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					CHAPTER 11
An Introduction to Financial Intermediaries and
Risk

Le arning Obje ctive s

    The characteristics common to all types of financial intermediaries (FIs)
    The services provided by FIs and the types of risks they must manage
    The major types of depository institutions and other FIs
    The principal assets and liabilities of the various FIs
    The characteristics that distinguish one type of FI from another type


Chapter Outline

I.       Are All Financial Intermediaries More or Less Alike?
II.      Common Characteristics
III.     Types of Risks Faced by All FIs
         A.      Credit or Default Risk
         B.      Interest Rate Risk
         C.      Liquidity Risk
         D.      Exchange Rate Risk
IV.      A Guide to FIs and Their Balance Sheets
         A.      Deposity-Type FIs
         B.      Commercial Banks
         C.      Savings Associations
         D.      Credit Unions
         E.      Contractual-Type FIs
         F.      Investment-Type FIs
         G.      Finance Company-Type FIs
V.       Pulling Things Together


Answe rs to Revie w Questions

List two services that FIs provide to the public. Why do intermediaries provide these
    services? What is a contingent financial claim? Give two exa mples.

FIs provide two main services to the public. First, by buying the financial liabilities of DSUs,
FIs provide borrowing opportunities for DSUs. Secondly, FIs provide an array of financial
claims and depository services to meet the needs of SSUs and society at large. FIs provide
these services for three main reasons: 1) to reduce the risks and costs associated with
borrowing, lending, and other financial transactions, 2) to fulfill the demand for various
financial assets and services, including protection against financial losses, and perhaps most
importantly 3) because doing so is profitable.



                                                   59
60                                                                                        Chapter 11


A contingent financial claim is a claim that offers the public some protection against the
catastrophic financial effects of theft, accidents, natural disasters , and death. Two examples of
such claims are life insurance policies and flood insurance policies.

“With financial intermediation, SSUs can earn a higher return on their surplus funds, and
   DSUs can acquire funds at a lowe r cost.” Explain how this seemingl y contradictory
   state ment can be true. (Hint: Conside r a risk-free return.)

Financial intermediation helps reduce the risks associated with lending and borrowing money.
Since FIs offer safety, SSUs don’t have to give up as much safety for higher returns, and the
reduction in risks will thus lower the borrowing rates for DSUs.

How are FIs like othe r firms? How are FIs similar to each other? How are the y diffe rent?

FIs are firms. They use inputs—sources of funds (SSUs) to extend loans to DSUs and acquire
securities. These financial claims appear on the asset side of the balance sheet and represent
the output of the firm. These FIs do this to earn a profit—just as any other firm would do. FIs
possess many common traits: they are regulated, profit -seeking firms that provide the public
with a wide range of financial services that help to reduce the risks associated with channeling
funds from SSUs to DSUs. The differences among FIs are manifested in the composition of
their balance sheets —which in turn explains why different FIs face risks in varying degrees.

If an FI has mainly long -term liabilities with fe w payment unce rtainties, in what type of
    assets is it most likely to invest? Why?

If an FI has mainly long-term liabilities with few payment uncertaintie s, it is likely to invest in
long-term, less liquid assets. These longer-term securities generally provide higher yields than
short-term securities. For these types of FIs that have few payment uncertainties, holding large
portions of liquid assets is not as essential as it is for FIs like commercial banks.

What is a depository institution? What are the main types of depos itory institutions?
   What distinguishes them from other intermediaries?

A depository institution has a large part of its liabilities in the form of deposits that have been
issued in order to obtain funds that can be used to make loans and other investments.
Depository institutions include commercial banks, S&Ls, savings banks, and credit unions.
Unlike other FIs, depository institutions play an important role in the nation’s money supply
process.

Why do banks hold reserve assets?

Banks hold reserve assets to help meet their liquidity and safety objectives, and also because
they are required by law to do so. The Fed sets reserve ratios re quiring banks to possess
reserve assets equal to a certain percentage of checkable deposit liabilities.

Identify the major contractual-type FIs. What are their main sources of funds (liabilities)
    and their main uses of funds (assets)?

