Lecture II- Financial

Market
FUNCTIONS OF FINANCIAL
INTERMEDIARIES: INDIRECT
FINANCE
Financial Intermediation
⮚ The Process of indirect finance using financial
intermediaries.
⮚ Is the primary route for moving funds from
lenders to borrowers.
Why are financial intermediaries and indirect finance so important
in financial markets?

To answer this question, we need to understand the role of transaction

costs, risk sharing, and information costs in financial markets

1. Transaction Costs
Transaction costs, the time and money spent in carrying out financial
transactions, are a major problem for people who have excess funds to lend.
Example: Carl the carpenter needs 1,000 for his new tool, and you know that it is an
excellent investment opportunity. You have the cash and would like to lend him the money,
but to protect your investment, you have to hire a lawyer to write up the loan contract that
specifies how much interest Carl will pay you, when he will make these interest payments,
and when he will repay you the 1,000. Obtaining the contract will cost you 500. When you
figure in this transaction cost for making the loan, you realize that you can’t earn enough
from the deal (you spend 500 to make perhaps 100) and reluctantly tell Carl that he will have
to look elsewhere. This example illustrates that small savers like you or potential borrowers
like Carl might be frozen out of financial markets and thus be unable to benefit from them.
Can anyone come to the rescue? Financial intermediaries can.
2.Risk Sharing
❖ Another benefit made possible by the low transaction costs of financial institutions is that
they can help reduce the exposure of investors to risk—that is, uncertainty about the
returns investors will earn on assets. Financial intermediaries do this through the process
known as risk sharing: They create and sell assets with risk characteristics that people are
comfortable with, and the intermediaries then use the funds they acquire by selling these
assets to purchase other assets that may have far more risk.
❖ Low transaction costs allow financial intermediaries to share risk at low cost, enabling them
to earn a profit on the spread between the returns they earn on risky assets and the
payments they make on the assets they have sold. This process of risk sharing is also
sometimes referred to as asset transformation because, in a sense, risky assets are
turned into safer assets for investors
❖ Financial intermediaries also promote risk sharing by helping individuals to diversify and
thereby lower the amount of risk to which they are exposed. Diversification entails
investing in a collection (portfolio) of assets whose returns do not always move together,
with the result that overall risk is lower than for individual assets. (Diversification is just
another name for the old adage, “You shouldn’t put all your eggs in one basket.”)
3.Asymmetric Information: Adverse Selection and Moral
Hazard
❖ An additional reason is that in financial markets, one party often does not know
enough about the other party to make accurate decisions. This inequality is called
asymmetric information.
***For example, a borrower who takes out a loan usually has better information
about the potential returns and risks associated with the investment projects for which
the funds are earmarked than the lender does. Lack of information creates problems
in the financial system both before and after the transaction is entered into.

