Introduction to Financial

Institutions

FIs provide a conduit to channel funds from savers to

borrowers

Savers

Borrower

Savers: entities with a surplus of funds

Borrowers: entities with a deficit of funds
3

This course is about:

The role that the financial institutions play in channeling

funds from savers to borrowers

How financial institutions profit from filling this role

Why study financial institutions instead of auto manufactures

or healthcare providers?

What is special about the services they provide?

Savers

Borrower
5

Why study financial institutions instead of auto manufactures

or healthcare providers?

What is special about the services they provide?

Cash

Savers
Buy Financial Assets

Debt & Equity Securities

Borrower
Buy Real Assets

Consider a world without

Financial Institutions

Ideal World:
Investors are perfectly informed they know everything about the company and

its actions
Information is costless
There are no market frictions liquidity, transaction costs
There would probably be no need for FIs

Do we live in an ideal world?

Investors are never perfectly informed
Information is costly
There are costs associated with investing (market frictions)

Wh
y

Without FIs: Low level of fund flows!

8

Real World: In reality investors face three types of costs

when directly lending to companies
1.

Information Costs (Monitoring Costs)

2.

Liquidity Risk

3.

Price Risk

Adverse Selection Prior to investing

Companies who are always in need of money are usually companies

who make poor investments and continuously lose money

Prior to purchasing a firms equity or lending to the firm, individuals
must incur costs to investigate the firms quality.
If not, they are likely to lend to the poorest (adverse) quality firms.

Moral Hazard After Investing

A company takes on excessive risk because managers (equity holders)

are compensated for good outcomes but they do not bear the full losses
for bad outcomes (agency cost!).
After a company receives a loan, managers may elect to invest in a
riskier project than what was agreed on.
Investors can try to monitor the firms actions
Monitoring is very costly
Free rider problem
10

How can investors reduce information risk?

Screening reduces adverse selection
Monitoring reduces moral hazard

Will individual investors screen and monitor? Not Likely!

Why Not?
There is a free rider problem

11

Investment Project:
Everyone gives me $100
I am going to invest in stocks and alternative investments
Every Saturday night at 10:00 pm we will meet here and discuss the

investment allocation and portfolio performance

How many people plan to attend all the meetings?

Ideally, would you want everyone to screen and monitor?

No, it is inefficient
ideally the screening and monitoring costs will be incurred one time. If everyone
screens and monitors these costs will be incurred several times

12

Moral Hazard

Adverse Selection

Who was facing the risk?

How were they managing it?
(Agency Costs and Delegated Monitor)

13

If FIs didnt exist there would be no secondary market for

companies debt or equity

There would be no easy way to convert securities to cash

investors would have to wait for them to mature

Investors who plan to use the money in the near future would
have to hold cash

14

If investors could sell securities in a market without FIs, they

would not likely get the full value of their securities

Transaction Costs:
The price of taking out an advertisement
The price of listing on an exchange
Delivery costs

Supply and demand:

The buyer may not want to purchase the security as much as the seller

needs to sell it

15

Conclusion:

Without FIs funds would flow slowly from

households to businesses because of:
Information costs
Liquidity risk
Price Risk

16

Now Lets Put FIs Back

Into the Economy

17

FI Functions
Broker

Savers

Borrower
Equity
& Debt

Cash
Asset
Transformer

Deposits/Insurance
Policies

Cash
18

FIs act as agents for savers - Perform 2 services

1. Transaction Services
Purchase or sell securities for a commission or fee

2. Information Services
Research Securities
Provide Recommendations

How dose
this help
investors?

Reduce

costs through economies of scale (lower costs

by expanding output)

Fixed costs (exchange membership) are spread out over more

transactions
Cost per trade is lower bulk discount or standardization

19

Purchase Primary Securities (stocks, bonds) from firms and

sell Secondary Securities (transformed assets) to individuals.
Secondary Assets (Transformed Assets)
1.
2.
3.

