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					                Lecture 1: Financial Intermediation and Risk

           Chapter 1. Why Are Financial Intermediaries Special?

Outline of Chapter 1.

Introduction

Financial Intermediaries’ Specialness

   Information Costs
   Liquidity and Price Risk
   Other Special Services

Other Aspects of Specialness
   The Transmission of Monetary Policy
   Credit Allocation
   Intergenerational Wealth Transfers or Time Intermediation
   Payment Services
   Denomination Intermediation

Specialness and Regulation
   Safety and Soundness Regulation
   Monetary Policy Regulation
   Credit Allocation Regulation
   Consumer Protection Regulation
   Investor Protection Regulation
   Entry Regulation

The Changing Dynamics of Specialness
   Trends in the United States
   Future Trends

Global Issues




                                        1
Lecture 1: Part 1

Financial Institutions

          1. depository (banks, credit unions, thrifts, savings banks)

          2. non-depository (insurance companies, investment bankers, security
             dealers and brokers, government sponsored enterprises, mutual funds
             and subsidiaries of holding companies)

Common function: channel funds from those with surplus funds (suppliers) to
those with shortages of funds (users).

What does “special mean”?

Proposition: Households consume some % of earnings, not all of it.
     What do they do with that which they do not consume?
         1. Hold cash
         2. Invest in securities issued by businesses.
             Businesses issue debt and equity to finance real assets and
             cover the gap between retained earnings and investment plans,

Real assets are used to produced goods and services Capital, Labor, Energy,
Materials.

Financial assets are claims to the income generated by real assets. Securities are
financial assets. Financial assets are part of investor’s wealth but NOT national
wealth.

Three sectors of economy: Household, Business, Government.
Households decide on investing funds.
Business and government in contrast typically need to raise funds.
Diverse tax and risk preferences of households create a demand for a wide variety
of securities. Businesses find it more efficient to offer relatively uniform
securities. T his conflict gives rise to financial intermediaries that create complex
derivative securities from primitive securities.

The “smallness” of households creates a market niche for financial intermediaries.

                                          2
These include banks, thrifts, mutual funds, insurance and investment companies
that service direct markets, brokered markets, dealer markets, auction markets, and
other markets NEC.

Text envisions a world without FI. (Note logic: first world without FIs then a world
with FIs)
This concept of change
risk, change in cash flow, change in flow of funds, change in economic welfare,
etc.

World of Direct Transfer NO FIs

            (Direct transfers of cash for equity and debt claims)



                             Without FIs

                                  Equity & Debt

      Households                                           Corporations
      (net savers)                                        (net borrowers)

                                       Cash




Flow of funds between Household and Corporate sector is likely to be low.
   1. Monitoring costs-time and money to get information
   2. Liquidity costs-cash tied up in long term securities is not available for
      consumption
   3. Price risk-financial assets can erode in value.

From the perspective of Society…households would prefer not to save or save only
with cash.

                                         3
Pressure to create a secondary market (households could trade among themselves)
would develop but not without transaction costs.


                               With FIs

                                       FI
                                    (Brokers)
     Households                                              Corporations
                                      FI
                   Cash             (Asset                 Equity & Debt
                                 Transformers)

   Deposits/Insurance                                               Cash
        Policies

Note the representation is a Financial Market in which Financial Institutions
become Financial Intermediaries.

Simple economic system-Emphasis (Flow, Circulation, Growth)

                   Product Markets
                   Retail
                   Wholesale


Producers          Financial Markets               Consumers
Business           Flow of Funds
Governments              Flow of Credit
                   Flow of Financial
                   Services, Financial
                   Income & Services



                                          4
                    Factor Markets
                    Energy, Capital, Labor
                    Materials

FIs become brokers and financial asset transformers

      •   Broker acts 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

Technically the financial claims of FIs sold to households may be considered
secondary securities because assets are backed by primary securities issued by
commercial corporations who in turn invest in REAL ASSETS (Plant, equipment,
real estate, etc.)

Balance Sheets

      Commercial Firm                                Financial Intermediary

Assets                     Liabilities               Assets            Liabilities

Real Assets         Primary                     Primary                Secondary
Plant               Securities                  Securities             Securities
Equipment           Debt & Equity               Debt & Equity          Deposits
                                                                       Insurance
                                                                       Policies
                                                                       Guarantees
Fundamental Question:

How can a FI purchase direct or primary securities issues by corporations,
businesses, and firms and transform them into secondary securities attractive to


                                          5
household savers? How in turn do the brokerage and asset transformation
activities make them so SPECIAL?