❖ Adverse selection is the problem created by asymmetric information before the

transaction occurs. Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an undesirable (adverse)
outcome—the bad credit risks—are the ones who most actively seek out a loan
and are thus most likely to be selected. Because adverse selection makes it more
likely that loans might be made to bad credit risks, lenders may decide not to make
any loans even though good credit risks exist in the marketplace
To understand why adverse selection occurs, suppose that you have two aunts to whom you
might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a conservative type who
borrows only when she has an investment she is quite sure will pay off. Aunt Sheila, by
contrast, is an inveterate gambler who has just come across a get-rich-quick scheme that will
make her a millionaire if she can just borrow 1,000 to invest in it. Unfortunately, as with most
get-rich-quick schemes, the probability is high that the investment won’t pay off and that Aunt
Sheila will lose the 1,000. Which of your aunts is more likely to call you to ask for a loan? Aunt
Sheila, of course, because she has so much to gain if the investment pays off. You, however,
would not want to make a loan to her because the probability is high that her investment will
turn sour and she will be unable to pay you back. If you knew both your aunts very well—that
is, if your information were not asymmetric—you wouldn’t have a problem because you would
know that Aunt Sheila is a bad risk and so you would not lend to her. Suppose, though, that
you don’t know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt Louise
because Aunt Sheila would be hounding you for the loan. Because of the possibility of
adverse selection, you might decide not to lend to either of your aunts, even though there are
times when Aunt Louise, who is an excellent credit risk, might need a loan for a worthwhile
investment.
Moral hazard
❖ is the problem created by asymmetric information after the transaction occurs. Moral
hazard in financial markets is the risk (hazard) that the borrower might engage in
activities that are undesirable (immoral) from the lender's point of view because they
make it less likely that the loan will be paid back. Because moral hazard lowers the
probability that the loan will be repaid, lenders may decide that they would rather not
make a loan.
❖ As an example of moral hazard, suppose that you made a 1,000 loan to another relative,
Uncle Melvin, who needs the money to purchase a computer so that he can set up a
business typing students’ term papers. Once you have made the loan, however, Uncle
Melvin is more likely to slip off to the track and play the horses. If he bets on a 20-to-1
long shot and wins with your money, he is able to pay back your 1,000 and live high off
the hog with the remaining 19,000. But if he loses, as is likely, you don’t get paid back,
and all he has lost is his reputation as a reliable, upstanding uncle. Uncle Melvin
therefore has an incentive to go to the track because his gains (19,000) if he bets
correctly are much greater than the cost to him (his reputation) if he bets incorrectly. If
you knew what Uncle Melvin was up to, you would prevent him from going to the track,
and he would not be able to increase the moral hazard. However, because it is hard for
you to keep informed about his whereabouts—that is, because information is asymmetric
—there is a good chance that Uncle Melvin will go to the track and you will not get paid
back. The risk of moral hazard might therefore discourage you from making the 1,000
loan to Uncle Melvin, even if you were sure that you would be paid back if he used it to
set up his business.
Type of Financial
Intermediaries
Three Categories:

1. DEPOSITORY INSTITUTIONS (BANKS)

2. CONTRACTUAL SAVINGS INSTITUTIONS
3. INVESTMENT INTERMEDIARIES
 Depository Institutions
Depository institutions (for simplicity, we refer to these as banks throughout this text)
are financial intermediaries that accept deposits from individuals and institutions and
make loans. These institutions include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual savings banks, and credit
unions

Commercial Banks
These financial intermediaries raise funds primarily by issuing checkable
deposits (deposits on which checks can be written), savings deposits
(deposits that are payable on demand but do not allow their owner to write
checks), and time deposits (deposits with fixed terms to maturity). They then
use these funds to make commercial, consumer, and mortgage loans and to
buy U.S. government securities and municipal bonds. Around 5,000
commercial banks are found in the United States, and as a group, they are
the largest financial intermediary and have the most diversified portfolios
(collections) of assets.
Depository Institutions
Savings and Loan Associations (S&Ls) and Mutual
Savings Banks
These depository institutions, of which there are
approximately 900, obtain funds primarily through savings
deposits (often called shares) and time and checkable
deposits. In the past, these institutions were constrained in
their activities and mostly made mortgage loans for
residential housing. Over time, these restrictions have been
loosened so the distinction between these depository
institutions and commercial banks has blurred. These
intermediaries have become more alike and are now more
competitive with each other
I. Depository Institutions

Credit Unions
These financial institutions, numbering about 7,000, are
typically very small cooperative lending institutions
organized around a particular group: union members,
employees of a particular firm, and so forth. They acquire
funds from deposits called shares and primarily make
consumer loans
 II. Contractual Savings Institutions
Contractual savings institutions, such as insurance companies and pension funds,
are financial intermediaries that acquire funds at periodic intervals on a contractual
basis. Because they can predict with reasonable accuracy how much they will have to
pay out in benefits in the coming years, they do not have to worry as much as
depository institutions about losing funds quickly. As a result, the liquidity of assets is
not as important a consideration for them as it is for depository institutions, and they
tend to invest their funds primarily in long-term securities such as corporate bonds,
stocks, and mortgages

