The Nature of Financial Intermediation

1. The Nature of Financial Intermediation Business 4039

2. Today Questions � course outline � term papers Availability of texts � who doesn�t have a text? Handout � class problem presentations News � Current Events � The Nature of Financial Intermediation

3. Key Concepts Pivotal role of banks and other deposit-taking FIs Rapid pace of change in markets, technologies and non-bank competition Information costs are responsible for emergence of financial intermediaries Financial intermediaries deal with: Search Verification Monitoring Enforcement costs.

4. Important Terms � Defined � Liquidity and funding risk The threat of insufficient liquidity on the part of the bank for normal operating requirements Settlement/payment risk Is created when one party to a deal pays money or delivers assets before receiving its own cash or assets, hence exposing itself to a potential loss and interest rate risk. Interest rate risk The risk that arises from mismatches in both the volume and maturity of interest-sensitive assets, liabilities and off-balance sheet items Market or price risk The exposure of banks to losses due to market or price fluctuations in well-defined markets Foreign exchange or currency risk The exposure of banks to fluctuations in foreign exchange rates that affect positions held in a particular currency for a customer or the bank. Sovereign risk In which the political or economic conditions in a particular country threaten to interrupt repayment of loans or other debt obligations Operating risk Arising from losses caused by fraud, failure of internal control, or unexpected expenses, as in the case of lawsuits.

5. Financial Intermediation Information is the underlying, core reason for the existence of financial intermediaries. Borrowers do not have the means to search out and contract with lenders. Even if they do, it is an expensive and time consuming and unsystematic process that can be prohibitively expensive. This situation does exist�for example in the case of angel capital.

6. Financial Intermediaries There are many types of financial intermediaries that have evolved over time: Deposit-taking financial intermediaries Banks Trust companies Credit unions Non-depositor Life and P&C insurance companies Investment dealers Task Force on the Future of Financial Services Finance Companies Other Mutual funds

7. Uniqueness Recognized One of the themes dominating FI organization in Canada is the degree to which the specialness of Fis should be enshrined in law and regulatory practice. The end result is that financial institutions are among the most heavily regulated and heavily taxed organizations in our society. You are encouraged to follow the current debates on this topic in the financial press. Look for: deposit taking FI regulation insurance company regulation securities industry regulation Bank of Canada policy concerning FIs CDIC policy concerning FIs Regulatory activities of liability insurers international coordination of FI regulation

8. Intermediation Services of FIs risk transfer, reduction, and monitoring services liquidity services maturity intermediation services transaction services financial information services denomination intermediation (mutual funds)

11. Price Risk the risk that the sale price of an asset will be lower than its purchase price.

12. Secondary Claims example: demand deposit in a deposit-taking FI it is a financial asset that has characteristics far different than primary securities (bonds, stocks, commercial loans) => often improved liquidity/safety of principal, etc.

13. Maturity Intermediation a service performed by deposit-taking FIs for secondary asset holders (depositors)....because of �pooling� and �diversification�.... mismatching the maturities of assets and liabilities of the FI.

14. Securitization The creation of a marketable financial asset through financial innovation�of otherwise illiquid financial assets Eg. MBSs

15. Economies of Scale FIs provide potential economies of scale in transactions costs...information collection and risk management.

16. Institutional Aspects of Special-ness money supply transmission (banks) credit allocation (banks, trusts, credit unions, and finance companies) risk offlay (insurance companies) intergenerational transfer (pensions, life insurance companies, and deposit-taking FIs) payment services (banks, trusts, and credit unions) denomination intermediation (mutual funds, pension funds)