Answer lies in the ability of the FIs to better resolve the 3 costs facing the saver
   Monitoring or information costs-time and money to get information
   Liquidity costs-cash tied up in long term securities is not available for
     consumption
   Price risk-financial assets can erode in value.

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


Agency costs-risk that the firm’s owners or managers will impose take actions with
the savers money contrary to the promises contained in covenants of the securities
contracts.

Monitoring costs are borne by FI and are part of agency costs.

Saver “Principal” is affected by actions of borrowing firm or FI “Agent”
FI incentive to collect information (reduce risk)!

A large number of “small” savers places funds in FI.
FI groups funds together and invests directly in primary financial claims issued by
firms.

Average cost of information reduced.

Consider a $10,000 investment and a one time $100 brokers report. Cost to
individual saver is high but averaged across many savers cost is low. For an FI
with $10 million under management costs may seem trivial. Economies of scale,
scope, size, etc.



                                           6
FIs develop secondary securities that enable them to monitor more effectively.
Consider a bank loan. Bank loans are shorter term than bond contracts. Banker
making the loan becomes like an insider to the firm regarding information. Banker
can monitor more effectively. Holders of bank debt and equity may benefit
accordingly. Firms can issue debt at lower costs to bank if bank has confidence in
the firm. FIs act as “delegated monitors” to produce better and more timely
information. They can reduce misinformation and asymmetry between suppliers
and users of funds in the economy… leading to improved efficiency.

Liquidity and Price Risk

      •   Secondary claims issued by FIs have less price risk

      •   FIs have advantage in diversifying risks

      •   S&L debacle of 1980s linked to inadequate diversification of S&Ls

Savers secondary claims to FIs have superior liquidity than primary securities. E.g.
banks and thrifts provide transaction accounts deposit contracts with fixed
principal and often a guaranteed interest rate. Households can withdraw
immediately on demand. Money market mutual funds issue shares to household
savers that allow savers to enjoy almost fixed principal (deposit-like) contracts
while earning interest rates higher than those on bank deposits.

Transition economies wonder at the ability of banks to offer highly liquid, low
price-risk contracts to savers on the liability side of the balance sheet while
investing in relatively illiquid and higher price-risk securities on the asset side.
Answer: Diversification of portfolios. Wonders of negative covariance! As the
number of securities in portfolio increases, portfolio risk may fall. FIs are bigger
than household savers and can exploit a more diversified portfolio.

Other Special Services

          • Reduced transaction costs (avoid commission charges)
          • Maturity intermediation (bear risk of mis-matched funds Mortgages)
               Ability to manage interest rate and credit risk through hedging.
          • Transmission of monetary policy(banks) see www.federalreserve.gov
          • Credit allocation (Areas of special need such as home mortgages).
          • Intergenerational transfers or time intermediation(pension funds, life
            insurance companies).


                                          7
          • Payment services (FedWire and CHIPS, banks and thrifts).
          • Denomination intermediation.(Minimum size of a negotiable
            Certificate of Deposit is $100,000 and Short term corporate debt often
            exceeds $250,000..buying shares in mutual fund a saver may be able
            to purchase such instruments.)

To Sum Up..

So what does “Special” mean
    Information and Monitoring
    Liquidity
    Price-risk reduction
    Transaction cost reduction
    Maturity intermediation
    Money supply transmission
    Credit allocation
    Intergenerational transfers
    Payment services
    Denomination Intermediation

So what happens when such services are not provided? Slower economic growth,
real investment, consumption, etc. What happens when they are provided faster
growth, more investment, etc. BUT…..

BUT FIs can breakdown! Moral hazard, principal agent problems….markets fail
and disequilibria can result.

Negative externalities (imposing costs on other economic agents) make a case for
regulation, but regulation is not without difficulty. Markets can break down …
Disequilibrium..bank failures, insurance company failures, panics, redlining, etc.

