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The main purpose of this chapter is to
introduce financial intermediaries.
Financial intermediaries include:
Savings and loan Associations
Their main function is inexpensive inflow of
money from savers to investors/borrowers.
Business entities include nonfinancial and
financial enterprises. Nonfinancial enterprises
provide following services:
Nonfinancial enterprises manufacture products or
provide nonfinancial services
Financial enterprises provide following
1. Transforming financial assets acquired through
the market and transforming them into different
and most widely used asset.
2. Exchanging the financial asset on behalf of
Exchanging the financial asset on their own
Assisting in the creation of FA for their customers
and then selling those FA to other market
Providing investment advise
Managing the portfolios of other market
Financial Intermediaries also include depository
institutions (commercial banks, savings and loan
associations, savings bank and credit unions)
which acquire bulk of their funds by offering
their liabilities to their customers in the form of
deposits; insurance companies; pension funds;
and finance companies.
Financial intermediaries also provide services
like underwriting, brokers and dealers.
Typically the FI that provide underwriting services also provide
Some nonfinancial enterprises also have subsidiaries that
provide financial services. These FI are also called Captive
Finance Companies. For example General Motors acceptance
corporation (a subsidiary of GM).
It means that GM have a subsidiary that provide financing to its
General Electric has a subsidiary called General Electric Credit
FI obtain funds by issuing financial claims
against themselves to market participants and
then invest those funds.
The investment made by FI can be loan or
security. These investments are called direct
The participants who hold those financial claims
have said to made indirect investment.
Example: Commercial Banks, Investment
Companies (Pooling of Funds). (See book pg. 16)
FI provide four basic functions:
1. Maturity Intermediation: In our example of
commercial banks two things should be
The maturity of at least a portion of the
deposits accepted is typically short term.
(certain types of deposits are payable on
demand and others have specific maturity
date, but most are less than two years).
Maturity of the loans made by the commercial
banks may be considerably longer than two years.
(If the Commercial Bank is absent then what will
The commercial bank by issuing it own financial
claim in essence transforms a longer-term asset
into a shorter-term one by giving the borrower
a loan for the length of the time sought and the
investor/depositor a FA for the desired
investment horizon. This function of Financial
Intermediary is called maturity intermediation.
Reducing Risk via Diversification: FI convert
more risky funds into less risky funds.
Reducing the costs of contracting and
information processing: Investors purchasing
FA should take time to develop skills necessary
to understand how to evaluate an investment.
Once skills are developed, investors should apply
those skills to the analysis of specific FA that are
candidates for purchase (or subsequent sale).
Investors who want to make a loan to a
consumer or business will need to write the
loan contract (or hire an attorney to do so).
In addition to the opportunity cost of time to
process the information about the FA and its
issuer, there is cost of acquiring this
information. All these costs are called
information processing costs.
Providing a payment mechanism: Although
most transactions made today are not done
Instead payments are made using
checks, credit cards, debit cards, and the
electronic transfer of funds. These methods of
making payments is called payment
mechanisms, are provided by certain
To know why managers of FI invest in
particular types of Financial Assets and the
types of investment strategies they employ.
The nature of the liability dictates which strategy is
Depository institutions buy money and sell money.
Banks BUY money by borrowing from depositors or
other sources of funds.
And they SELL money by lending it to businesses
The difference between the buying and selling value
is called SPREAD.
The cost of the funds and the return on the funds
sold is expressed in terms of interest rate per unit of
By liabilities of FI we mean the amount and timing
of the cash outlays that must be made to satisfy the
contractual terms of the obligations issued.
The liabilities of any FI can be categorized according
to four types, mentioned below:
Amount of Cash
Timings of Cash
Both the amount and timings are known with certainty.
Example: a liability requiring FI to pay $50,000 six
months from now will be a good example. (Principal +
Interest). Where interest rate is always fixed.
Type I liabilities are not just sold by depository
institutions but also by life insurance companies.
EXAMPLE: Life insurance companies have obligation to
fulfill under this contract for some of money called
PREMIUM, it will guarantee an interest rate up to some
specified maturity date.
In type II liabilities the amount of the cash
outlay is known, but the timings are uncertain.
EXAMPLE: Life insurance policy. (will be
discussed in chapter 7).
In this type for an annual premium, a life
insurance company agrees to make specified
$$ payment to the policy beneficiaries/holders
upon the death of the insured.
In this type timing of the cash outlay is known but
the amount is uncertain.
EXAMPLE: FI issue an obligation in which the
interest rate adjusts periodically according to
some interest rate benchmark.
Depository Institutions issues:
CD: Have stated maturity and Interest rate fluctuate over the
life of the deposit.
3-years floating rate certificate of deposit: Interest rate adjusts
every 3-months and is benchmarked against the Treasury Bill
rate plus 1 percentage point. And matures after 3 years.
There are numerous insurance products and pension
obligations that present uncertainty to both the amount
and the timings of the cash outlay.
EXAPMPLE: Automobile and home insurance policies
in which amount/payment and timings are uncertain.
Also retirement benefits depends on the total number of
employment years and this will affect the cash outlay.
Because of the uncertainty about the timings
and amount of the cash outlays, a FI must be
prepared to fulfill/satisfy the financial
EXAMPLE: If the depositor request the
withdrawal of the funds prior of the maturity
date. The deposit accepting institution will
grant this request will take an early
In certain type of investment companies the
shareholders have the right to redeem their
shares at any time.
Regulations and Taxation: Numerous
regulations ad tax considerations influence the
investment policies that FI pursue.
Categorization of Financial Innovation:
Since 1960s there is significant surge in
Financial Innovation. Here are just 3 ways to
categorize the innovations suggested by
Economic Council of Canada.
Market Broadening Instruments: which increase
the liquidity of the markets and the availability of
the funds by attracting new investors and offering
new opportunities for the borrowers.
Risk Management Instruments: which relocate
financial risk to those who are less averse to them
or who have better diversification.
Arbitraging Instruments and Processes: which
enable the investors and borrowers to take
advantage of the differences in cost and return
between markets, which reflect differences in the
perception of the risk, as well as in information,
taxations and regulations.