The Economic Roles of Financial Intermediaries

1. The Economic Roles of Financial Intermediaries • Objectives: • Consider the economic functions of financial intermediaries (FIs) in the financial system. • Discuss the link between FIs, monetary policy, and the need for safety and soundness regulation. • Discuss the trends in FIs’ market shares and begin to think about the causes of these changes.

2. Equity & Debt Individuals (Savers) Cash A Financial System Without FIs (Claim on Future Purchasing Power) Firms (Dis-savers or Borrowers) (Current Purchasing Power)

3. Potential problems when FIs are absent: • Adverse SelectionPrior to purchasing a firm’s debt or equity, each individual must incur costs to investigate its quality. If not, the poorest (adverse) quality firms have the greatest incentive to issue securities to unwary investors. • Moral HazardAfter purchasing a firm’s securities, each individual needs to monitor the firm’s managers. When managers have control of other people’s money, they may have the incentive to spend it on excessively risky projects or perquisite consumption, resulting in agency costs. • Risk and Liquidity The firm’s debt or equity may have risk characteristics, maturities, and liquidity that may not be attractive to particular individuals.

4. FI (Brokers) FI (Asset Transformers) Individuals Firms Equity & Debt Cash Deposits/Insurance Policies Cash A Financial System With FIs (Dis-savers or borrowers) (Savers)

5. Functions of FIs • By acting as a broker, a FI can provide information to individuals about the quality of security issues. Only a single entity, the FI broker, needs to incur costs to screen the quality of the firm’s securities. This is an efficient way to produce information and resolve adverse selection. • Example: A firm wishes to issue an initial public offering (IPO) of securities. Since the firm’s quality is unknown to potential individual investors, a reputable investment bank underwriter researches the firm and then organizes a “road show” that informs potential investors of the firm’s quality. Investors are now willing to purchase the firm’s securities at a fair offering price. The broker “matches” savers to quality firms that desire financing.

6. By acting as an asset transformer, a FI may solve a number of problems: • The FI can function as a delegated monitor to efficiently produce information on a borrowing firm’s activities and reduce moral hazard. • Example: Rather than each individual buy the firm’s debt and incur monitoring costs, the individuals give their funds to a bank which issues deposits to them. Along with these funds, a bank manger (loan officer) contributes her own funds (bank equity) and makes a loan to (purchases debt of) the firm. The bank manager, as the residual claimant, has the incentive to be a delegated monitor of the borrowing firm’s activities. Only the manager incurs the cost of monitoring.

7. Bank Acting as a Delegated Monitor Deposits/Debt Individuals Loan/ Debt Cash Firms Bank Equity Cash Manager- Loan Officer Cash L Bank Firm A A L Managers’ Equity Projects Loan Firm Loan Individuals’ Deposits

8. The FI can pool risks, thereby providing diversification. • Example 1: A mutual fund purchases a portfolio of many firms’ equities (stocks) and issues shares to individuals that are more diversified (lower risk) than each of the equities. Mutual Fund A L Firms’ equities (stocks) Individuals’ shares of the fund Example 2: An insurance company pools the risks of accidents or life faced by many individuals. In return for contributing an insurance premium (cash), each individual obtains a claim on the insurance company that pays off when an accident occurs.

9. The FI can split the cashflows of its underlying assets, creating new securities whose risks may be attractive to different investor clienteles. • Example 1: A finance company makes loans to risky firms and finances these loans by issuing debt and equity shares. The finance company’s equity, being a residual or junior claim, is more risky than the underlying loans. The debt, being a senior claim, is safer than the underlying loans. Hence, the finance company has created new (secondary) securities with risk characteristics that may appeal to different types of investors. Finance Company A L Equity (junior claim on loans) Risky loans Debt (senior claim on loans)

10. The FI can provide maturity intermediation: the maturities of its assets may differ from the maturities of its liabilities. This can be one way of creating liquidity. • Example 1: A bank makes long-maturity loans financed by short-maturity (demandable) deposits. The deposits are more liquid than the underlying loans, as they can be withdrawn for cash at a depositor’s discretion. A Bank L Long maturity loans Equity Cash reserves Demandable (liquid) deposits Example 2: A money market mutual fund (mmmf) invests in firms’ debts having 90 day average maturities. It issues fund shares to investors that can be liquidated on demand.

11. Liquidity Creation and Monetary Policy • The liquid (demandable) nature of deposits and money market mutual fund shares make them close substitutes for currency. • Outside money is created by the Federal government and consists of currency held by the public or by banks as vault cash or reserves at Federal Reserve Banks. • Inside monies are created by FI’s and are substitutes for currency in making transactions. They include bank deposits, mmmf shares, and perhaps even credit cards. • Importantly, variation in the demand for inside monies can affect the demand for outside money. Since prices are denominated in (outside money) currency units (e.g., $ or €), changes in inside money demand affect monetary policy.

12. The demand for some inside monies, such as bank deposits, can be unstable. • Example: During the early 1930’s, depositors feared that they would bear a loss if their banks failed. They withdrew deposits (demand for inside money ) for currency (demand for outside money ). • Unfortunately, the Federal Reserve failed to increase the supply of outside money to offset this increased demand, leading to severely contractionary monetary policy, deflation, and unemployment.

13. Currency Supply Value of Currency = 1/CPI1 Currency Demand at date 1 after bank run 1/CPI0 Currency Demand at date 0 Quantity of Currency • Governments can prevent the adverse effects of bank runs by • Acting as a lender of last resort (Discount Window lending) or by engaging in open market operations to increase the supply of outside money. • Providing deposit insurance to reduce the incentive for depositors to withdraw.

14. Deposit insurance was instituted by the Banking Act of 1933 (Glass-Steagall Act). It created the Federal Deposit Insurance Corporation (FDIC). • With deposit insurance, the government (taxpayers) must cover losses incurred by depositors when a bank fails. • Hence, with deposit insurance, there is a need to regulate the “safety and soundness” of depository institutions to prevent their taking excessive risks. This can be done by • Capital (bank equity-to-debt) ratio regulation. • Restrictions on high-risk bank activities. • Risk-related deposit insurance premiums.

15. Changes in FI Market Shares Percentage Shares of Total FI Assets

16. Recent Trends Affecting FI • Large and medium-sized firms’ shift toward public security financing and away from bank loan financing. • Loan selling (asset securitization). • Growth in mutual fund investing. • The above phenomenon are the results of improvements in information technology that have reduced the need for banks to screen the quality and monitor the activities of many large and medium-sized firms. • More information is available to individual investors, so that firms’ securities and loans, that banks previously held, can now be sold directly to the public or to mutual funds that provide pooling and portfolio diversification.

17. Other Issues Affecting FI • Consolidation of financial services firms. This is primarily due to liberalized branching laws and to new technologies that allow economies of scale and scope in providing FI services. • Conflicts of interest that occur when FIs provide multiple services. Examples: • Analysts providing favorable recommendations for stocks that are underwritten by the analyst’s investment bank. • Trading and commissions conflicts of mutual funds. • Reform of bank capital regulation (Basel II) and deposit insurance.