? Explain how.

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