Certificates of deposit
Insurance claims
Mutual funds

20

Reduces Information Costs

1.
a.
b.

Due Diligence
Delegated Monitoring

2.

Reduce Liquidity Risk

3.

Reduce Price Risk

21

FIs specialize in doing due diligence Collecting

information prior to investing.

1.

Example An asset manager investigates a companies prior to investing

Does this reduce adverse selection or moral hazard?

FIs are appointed delegated monitoring watches over

the borrower, their actions and how they perform

2.

Example Bank Loan

Does this reduce adverse selection or moral hazard?

Where does the cost reduction come from?

1. Investors now share the cost of collecting information
1. Example: Bloomberg Subscription

2. Secondary securities that the bank creates, are easier to monitor

1. Example: Bank loans, are shorter term and have covenants allow for more frequent
updating of information as firms refinance their loans
22

FIs specialize in engineering securities to have desirable

properties.

Increase Liquidity:
Deposit contracts can be withdrawn immediately
They pay a higher interest rate than holding cash because banks
finance these accounts using longer-term mortgages with higher
rates. Banks are better able to bear the risk of mismatching
maturities of their assets and liabilities (e.g. long maturity assets vs.
demand deposits)

Mutual funds easier to trade than a individual asset

23

Through diversification:

1.

Asset diversification: FIs offer investors shares in diversified portfolios

(mutual funds). The portfolio and thus the price of its shares are less
exposed to fluctuations in the price of any individual asset.

Claim diversification: Insurance companies pool different types of risk

faced by individuals to offer claims that are contingent on certain events.

Through a decrease in transaction costs

2.

It cost less for an investor to buy shares in a mutual fund than to buy all
the assets in a portfolio.
Several individuals pay premiums but only a small subset file
claims at any given time therefore the pool of funds should be
relatively unaffected by individual claims

FIs add value by reducing

Information Risk
Liquidity Risk
Price Risk

Through their roles as:

Brokers
Asset Transformers

25

Transmission of monetary policy

1.

Banks control deposits, which are a large part of the money supply.
Therefore, FI activity can affect inflation

Credit Allocation

2.

FIs are the main and sometimes only source of financing for some
sectors of the economy (residential real estate, farming)

Intergenerational wealth transfer

3.

Life insurance, trusts, pension funds allow savers to transfer

wealth across generations.

26

Payment Services

4.

Without the payment services that DIs provide (ATMs, checking, wire
transfer), it would be very difficult to conduct business.

Denomination Intermediation

5.

Some assets trade in large amounts (commercial paper $250,000;

Negotiable CD $100,000). FIs give small investors access to these assets by
selling shares of a portfolio.

Maturity Intermediation

6.

FIs are in the business of collecting short term deposits and pooling them to
issue long-term loans (mortgages)
Long-term loans have higher interest rates and generate profit for the bank
FIs hold a fraction of the deposits in reserve to satisfy depositor liquidity
needs
27

Safety and soundness regulation

1.

Meant to enhance FI stability include: diversification requirements, guaranty funds, monitoring and
surveillance, equity capital requirements

Monetary policy regulation

2.

Regulations meant to ensure that monetary policies can be transmitted through FIs quantitative easing
or reserve requirements

Credit allocation regulation

3.

Provide special treatment for certain sectors to ensure that financing is available (farming )

Consumer protection regulation

4.

Regulations to prevent discriminatory lending practices

Investor protection regulation

5.

Reduce moral hazard problem insider trading, lack of disclosure

Entry and charter regulation

6.
1.

Limits the entry of new FIs through charting by state or federal agencies

28

FIs allow funds to easily flow from savers to borrowers

FIs reduce
Information risk
Liquidity risk
Price risk

They reduce risks through their roles as brokers and asset

transformers

FIs also provide

Payment services
Denomination Intermediation
Maturity Intermediation

Because they are special FIs are subject to special regulation

29