FI and Risk

FIs hold assets that are subject to default or credit risk (losses because value erode)
FIs tend to mismatch maturities of assets and liabilities
FIs exposed to liability risk (withdrawal) depending upon claims.
FIs exposed to underwriting risk, whether through sale of securities or issuance of
credit guarantees on or off balance sheets



                                           8
Regulators in principle need to monitor risks and actions.



Six types of Regulations

   1. Safety and Soundness-capital adequacy, guarantees and insurance,
      monitoring, diversification regulatory limits lending limits (in case of banks
      and thrifts, <15% of equity to any one borrower, <.9 percent of assets). See
      www.occ.treas.gov, www.fdic.gov, www.ots.gov for depository institutions.
   2. Monetary Policy quantity of notes and coin, quantity of deposits D=1/r*R
      where D is deposits, r is cash reserves to deposits, and R is notes and coin
      plus bank deposits held on reserve at the central bank. If r is stable control
      of D is straightforward. See definitions of M1, M2, M3 in
      www.federalreserve.gov. FIs view required reserves as a tax. MV=PQ.
   3. Credit allocation: housing and farming, special interests. See www.fhfb.gov;
      www.fanniemae.com; www.freddiemac.com; www.hud.gov
   4. Consumer Protection see www.ffiec.gov,www.sec.gov
   5. Investor Protection see www.sipc.org
   6. Entry and Chartering banks, thrifts, insurance companies, brokerages, etc.


When there are technological changes, shifts in demand and supply of FIs profits
and services may require adjustment….so too regulators must adapt and change
with changes in FI markets. Failure to adjust can impose not just net regulatory
burden but can interfere with technological advances and/or limit growth.

Trends
   Trends in the United States
          • Decline in share of depository institutions.
          • Increases in pension funds and investment companies.
          • May be attributable to net regulatory burden imposed on depository FIs.
          • Technological changes affect delivery of financial services and regulatory issues

Trends: Globalization, securitization, credit enhancements, and financial engineering.




                                                9
         Trillions of Dollars of Financial Assets

16.000

14.000

12.000

10.000

 8.000                                    What caused the
                                          takeoff?
 6.000

 4.000

 2.000

 0.000
    60
    67

    74

    81
    88
    95

    02
    09
    16

    23
    30
    37

    44

    51
    58

    65
    72

    79

    86
    93
    00
  18
  18

  18

  18
  18
  18

  19
  19
  19

  19
  19
  19

  19

  19
  19

  19
  19

  19

  19
  19
  20
                      Shares of Assets

80.0%

70.0%
                                                            Com Banks
60.0%                                                       Thrifts
                                                            Insurance
50.0%
                                                            Investment
40.0%                                                       Pension
                                                            Finance
30.0%
                                                            Sec Brok
20.0%                                                       Mort Co
                                                            Reit
10.0%

 0.0%
     60

     69

     78

     87

     96

     05

     14

     23

     32

     41

     50

     59

     68

     77

     86

     95
  18

  18

  18

  18

  18

  19

  19

  19

  19

  19

  19

  19

  19

  19

  19

  19




                               10
                                     Assets of Depositories and Non Depositories

  9

  8

  7

  6

  5

  4

  3

  2

  1

  0
      1860
             1866
                    1872
                           1878
                                  1884
                                         1890
                                                1896
                                                       1902
                                                              1908
                                                                     1914
                                                                            1920
                                                                                   1926
                                                                                          1932
                                                                                                  1938
                                                                                                         1944
                                                                                                                1950
                                                                                                                       1956
                                                                                                                              1962
                                                                                                                                     1968
                                                                                                                                            1974
                                                                                                                                                   1980
                                                                                                                                                          1986
                                                                                                                                                                 1992
                                                                                                                                                                        1998
                                                               Depositories                      Non Depositories




Rising share of investment companies-mutual funds and money market mutual funds increased
their share from 1.3% to 17% between 1948 and 2000. Investment companies give savers
cheaper access to the direct securities markets.

Savers increasingly prefer the investments (brokerage) activities that closely mimic diversified
investments in direct securities markets over the transformed financial claims offered by
traditional FI (depositories and insurance companies)

Mutual funds buy stocks and bonds directly in financial markets and issue savers shares whose
value is linked in a direct pro rata fashion to the value of the mutual fund’s asset portfolio.

Money market mutual funds invest in short-term financial assets such as commercial paper
(bonds), CDs, T bills, and issue shares linked directly to value of the underlying portfolio.

