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Why Are Financial Intermediaries Special?

Why Are Financial Intermediaries Special?. Objectives: Develop the tools needed to measure and manage the risks of FIs. Explain the special role of FIs in the financial system and the functions they provide. Explain why the various FIs receive special regulatory attention.

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Why Are Financial Intermediaries Special?

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  1. Why Are Financial Intermediaries Special? • Objectives: • Develop the tools needed to measure and manage the risks of FIs. • Explain the special role of FIs in the financial system and the functions they provide. • Explain why the various FIs receive special regulatory attention. • Discuss what makes some FIs more special than others.

  2. Equity & Debt Households (net savers) Cash Without FIs Corporations (net borrowers)

  3. FIs’ Specialness • Without FIs: Low level of fund flows. • Information costs: • Economies of scale reduce costs for FIs to screen and monitor borrowers • Less liquidity • Substantial price risk

  4. FI (Brokers) FI (Asset Transformers) Households Corporations Equity & Debt Cash Deposits/Insurance Policies Cash With FIs

  5. Functions of FIs • Brokerage function • Acting as an agent for investors: • e.g. Merrill Lynch, Charles Schwab • Reduce costs through economies of scale • Encourages higher rate of savings • Asset transformer: • Purchase primary securities by selling financial claims to households • These secondary securities often more marketable • Transformation of financial risk

  6. Role of FIs in Cost Reduction • Information costs: • Investors exposed to Agency Costs • Role of FI as Delegated Monitor (Diamond, 1984) • Shorter term debt contracts easier to monitor than bonds • FI likely to have informational advantage • FI as information producer • Monitoring power and control • Acting as delegated monitor, FIs reduce information asymmetry between borrowers and lenders

  7. Specialness of FIs • Liquidity and Price Risk • Secondary claims issued by FIs have less price risk • FIs have advantage in diversifying risks • Reduced transaction & information costs • economies of scale • Bid-ask spreads narrower for assets bought and sold in large quantities.

  8. Other Special Services • Maturity intermediation • Transmission of monetary policy. • Credit allocation (Areas of special need such as home mortgages). • Intergenerational transfers or time intermediation. • Payment services (FedWire and CHIPS). • Denomination intermediation.

  9. Specialness and Regulation • FIs receive special regulatory attention. Reasons: • Special services provided by FIs in general. • Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks,thrifts), etc. • Negative externalities arise if these services are not provided.

  10. Regulation of FIs • Important features of regulatory policy: • Protect ultimate sources and users of savings. • Including prevention of unfair practices such as redlining and other discriminatory actions. • Primary role: Ensure soundness of the system as a whole. • Regulation is not costless • Net regulatory burden.

  11. Regulation • Safety and soundness regulation: • Regulations to increase diversification • No more than 10 percent of equity to single borrower • Minimum capital requirements • Guaranty funds: • Deposit insurance fund (DIF): • Securities Investors Protection Fund (SIPC) • Monitoring and surveillance. • FDIC monitors and regulates DIF participants.

  12. Web Resources • For information on regulation of depository institutions and investment firms visit: FDIC www.fdic.gov SIPC www.sipc.org Federal Reserve www.federalreserve.gov

  13. Regulation • Monetary policy regulation • Federal Reserve directly controls outside money. • Bulk of money supply is inside money (deposits). • Reserve requirements facilitate transmission of monetary policy.

  14. Regulation • Credit allocation regulation • Supports socially important sectors such as housing and farming. • Requirements for minimum amounts of assets in a particular sector or maximum interest rates or fees. • Qualified Thrift Lender Test (QTL) • 65 percent of assets in residential mortgages • Usury laws and Regulation Q (abolished)

  15. Regulation • Consumer protection regulation • Community Reinvestment Act (CRA). • Home Mortgage Disclosure Act (HMDA). • Effect on net regulatory burden • FFIEC processed info on as many as 31 million mortgage transactions in 2006. • Potential extensions of regulations such as CRA to other FIs such as insurance companies in light of consolidation and trend toward universal banking.

  16. Regulation • Investor protection regulation • Protections against abuses such as insider trading, lack of disclosure, malfeasance, breach of fiduciary responsibility. • Key legislation • Securities Acts of 1933, 1934. • Investment Company Act of 1940.

  17. Regulation • Entry regulation • Level of entry impediments affects profitability and value of charter. • Regulations define scope of permitted activities. • Financial Services Modernization Act of 1999. • Affects charter value and size of net regulatory burden.

  18. Web Resources • For more information on regulation of depository institutions visit: www.ffiec.gov www.federalreserve.gov www.fdic.gov www.occ.treas.gov

  19. Changing Dynamics of Specialness • Trends in the United States • Decline in share of depository institutions. • Increases in investment companies. • May be attributable to net regulatory burden imposed on depository FIs. • Financial Services Modernization Act • Ethics issues and weakening of public trust

  20. Future Trends • Further weakening of public trust and confidence in FIs may encourage disintermediation • Increased merger activity within and across sectors • Citicorp and Travelers, UBS and Paine Webber • More large scale mergers such as J.P. Morgan and Chase, and Bank One • Growth in Online Trading • Amendment of SEC 144A • Private placement market effects

  21. Equity Trading on the Internet

  22. Global Issues • Increased competition from foreign FIs at home and abroad • Mergers involving world’s largest banks • Mergers blending together previously separate financial services sectors

  23. World’s Largest Banks ($Billions) BankAssets Barclays Bank (UK) 1,591.5 UBS (Switzerland) 1,567.6 Mitsubishi UFJ (Japan) 1,508.5 HSBC Holdings (UK) 1,502.0 Citigroup (USA) 1,494.0 BNP Paribas (France) 1,484.1 Credit Agricole Groupe (France) 1,380.6 Royal Bank of Scotland (UK) 1,337.5 Bank of America (USA) 1,291.8

  24. The Banker Federal Reserve FDIC FFIEC Investment Co. Institute OCC SEC SIPC Wall Street Journal Thompson Fin. Sec. Data www.thebanker.com www.federalreserve.gov www.fdic.gov www.ffiec.gov www.ici.com www.occ.treas.gov www.sec.gov www.sipc.org www.wsj.com www.thompson.com Pertinent Websites

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