Chapter 7

An Introduction to Financial Intermediaries and Risk

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Answers to Review Questions

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

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FIs provide two main services to the public. First, by buying the financial liabilities of net

borrowers, FIs provide borrowing opportunities for net borrowers. Secondly, FIs provide an array of financial claims and depository services to meet the needs of net lenders and society at large.

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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.

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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.

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2.“With financial intermediation, net lenders can earn a higher return on their surplus funds, and net borrowers can acquire funds at a lower cost.” Explain how this seemingly contradictory statement can be true. (Hint: Consider a risk-free return.)

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

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3.How are FIs like other firms? How are FIs similar to each other? How are they different?

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FIs are firms. They use inputs—sources of funds (net lenders) to extend loans to net borrowers 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.

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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 net lenders to net borrowers. 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.

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4.If an FI has mainly long-term liabilities with few payment uncertainties, in what type of assets is it most likely to invest? Why?

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If an FI has mainly long-term liabilities with few payment uncertainties, 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.

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

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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.

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6.Why do banks hold reserve assets?

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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 requiring banks to possess reserve assets equal to a certain percentage of checkable deposit liabilities.

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

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Contractual-type FIs have liabilities 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.

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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 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.

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Like life insurance companies, 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, 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, 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.

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

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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.

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

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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. This 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.

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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.

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

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

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11.How do money market mutual funds differ from mutual funds? How are money 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?

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It’s easier to answer this question by first defining a mutual fund. Mutual funds are financial intermediaries which pool the funds of net lenders (investors), purchase the financial claims of net borrowers (primarily stocks and bonds), and return the income received minus a management fee to the net lenders. 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 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.

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12.Would a property and casualty company hold municipal securities in its portfolio of assets? What about a credit union and a life insurance company? Why or why not?

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A casualty company is subject to the full corporate income tax and thus would 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.

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13.How can diversification reduce credit or default risk? In the event of widespread economic collapse will diversification always reduce this risk?

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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.

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

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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).

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

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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 1980s 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.

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16.Which FIs have deposit insurance? Depository institutions such as commercial

banks, S&Ls, savings banks, and credit unions have deposit insurance.

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17.What is a mutual savings bank?

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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 relieve 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.

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Answers to Analytical Questions

18.If a bank has assets of $100 million and liabilities of $95 million, what is its net worth? If 60 percent of its assets are loans, what percentage of the loans could go sour before the bank would lose all of its capital?

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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 capital and dividing that by the amount of loans. In this case $5 million/$60 million = 8.333%.

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19.Make a chart listing the main sources of funds (liabilities) and main uses of funds (assets) in order of importance for the following depository institutions: commercial banks, S&Ls, mutual savings banks, and credit unions. Describe how the sources and uses of funds have changed through the years for the various depository institutions.

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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

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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

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

deposits Credit 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

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

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20.What type of risk does each of the following situations portray?

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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.

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