Good diversification offers price risk protection and liquidity.




                                                                                    11
                                 Share of Depositories vs Non-Depositories

  100.0%
   90.0%
   80.0%
   70.0%
   60.0%
   50.0%
   40.0%
   30.0%
   20.0%
   10.0%
     0.0%
            1860
                   1867
                          1874
                                 1881
                                        1888
                                               1895
                                                      1902

                                                              1909
                                                                     1916
                                                                            1923
                                                                                   1930
                                                                                          1937
                                                                                                 1944
                                                                                                        1951
                                                                                                               1958

                                                                                                                      1965
                                                                                                                             1972
                                                                                                                                    1979
                                                                                                                                           1986
                                                                                                                                                  1993
                                                                                                                                                         2000
                                                             Depositories                 Non-Depositories




Banks only partially fund a 10 year loan with demand deposits,
Thrifts may fund 30 year conventional mortgage with 3 month time deposits
Life insurance may fund purchase of 30 year junk bonds with a 7 year fixed interest guaranteed
investment contract.

Banks, thrifts, and insurance companies have a lower correlation of performance with primary
securities than do investment companies.

Correlation vs. causality. In all likelihood the changes in technology, telecommunications, and
information will continue to lower the risks for well diversified portfolios. It is clear that FIs are
becoming more efficient with less classical intermediation necessary. Alternatives for savers
have become more prominent.

 De-regulation of the financial sector has been in process in the US over the last two decades.
Banks can now acquire mutual funds and expand both asset and pension fund management as
well as security underwriting. Banks are getting fewer in number but much larger in size. Banks
did well during the late 1990s and early 2000s despite recessions and terrorist attacks (9/11).
However direct financial markets have been able to take greater advantage and avoid regulatory
issues that hang over the bank and thrift sectors after the 1980s.


                                                                            12
144a placements: Bell Atlantic, Bell/South, IBM, Walt Disney offer direct stock purchase plans
after April 1990 ruling by SEC. Large investors may trade privately placed securities among
themselves. Sold without underwriters and minimum disclosures.

Internet alone will reduce transaction costs and avoid stockbroker and transaction fees. See
www.quicken.com and www.yahoofinance.com for information and analysis that would
previously was unavailable. E*trade accounts in 2002 tripled! By March 2002, 2.6 million
accounts. Schwab has over 3.5 million accounts. Merrill Lynch offers clients $29.95 trades
compared to $100-$400 fees paid to full service brokers. Schwab offers clients $14.95 trades and
shares research and advice freely. This trend will continue.

Banking has become bi-furcated. Niche markets remain but many banks have become global
with the number of banks halved compared to 2 decades ago.

Lecture 1. Part I Solutions for End-of-Chapter Questions and Problems: Chapter One

1.   Explain how economic transactions between household savers of funds and corporate users
     of funds would occur in a world without financial intermediaries (FIs).

In a world without FIs the users of corporate funds in the economy would have to approach
directly the household savers of funds in order to satisfy their borrowing needs. This process
would be extremely costly because of the up-front information costs faced by potential lenders.
Cost inefficiencies would arise with the identification of potential borrowers, the pooling of
small savings into loans of sufficient size to finance corporate activities, and the assessment of
risk and investment opportunities. Moreover, lenders would have to monitor the activities of
borrowers over each loan's life span. The net result would be an imperfect allocation of resources
in an economy.

2.   Identify and explain three economic disincentives that probably would dampen the flow of
     funds between household savers of funds and corporate users of funds in an economic
     world without financial intermediaries.

Investors generally are averse to purchasing securities directly because of (a) monitoring costs,
(b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive
time, expense, and expertise. As a result, households would prefer to leave this activity to
others, and by definition, the resulting lack of monitoring would increase the riskiness of
investing in corporate debt and equity markets. The long-term nature of corporate equity and
debt would likely eliminate at least a portion of those households willing to lend money, as the
preference of many for near-cash liquidity would dominate the extra returns which may be
available. Third, the price risk of transactions on the secondary markets would increase without
the information flows and services generated by high volume.

3.   Identify and explain the two functions in which FIs may specialize that enable the smooth
     flow of funds from household savers to corporate users.