Life Insurance Companies

Life Insurance Companies Life insurance companies insure people against
financial hazards following a death and sell annuities (annual income
payments upon retirement). They acquire funds from the premiums that
people pay to keep their policies in force and use them mainly to buy
corporate bonds and mortgages. They also purchase stocks but are
restricted in the amount that they can hold. Currently, with $6.4 trillion in
assets, they are among the largest of the contractual savings institutions
 Contractual Savings Institutions
Fire and Casualty Insurance Companies
These companies insure their policyholders against loss from theft, fire, and
accidents. They are very much like life insurance companies, receiving funds through
premiums for their policies, but they have a greater possibility of loss of funds if major
disasters occur. For this reason, they use their funds to buy more liquid assets than
life insurance companies do. Their largest holding of assets consists of municipal
bonds; they also hold corporate bonds and stocks and U.S. government securities

Pension Funds and Government Retirement Funds Private

pension funds and state and local retirement funds provide retirement income
in the form of annuities to employees who are covered by a pension plan.
Funds are acquired by contributions from employers and from employees, who
either have a contribution automatically deducted from their paychecks or
contribute voluntarily. The largest asset holdings of pension funds are
corporate bonds and stocks. The establishment of pension funds has been
actively encouraged by the federal government, both through legislation
requiring pension plans and through tax incentives to encourage contributions.
 III. Investment Intermediaries
This category of financial intermediaries includes finance companies, mutual funds,
money market mutual funds, and investment banks

Finance Companies
Finance companies raise funds by selling commercial paper (a
short-term debt instrument) and by issuing stocks and bonds. They
lend these funds to consumers (who make purchases of such items
as furniture, automobiles, and home improvements) and to small
businesses. Some finance companies are organized by a parent
corporation to help sell its product. For example, Ford Motor Credit
Company makes loans to consumers who purchase Ford
automobiles
III. Investment Intermediaries
Mutual Funds
These financial intermediaries acquire funds by selling shares to
many individuals and use the proceeds to purchase diversified
portfolios of stocks and bonds. Mutual funds allow shareholders to
pool their resources so that they can take advantage of lower
transaction costs when buying large blocks of stocks or bonds. In
addition, mutual funds allow shareholders to hold more diversified
portfolios than they otherwise would. Shareholders can sell
(redeem) shares at any time, but the value of these
shares will be determined by the value of the mutual
fund’s holdings of securities. Because these fluctuate
greatly, the value of mutual fund shares does, too;
therefore, investments in mutual funds can be risky.
 III. Investment Intermediaries
Money Market Mutual Funds
These financial institutions have the characteristics of a mutual fund but
also function to some extent as a depository institution because they
offer deposit-type accounts. Like most mutual funds, they sell shares to
acquire funds that are then used to buy money market instruments that
are both safe and very liquid. The interest on these assets is paid out to
the shareholders. A key feature of these funds is that shareholders can
write checks against the value of their shareholdings. In effect, shares in
a money market mutual fund function like checking account deposits
that pay interest. Money market mutual funds have experienced
extraordinary growth since 1971, when they first appeared. By the end
of 2015, their assets had climbed to nearly $2.7 trillion
 III. Investment Intermediaries
Hedge Funds
Hedge funds are a type of mutual fund with special
characteristics. Hedge funds are organized as limited
partnerships with minimum investments ranging from $100,000
to, more typically, $1 million or more. These limitations mean
that hedge funds are subject to much weaker regulation than
other mutual funds. Hedge funds invest in many types of
assets, with some specializing in stocks, others in bonds,
others in foreign currencies, and still others in far more exotic
assets.
 III. Investment Intermediaries
Investment Banks
Despite its name, an investment bank is not a bank or a
financial intermediary in the ordinary sense; that is, it does not
take in deposits and then lend them out. Instead, an
investment bank is a different type of intermediary that helps a
corporation issue securities. First it advises the corporation on
which type of securities to issue (stocks or bonds); then it helps
sell (underwrite) the securities by purchasing them from the
corporation at a predetermined price and reselling them in the
market. Investment banks also act as deal makers and earn
enormous fees by helping corporations acquire other
companies through mergers or acquisitions
Regulation of
Financial System
Thank you…