Contractual-type FIs have liabilit ies that are defined by contract. They call for regular
payments to be made to these FIs in exchange for future payments under specified conditions.
Three main types of contractual-type FIs are life insurance companies, pension funds, and
property and casualty companies. Each taps different sources of funds and uses them to
purchase different types of financial assets. Life insurance companies collect life insurance
premium payments and use these funds to purchase corporate and foreign bonds , corporate
An Introduction to Financial Intermediaries and Risk                                             61


equities, and other financial assets. These assets yield investment earnings for the life
insurance companies and serve as a reserve for when the insurance company must make future
payments against these policies. Like life insurance companie s, property and casualty
companies receive their revenues from insurance premiums. These funds are then used to buy
corporate and foreign bonds, municipal securities, corporate equities, U.S. Government
securities, and other financial assets. Like life insurers, these assets are used to generate
earnings and serve as a reserve until future claims are made by policyholders. Pension funds
take in regular contributions from future retirees and use these funds to primarily buy
corporate equities, U.S. Government securities, mutual funds, as well as corporate and foreign
bonds. These assets are then used to fund the retirement of contributors or their employees.

What are the main sources of funds (liabilities) and uses of funds (assets) for finance
   company-type FIs?

The main sources of funds for finance companies are corporate bonds, commercial paper, and
bank loans. Finance companies use these funds to make loans to households for the purchase
of consumer durables and to businesses to finance inventories.

Why does A-1 Student Auto Insurance Company need to hold more liquid assets than
   Se nior Life Insurance Company? How do depository institutions manage liquidity
   risk?

For a life insurance company, the influx of premium payments is relatively steady and
actuaries can fairly well predict the proportion of policyholders likely to become disabled, die,
or become ill in a given year. Thus, life insurance companies have a reasonably predictable
stream of benefit payments to policyholders distributed over time. Th is allows these firms to
use a large portion of their funds to acquire longer -term assets or financial investments. For
property and casualty companies, it is much more difficult to predict the stream of benefit
payments. It is hard to predict for example, when a hurricane or other natural disaster will
occur—let alone accidents. Thus, these companies need to have liquid assets in the event that
a disaster would occur and large benefit payments must be made.

Depository institutions hold reserves (assets ) equal to a certain proportion of their deposits to
manage liquidity risk. They also make use of the fed funds and repurchase agreement market
to borrow (increase their liabilities). Also the Fed stands ready to provide liquidity for
depository institutions, by acting as a lender of last resort.

John, a recent college graduate, is buying his first house. From which FIs could he obtain
   a mortgage loan?

John could obtain a mortgage loan from a commercial bank, savings association, credit union,
or a finance company.

How do money market mutual funds diffe r from mutual funds? How are mone y market
   mutual funds similar to depository institutions? As an investor, Sam holds both
   mutual funds and money market mutual funds. Holding which asset entails greater
   interest rate risk for him? Why?

It’s easier to answer this question by first defining a mutual fund. Mutual funds are financial
intermediaries which pool the funds of SSUs (investors), purchase the financial claims of
DSUs (primarily stocks and bonds), and return the income received minus a management fee to
the SSUs. Money market mutual funds are mutual funds that invest in money market
instruments. In the early 1980s, depositors started to redirect their surplus funds from banks
and thrifts to higher interest earning money market mutual funds. Mutual funds entail greater
62                                                                                     Chapter 11


risk than money market mutual funds. This is because the stocks and bonds in a mutual fund
have longer maturities and greater price risk than the money market assets backing money
market mutual funds.

Wo uld a prope rty and casualty company hold municipal securities in its portfolio of
    assets? What about a cre dit union and a life insurance company? Why or why not?

A casualty company is subject to the full corporate income tax and thus wou ld hold municipal
securities because these securities are exempt from federal taxation. Credit unions and life
insurance companies are not taxed at a high marginal rate, and therefore would not hold
municipal securities in their portfolios.

How can diversification reduce credit or de fault risk? In the event of widespread
   economic collapse will dive rsification always reduce this risk?

Diversification will help cover the losses of some investments if other investments in the
portfolio are earning positive gains. The losses of some investments will be offset by the gains
of others. But, in the event of a widespread economic collapse, all of the investments may be
taking losses, and thus diversification may not be able to help.

What are the major dete rminants of an FI’s liability structure? Give examples of each.

The major determinants of an FI’s liability structure are the range of financial services offered
(e.g. banking and investment services vs. insurance benefits); any specialization in a particular
area, perhaps as a result of custom (e.g.S&L focus on mortgages) ; the tax status of the
institution (e.g. tax exempt or not); and legal constraints or regulations (e.g. many FIs are not
allowed to accept deposits).

What was the purpose of the Financial Insti tutions Reform, Recovery, and Enforcement
   Act (FIRREA) of 1989? Why was the act needed?