                                                13
FIs serve as conduits between users and savers of funds by providing a brokerage function and
by engaging in the asset transformation function. The brokerage function can benefit both savers
and users of funds and can vary according to the firm. FIs may provide only transaction services,
such as discount brokerages, or they also may offer advisory services which help reduce
information costs, such as full-line firms like Merrill Lynch. The asset transformation function is
accomplished by issuing their own securities, such as deposits and insurance policies that are
more attractive to household savers, and using the proceeds to purchase the primary securities of
corporations. Thus, FIs take on the costs associated with the purchase of securities.

4.   In what sense are the financial claims of FIs considered secondary securities, while the
     financial claims of commercial corporations are considered primary securities? How does
     the transformation process, or intermediation, reduce the risk, or economic disincentives, to
     the savers?

The funds raised by the financial claims issued by commercial corporations are used to invest in
real assets. These financial claims, which are considered primary securities, are purchased by
FIs whose financial claims therefore are considered secondary securities. Savers who invest in
the financial claims of FIs are indirectly investing in the primary securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring
expenses, liquidity costs, and price risk of placing the investments directly with the commercial
corporation are reduced because of the efficiencies of the FI.

5.   Explain how financial institutions act as delegated monitors. What secondary benefits
     often accrue to the entire financial system because of this monitoring process?

By putting excess funds into financial institutions, individual investors give to the FIs the
responsibility of deciding who should receive the money and of ensuring that the money is
utilized properly by the borrower. In this sense the depositors have delegated the FI to act as a
monitor on their behalf. The FI can collect information more efficiently than individual
investors. Further, the FI can utilize this information to create new products, such as commercial
loans, that continually update the information pool. This more frequent monitoring process
sends important informational signals to other participants in the market, a process that reduces
information imperfection and asymmetry between the ultimate sources and users of funds in the
economy.

6.   What are five general areas of FI specialness that are caused by providing various services
     to sectors of the economy?

First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price-risk conditions than primary securities. Fourth,
FIs provide economies of scale in transaction costs because assets are purchased in larger
amounts. Finally, FIs provide maturity intermediation to the economy which allows the
introduction of additional types of investment contracts, such as mortgage loans, that are
financed with short-term deposits.



                                                14
7.    How do FIs solve the information and related agency costs when household savers invest
      directly in securities issued by corporations? What are agency costs? What is the free-
      rider problem?

Agency costs occur when owners or managers take actions that are not in the best interests of the
equity investor or lender. These costs typically result from the failure to adequately monitor the
activities of the borrower. Because the cost is high, individual investors may do an incomplete
job of collecting information and monitoring under the assumption that someone else is doing
these tasks. In this case, the individual becomes a free rider. But if no other lender performs
these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the
lending agreement. Because the FI invests the funds of many small savers, the FI has a greater
incentive to collect information and monitor the activities of the borrower.

8.    What often is the benefit to the lenders, borrowers, and financial markets in general of the
      solution to the information problem provided by the large financial institutions?

One benefit to the solution process is the development of new secondary securities that allow
even further improvements in the monitoring process. An example is the bank loan that is
renewed more quickly than long-term debt. The renewal process updates the financial and
operating information of the firm more frequently, thereby reducing the need for restrictive bond
covenants that may be difficult and costly to implement.

9.    How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in
      the securities of corporations?

Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial
banks, for example, offer deposits that can be withdrawn at any time. Yet the banks make long-
term loans or invest in illiquid assets because they are able to diversify their portfolios and better
monitor the performance of firms that have borrowed or issued securities. Thus individual
investors are able to realize the benefits of investing in primary assets without accepting the
liquidity risk of direct investment.

10.   How do financial institutions help individual savers diversify their portfolio risks? Which
      type of financial institution is best able to achieve this goal?

Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government customers,
and insurance companies have investments in many different types of assets. Investment in a
mutual fund may generate the greatest diversification benefit because of the fund’s investment in
a wide array of stocks and fixed income securities.

11.   How can financial institutions invest in high-risk assets with funding provided by low-risk
      liabilities from savers?

Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an



                                                  15
FI will be less than the average risk of the individual assets in which it has invested. Thus
individual investors realize some of the returns of high-risk assets without accepting the
corresponding risk characteristics.

12.   How can individual savers use financial institutions to reduce the transaction costs of
      investing in financial assets?

