chapter 4 financial intermediaries

8/2/2019 Chapter 4 Financial Intermediaries

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Chapter 4

Financialintermediaries


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Financialintermediaries

Deposit takinginstitutions

Non-deposit takinginstitutions

Commercial banks and theso-called thrift institutions

(thrifts) such as savings andloan associations, mutualsavings banks, and creditunions

Contractualsavings institutionssuch as insurance

companies andpension funds

InvestmentIntermediaries

including financecompanies, mutualfunds, and money

market mutualfunds


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Basic BankingCash Deposit

Opening of a checking account leads to anincrease in the banks reserves equal to the

increase in checkable deposits

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault

Cash

+$100 Checkable

deposits

+$100 Reserves +$100 Checkable

deposits

+$100


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Basic BankingCheckDeposit

When a bank receives

additional deposits, it

gains an equal amount of reserves;

when it loses deposits,

it loses an equal amount of reserves

First National Bank Second National Bank


Reserves +$100 Checkabledeposits

+$100 Reserves -$100 Checkabledeposits

-$100

First National Bank

Assets Liabilities

Cash itemsin process

of collection

+$100 Checkabledeposits

+$100


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Basic BankingMaking a Profit

Asset transformation-selling liabilities with one set of

characteristics and using the proceeds to buy assetswith a different set of characteristics

The bank borrows short and lends long

First National Bank Second National Bank


Requiredreserves


+$100 Requiredreserves


+$100

Excessreserves

+$90 Loans +$90


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How do commercial banks

manage their liquidity,assets, and liabilities?


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Liquidity Management:Ample Excess Reserves

If a bank has ample excess reserves, a

deposit outflow does not necessitate changesin other parts of its balance sheet


Reserves $20M Deposits $100M Reserves $10M Deposits $90M

Loans $80M BankCapital

$10M Loans $80M BankCapital

$10M

Securities $10M Securities $10M


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Liquidity Management:Shortfall in Reserves

Reserves are a legal requirement and the

shortfall must be eliminatedExcess reserves are insurance against the

costs associated with deposit outflows


Reserves $10M Deposits $100M Reserves $0 Deposits $90M

Loans $90M BankCapital

$10M Loans $90M BankCapital

$10M

Securities $10M Securities $10M


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Liquidity Management:Borrowing

Cost incurred is the interest rate paid on the

borrowed funds

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Borrowing $9MSecurities $10M Bank Capital $10M


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Liquidity Management:Securities Sale

The cost of selling securities is the brokerage

and other transaction costs

Assets Liabilities


Loans $90M Bank Capital $10MSecurities $1M


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Liquidity Management:Federal Reserve

Borrowing from the Fed also incurs interest

payments based on the discount rate

Assets Liabilities


Loans $90M Borrow from Fed $9MSecurities $10M Bank Capital $10M


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Liquidity Management: ReduceLoans

Reduction of loans is the most costly way ofacquiring reserves

Calling in loans antagonizes customers

Other banks may only agree to purchase loans at asubstantial discount

Assets Liabilities


Loans $81M Bank Capital $10MSecurities $10M


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Asset Management: ThreeGoals

Seek the highest possible returnson loans and securities

Reduce risk

Have adequate liquidity


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Asset Management: FourTools

Find borrowers who will pay highinterest rates and have lowpossibility of defaulting

Purchase securities with highreturns and low risk

Lower risk by diversifying

Balance need for liquidity againstincreased returns from less liquidassets


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Liability Management

Recent phenomenon due to rise ofmoney center banks

Expansion of overnight loanmarkets and new financialinstruments (such as negotiableCDs)

Checkable deposits havedecreased in importance as sourceof bank funds


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Savings and Loan Associations

Chartered by the federal government or bystates

Most are members of Federal Home LoanBank System (FHLBS)

Deposit insurance provided by SavingsAssociation Insurance Fund (SAIF), part ofFDIC

Regulated by the Office of Thrift Supervision

Assets Liabilities

- Mortgage loans forresidential housing

- Becoming more diversified

Savings deposits (often calledshares) and time and checkabledeposits


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Mutual Banks

Approximately half are chartered by states

Regulated by state in which they are located

Deposit insurance provided by FDIC or state

insurance

Assets Liabilities

- Mortgage loans forresidential housing

- Becoming more diversified

Savings deposits (often calledshares) and time and checkabledeposits


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Credit Unions

Tax-exempt

Chartered by federal government or by states

Regulated by the National Credit UnionAdministration (NCUA)

Deposit insurance provided by National CreditUnion Share Insurance Fund (NCUSIF)

Assets Liabilities

Consumer loans Deposits called shares


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Life insurance companies

Organized in two forms: as stockcompanies or as mutuals.

Regulated by the states

Holding long-term assets that are notparticularly liquidcorporate bonds andcommercial mortgages as well as somecorporate stock

Two principal forms of life insurancepolicies: permanent life insurance (suchas whole, universal, and variable life)

and temporary insurance (such as term)


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Property and CasualtyInsurance Companies

o Very much like life insurance companieso Having a greater possibility of loss of

funds if major disasters occur

Buy more liquid assets than lifeinsurance companies do.

o Their largest holding of assets ismunicipal bonds; they also hold

corporate bonds and stocks andgovernment securities


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Pension Funds and GovernmentRetirement Funds

Acquired by contributions fromemployers or from employees

The largest asset holdings ofpension funds are corporate bondsand stocks


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Finance companies

Raising funds by selling commercial paper (ashort-term debt instrument) and by issuingstocks and bonds

Lending these funds to consumers, whomake purchases of such items as furniture,automobiles, and home improvements, and to

small businessesSome finance companies are organized by a

parent corporation to help sell its product


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Finance companies (contd)

Finance companies

Salesfinance

companies

Consumerfinance

companies

Businessfinance

companies


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Mutual funds

Acquiring funds by selling shares to manyindividuals and use the proceeds to

purchase diversified portfolios of stocksand bonds

The value of mutual fund sharesfluctuates greatly

Investments in mutual funds can be risky


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Money Market Mutual Funds

Having the characteristics of amutual fund but also function to

some extent as a depositoryinstitution


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Hedge funds

A special type of mutual fundLike mutual funds, hedge funds accumulate

money from many people and invest on their

behalfDistinction:

Hedge funds have a minimum investmentrequirement between $100,000 and $20 million

Hedge funds usually require that investors committheir money for long periods of time, often severalyears


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Investigate the structure of financialintermediaries in the UK and other

European countries.

chapter 4 financial intermediaries

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