The FIRREA of 1989 attempted to resolve the S&L crisis of the 1980s. More than 500
institutions became insolvent and were seized by the regulators during the late 1980 s at the
taxpayers’ expense. The FIRREA tried to resolve this crisis by creating a new federal
regulatory structure, limiting the assets S&Ls could acquire, and requiring S&Ls to maintain
adequate capital.

Which FIs have deposit insurance?

Depository institutions such as commercial banks, S&Ls, savings banks, and credit unions have
deposit insurance.

What is a mutual savings bank?

Mutual savings banks are depository institutions, located mainly on the East Coast, set up to
help finance the construction and purchase of homes. The original savings banks were
“mutuals,” which meant that the depositors were really the owners of the institutions. These
institutions were established to encourage the poor and the working class to save to reli eve
poverty and pauperism. The poor deposited funds, and in turn wealthy entrepreneurs managed
the funds. Today, about two-thirds of savings banks retain this form of ownership, and one -
third have sold stock and converted their ownership to stock savings banks.
Answe rs to Analytical Que stions
An Introduction to Financial Intermediaries and Risk                                             63


If a bank has assets of $100 million and liabilities of $95 million, what is its net worth? If
     60 pe rcent of its assets are loans, what percentage of the loans could go sour be fore
     the bank would lose all of its capital?

If the bank has assets of $100 million and liabilities of $95 million, its net worth is the
difference between the two, and is thus $5 million. We can compute the percentage of loans
that may go bad before all of the bank’s capital is exhausted by taking the amount of ca pital
and dividing that by the amount of loans. In this case $5 million/$60 million = 8.333%.

M ake a chart listing the main sources of funds (liabilities) and main uses of funds (assets)
    in order of importance for the following depository institutions: co mme rcial banks,
    S&Ls, mutual s avings banks, and credit unions. Describe how the sources and uses of
    funds have changed through the years for the various depository institutions.

                     Commercial Banks
         Assets                                           Liabilities
Mortgages                                         small time and savings deposits
Business loans                                    miscellaneous
Miscellaneous                                     large time deposits
Government agency securities                      Fed funds & repurchase agreements
Consumer credit                                   checkable deposits
Treasury securities                               corporate bonds
Corporate & foreign bonds                         Eurodollar Borrowings
Security credit                                   loans & advances
Municipal securities                              commercial paper
Vault cash                                        to the Fed
Deposits at the Fed                               to domestic banks

                     Savings & Loans
        Assets                                            Liabilities
Mortgages                                         small time & savings deposits
U.S. government securities                        loans & advances
Corporate & foreign bonds                         checkable deposits
Miscellaneous                                     large time deposits
Consumer credit                                   miscellaneous
Corporate equities                                repurchase agreements
Loans & advances                                  corporate bonds
Checkable deposits & currency
Fed funds & repurchase agreements
Municipal securities
Reserves at the Fed
Time & savings deposits

                  Mutual Savings Banks
Same as S&Ls—the vast majority of funds come from various types of deposits
64                                                                                      Chapter 11


                    Cre dit Unions
        Assets                                         Liabilities
Consumer credit                                small time & savings deposits
Mortgages                                      checkable deposits
U.S. government securities                     large time deposits
Miscellaneous                                  miscellaneous
Time & savings deposits
Checkable deposits & currency
Fed funds & repurchase agreements

Savings and Loans and credit unions can now use checkable deposits —something they were
once forbidden. Commercia l banks now make more mortgages than they did in the past —
blurring the distinctions between commercial banks and S&Ls.

What type of risk does each of the following situations portray?
     a.    After the attack on the World Trade Center, several major insurance companies did not
           have sufficient cash assets available to meet casualty claims.
     b.    ABC Bank, located along the U.S.-Mexican border, was holding a large quantity of
           Mexican pesos when the value of the peso collapsed.
     c.    Friendly S&L specializes in fixed rate mortgages. There is a sharp increase in short-
           term interest rates.
     d.    A family needs funds immediately to meet a medical emergency. All of its assets are tied
           up in real estate.
     e.    I am planning a trip to Europe next summer and have exactly $5,000. At the present
           exchange rates, I will have a great time. Is there any doubt?
     f.    Chad takes a loan for an expensive racing truck and then loses his job.

a. Liquidity risk
b. Exchange rate risk
c. Interest rate risk
d. Liquidity risk
e. Exchange rate risk
f. Default risk

				
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