By pooling the assets of many small investors, FIs can gain economies of scale in transaction
costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or
purchasing assets in the money and capital markets. In either case, operating activities that are
designed to deal in large volumes typically are more efficient than those activities designed for
small volumes.

13.   What is maturity intermediation? What are some of the ways in which the risks of maturity
      intermediation are managed by financial intermediaries?

If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by matching their asset and liability maturities through on- and off-balance sheet hedging
activities and flexible access to the financial markets. For example, the FI can offer the
relatively short-term liabilities desired by households and also satisfy the demand for long-term
loans such as home mortgages. By investing in a portfolio of long-and short-term assets that
have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing
liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options,
swaps, and other derivative products.

14.   What are five areas of institution-specific FI specialness, and which types of institutions are
      most likely to be the service providers?

First, commercial banks and other depository institutions are key players for the transmission of
monetary policy from the central bank to the rest of the economy. Second, specific FIs often are
identified as the major source of finance for certain sectors of the economy. For example, S&Ls
and savings banks traditionally serve the credit needs of the residential real estate market. Third,
life insurance and pension funds commonly are encouraged to provide mechanisms to transfer
wealth across generations. Fourth, depository institutions efficiently provide payment services to
benefit the economy. Finally, mutual funds provide denomination intermediation by allowing
small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs
and commercial paper issues.

15.   What are the differences between the various definitions of the money supply: M1, M2,
      and M3? Why is it important to track the level of the money supply?

Table 1-4 details the precise components of the money supply definitions. Generally, M1
consists primarily of demand deposits plus currency. M2 includes all of M1 along with savings
and small time deposits. M3 includes all of M2 plus other large time deposit balances,
repurchase agreements, and Eurodollars. The money supply is used by the central bank as the
primary vehicle to ensure the desired level of economic growth. An excess amount of money



                                                 16
can lead to inflation, and an insufficient growth of money can result in economic stagnation or a
recession.

16.   How do depository institutions such as commercial banks assist in the implementation and
      transmission of monetary policy?

The Federal Reserve Board can involve directly the commercial banks in the implementation of
monetary policy through changes in the reserve requirements and the discount rate. The open
market sale and purchase of Treasury securities by the Fed involves the banks in the
implementation of monetary policy in a less direct manner.

17.   What is meant by credit allocation regulation? What social benefit is this type of regulation
      intended to provide?

Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the
economy, which are considered to be socially important. These may include housing and
farming. Presumably the provision of credit to make houses more affordable or farms more
viable leads to a more stable and productive society.

18.   Which intermediaries best fulfill the intergenerational wealth transfer function? What is
      this wealth transfer process?

Life insurance and pension funds often receive special taxation relief and other subsidies to assist
in the transfer of wealth from one generation to another. In effect, the wealth transfer process
allows the accumulation of wealth by one generation to be transferred directly to one or more
younger generations by establishing life insurance policies and trust provisions in pension plans.
Often this wealth transfer process avoids the full marginal tax treatment that a direct payment
would incur.

19.   What are two of the most important payment services provided by financial institutions?
      To what extent do these services efficiently provide benefits to the economy?

The two most important payment services are check clearing and wire transfer services. Any
breakdown in these systems would produce gridlock in the payment system with resulting
harmful effects to the economy at both the domestic and potentially the international level.

20.   What is denomination intermediation? How do FIs assist in this process?

Denomination intermediation is the process whereby small investors are able to purchase pieces
of assets that normally are sold only in large denominations. Individual savers often invest small
amounts in mutual funds. The mutual funds pool these small amounts and purchase negotiable
CDs which can only be sold in minimum increments of $100,000, but which often are sold in
million dollar packages. Similarly, commercial paper often is sold only in minimum amounts of
$250,000. Therefore small investors can benefit in the returns and low risk which these assets
typically offer.




                                                 17
21.   What is negative externality? In what ways do the existence of negative externalities justify
      the extra regulatory attention received by financial institutions?

A negative externality refers to the action by one party that has an adverse affect on some third
party who is not part of the original transaction. For example, in an industrial setting, smoke
from a factory that lowers surrounding property values may be viewed as a negative externality.
For financial institutions, one concern is the contagion effect that can arise when the failure of
one FI can cast doubt on the solvency of other institutions in that industry.

22.   If financial markets operated perfectly and costlessly, would there be a need for financial
      intermediaries?

To a certain extent, financial intermediation exists because of financial market imperfections. If
information is available costlessly to all participants, savers would not need intermediaries to act
as either their brokers or their delegated monitors. However, if there are social benefits to
intermediation, such as the transmission of monetary policy or credit allocation, then FIs would
exist even in the absence of financial market imperfections.

23.   Why are FIs among the most regulated sectors in the world? When is net regulatory
      burden positive?

FIs are required to enhance the efficient operation of the economy. Successful financial
intermediaries provide sources of financing that fund economic growth opportunity that
ultimately raises the overall level of economic activity. Moreover, successful financial
intermediaries provide transaction services to the economy that facilitate trade and wealth
accumulation.

Conversely, distressed FIs create negative externalities for the entire economy. That is, the
adverse impact of an FI failure is greater than just the loss to shareholders and other private
claimants on the FI's assets. For example, the local market suffers if an FI fails and other FIs
also may be thrown into financial distress by a contagion effect. Therefore, since some of the
costs of the failure of an FI are generally borne by society at large, the government intervenes in
the management of these institutions to protect society's interests. This intervention takes the
form of regulation.

However, the need for regulation to minimize social costs may impose private costs to the firms
that would not exist without regulation. This additional private cost is defined as a net regulatory
burden. Examples include the cost of holding excess capital and/or excess reserves and the extra
costs of providing information. Although they may be socially beneficial, these costs add to
private operating costs. To the extent that these additional costs help to avoid negative
externalities and to ensure the smooth and efficient operation of the economy, the net regulatory
burden is positive.

24.   What forms of protection and regulation do regulators of FIs impose to ensure their safety
      and soundness?




                                                 18
Regulators have issued several guidelines to insure the safety and soundness of FIs:

a.    FIs are required to diversify their assets. For example, banks cannot lend more than 15
      percent of their equity to a single borrower.
b.    FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.
      In the case of banks, the Basle standards require a minimum core and supplementary
      capital of 8 percent of their risk-adjusted assets.
c.    Regulators have set up guaranty funds such as BIF for commercial banks, SIPC for
      securities firms, and state guaranty funds for insurance firms to protect individual investors.
d.    Regulators also engage in periodic monitoring and surveillance, such as on-site
      examinations, and request periodic information from the FIs.

25.   In the transmission of monetary policy, what is the difference between inside money and
      outside money? How does the Federal Reserve Board try to control the amount of inside
      money? How can this regulatory position create a cost for the depository financial
      institutions?

Outside money is that part of the money supply directly produced and controlled by the Fed, for
example, coins and currency. Inside money refers to bank deposits not directly controlled by the
Fed. The Fed can influence this amount of money by reserve requirement and discount rate
policies. In cases where the level of required reserves exceeds the level considered optimal by
the FI, the inability to use the excess reserves to generate revenue may be considered a tax or
cost of providing intermediation.

26.   What are some examples of credit allocation regulation? How can this attempt to create
      social benefits create costs to the private institution?

The qualified thrift lender test (QTL) requires thrifts to hold 65 percent of their assets in
residential mortgage-related assets to retain the thrift charter. Some states have enacted usury
laws that place maximum restrictions on the interest rates that can be charged on mortgages
and/or consumer loans. These types of restrictions often create additional operating costs to the
FI and almost certainly reduce the amount of profit that could be realized without such
regulation.

27.   What is the purpose of the Home Mortgage Disclosure Act? What are the social benefits
      desired from the legislation? How does the implementation of this legislation create a net
      regulatory burden on financial institutions?

The HMDA was passed by Congress to prevent discrimination in mortgage lending. The social
benefit is to ensure that everyone who qualifies financially is provided the opportunity to
purchase a house should they so desire. The regulatory burden has been to require a written
statement indicating the reasons why credit was or was not granted. Since 1990, the federal
regulators have examined millions of mortgage transactions from 8,300 institutions each
calendar quarter.




                                                 19
28.   What legislation has been passed specifically to protect investors who use investment
      banks directly or indirectly to purchase securities? Give some examples of the types of
      abuses for which protection is provided.

The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by
Congress to protect investors against possible abuses such as insider trading, lack of disclosure,
outright malfeasance, and breach of fiduciary responsibilities.

29.   How do regulations regarding barriers to entry and the scope of permitted activities affect
      the charter value of financial institutions?

The profitability of existing firms will be increased as the direct and indirect costs of establishing
competition increase. Direct costs include the actual physical and financial costs of establishing
a business. In the case of FIs, the financial costs include raising the necessary minimum capital
to receive a charter. Indirect costs include permission from regulatory authorities to receive a
charter. Again in the case of FIs this cost involves acceptable leadership to the regulators. As
these barriers to entry are stronger, the charter value for existing firms will be higher.

30.   What reasons have been given for the growth of investment companies at the expense of
      “traditional” banks and insurance companies?

The recent growth of investment companies can be attributed to two major factors:

a.    Investors have demanded increased access to direct securities markets. Investment
      companies and pension funds allow investors to take positions in direct securities markets
      while still obtaining the risk diversification, monitoring, and transactional efficiency
      benefits of financial intermediation. Some experts would argue that this growth is the
      result of increased sophistication on the part of investors; others would argue that the
      ability to use these markets has caused the increased investor awareness. The growth in
      these assets is inarguable.

b.    Recent episodes of financial distress in both the banking and insurance industries have led
      to an increase in regulation and governmental oversight, thereby increasing the net
      regulatory burden of “traditional” companies. As such, the costs of intermediation have
      increased, which increases the cost of providing services to customers.

31.   What are some of the methods which banking organizations have employed to reduce the
      net regulatory burden? What has been the effect on profitability?

Through regulatory changes, FIs have begun changing the mix of business products offered to
individual users and providers of funds. For example, banks have acquired mutual funds, have
expanded their asset and pension fund management businesses, and have increased the security
underwriting activities. In addition, legislation that allows banks to establish branches anywhere
in the United States has caused a wave of mergers. As the size of banks has grown, an expansion
of possible product offerings has created the potential for lower service costs. Finally, the




                                                 20
FuB
  ro
nct
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        emphasis in recent years has been on products that generate increases in fee income, and the
        entire banking industry has benefited from increased profitability in recent years.

        32.   What characteristics of financial products are necessary for financial markets to become
ion
  er          efficient alternatives to financial intermediaries? Can you give some examples of the
              commoditization of products which were previously the sole property of financial
              institutions?

 sa     Financial markets can replace FIs in the delivery of products that (1) have standardized terms, (2)

  g     serve a large number of customers, and (3) are sufficiently understood for investors to be
        comfortable in assessing their prices. When these three characteristics are met, the products

 of
  e
        often can be treated as commodities. One example of this process is the migration of over-the-
        counter options to the publicly traded option markets as trading volume grows and trading terms
        become standardized.

FIs
  fu    33.   In what way has Regulation 144A of the Securities and Exchange Commission provided an
              incentive to the process of financial disintermediation?

 n      Changing technology and a reduction in information costs are rapidly changing the nature of
        financial transactions, enabling savers to access issuers of securities directly. Section 144A of the
 ct     SEC is a recent regulatory change that will facilitate the process of disintermediation. The
        private placement of bonds and equities directly by the issuing firm is an example of a product
        that historically has been the domain of investment bankers. Although historically private
 io     placement assets had restrictions against trading, regulators have given permission for these
        assets to trade among large investors who have assets of more than $100 million. As the market

 n      grows, this minimum asset size restriction may be reduced.

        34.   Go to the Web site of the Federal Reserve Board and find the latest figures for M1, M2,
  •    A      and M3. By what percentage have these measures of the money supply grown over the
              past year? The web site is http://www.federalreserve.gov.
       c answer will depend on the date of the assignment. At the web site, click on “Research and
        The
                Click on              Releases
       tData.”Measures.” “Statistics:“Releases. and Historical Data.” Click on “H.6: Money Stock and
        Debt              Click on

       i35. Go to the Federal Reserve Boards website and find the latest figures for financial assets
              outstanding at various types of financial institutions. The web site is
       n http://www.federalreserve.gov
        At                                                          “Statistics: Releases and Historical
       g the web site, click onof“Research and Data.”theClick onStates, Releases.” Click on the most
        Data.” Click on “Flow Funds Accounts of             United
        recent date. Click on “Level Tables.” This downloads a file onto your computer that contains
        the relevant data.

       a
       s
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