2. 1-2Why Are Financial
Intermediaries Special?
Objectives:
Develop the tools needed to measure and
manage the risks of FIs.
Explain the special role of FIs in the financial
system and the functions they provide.
Explain why the various FIs receive special
regulatory attention.
Discuss what makes some FIs more special
than others.
4. 1-4
FIs’ Specialness
Without FIs: Low level of fund flows.
Information costs:
Economies of scale reduce costs for FIs to screen
and monitor borrowers
Less liquidity
Substantial price risk
6. 1-6
Functions of FIs
Brokerage function
Acting as 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
• Transformation of financial risk
7. 1-7
Role of FIs in Cost Reduction
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
FI as information producer
• Monitoring power and control
• Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders
8. 1-8
Specialness of FIs
Liquidity and Price Risk
Secondary claims issued by FIs have less price
risk
FIs have advantage in diversifying risks
Reduced transaction & information costs
economies of scale
Bid-ask spreads narrower for assets bought and
sold in large quantities.
9. 1-9
Other Special Services
Maturity intermediation
Transmission of monetary policy.
Credit allocation (Areas of special need such as
home mortgages).
Intergenerational transfers or time
intermediation.
Payment services (FedWire and CHIPS).
Denomination intermediation.
10. 1-10
Specialness and Regulation
FIs receive special regulatory attention.
Reasons:
Special services provided by FIs in general.
Institution-specific functions such as money
supply transmission (banks), credit allocation
(thrifts, farm banks), payment services
(banks,thrifts), etc.
Negative externalities arise if these services are
not provided.
11. 1-11
Regulation of FIs
Important features of regulatory policy:
Protect ultimate sources and users of savings.
Including prevention of unfair practices such as
redlining and other discriminatory actions.
Primary role:
Ensure soundness of the system as a whole.
Regulation is not costless
Net regulatory burden.
12. 1-12
Regulation
Safety and soundness regulation:
Regulations to increase diversification
No more than 10 percent of equity to single borrower
Minimum capital requirements
Guaranty funds:
Deposit insurance fund (DIF):
Securities Investors Protection Fund (SIPC)
Monitoring and surveillance.
FDIC monitors and regulates DIF participants.
13. 1-13
Web Resources
For information on regulation of depository
institutions and investment firms visit:
FDIC www.fdic.gov
SIPC www.sipc.org
Federal Reserve www.federalreserve.gov
14. 1-14
Regulation
Monetary policy regulation
Federal Reserve directly controls outside
money.
Bulk of money supply is inside money
(deposits).
Reserve requirements facilitate transmission of
monetary policy.
15. 1-15
Regulation
Credit allocation regulation
Supports socially important sectors such as
housing and farming.
Requirements for minimum amounts of assets in a
particular sector or maximum interest rates or fees.
Qualified Thrift Lender Test (QTL)
• 65 percent of assets in residential mortgages
Usury laws and Regulation Q (abolished)
16. 1-16
Regulation
Consumer protection regulation
Community Reinvestment Act (CRA).
Home Mortgage Disclosure Act (HMDA).
Effect on net regulatory burden
FFIEC processed info on as many as 31 million
mortgage transactions in 2006.
Potential extensions of regulations such as
CRA to other FIs such as insurance
companies in light of consolidation and
trend toward universal banking.
17. 1-17
Regulation
Investor protection regulation
Protections against abuses such as insider
trading, lack of disclosure, malfeasance, breach
of fiduciary responsibility.
Key legislation
Securities Acts of 1933, 1934.
Investment Company Act of 1940.
18. 1-18
Regulation
Entry regulation
Level of entry impediments affects profitability
and value of charter.
Regulations define scope of permitted activities.
Financial Services Modernization Act of 1999.
Affects charter value and size of net regulatory
burden.
19. 1-19
Web Resources
For more information on regulation of
depository institutions visit:
www.ffiec.gov
www.federalreserve.gov
www.fdic.gov
www.occ.treas.gov
20. 1-20
Changing Dynamics of Specialness
Trends in the United States
Decline in share of depository institutions.
Increases in investment companies.
May be attributable to net regulatory burden
imposed on depository FIs.
Financial Services Modernization Act
Ethics issues and weakening of public trust
21. 1-21
Future Trends
Further weakening of public trust and
confidence in FIs may encourage
disintermediation
Increased merger activity within and across
sectors
Citicorp and Travelers, UBS and Paine Webber
More large scale mergers such as J.P. Morgan
and Chase, and Bank One
Growth in Online Trading
Amendment of SEC 144A
Private placement market effects
23. 1-23
Global Issues
Increased competition from foreign FIs at
home and abroad
Mergers involving world’s largest banks
Mergers blending together previously
separate financial services sectors
24. 1-24
World’s Largest Banks ($Billions)
Bank Assets
Barclays Bank (UK) 1,591.5
UBS (Switzerland) 1,567.6
Mitsubishi UFJ (Japan) 1,508.5
HSBC Holdings (UK) 1,502.0
Citigroup (USA) 1,494.0
BNP Paribas (France) 1,484.1
Credit Agricole Groupe (France) 1,380.6
Royal Bank of Scotland (UK) 1,337.5
Bank of America (USA) 1,291.8
25. 1-25
Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co. Institute
OCC
SEC
SIPC
Wall Street Journal
Thompson Fin. Sec. Data
www.thebanker.com
www.federalreserve.gov
www.fdic.gov
www.ffiec.gov
www.ici.com
www.occ.treas.gov
www.sec.gov
www.sipc.org
www.wsj.com
www.thompson.com
Notes de l'éditeur
The S&L debacle of 1980s was linked to inadequate diversification of S&Ls, especially in the oil based economies of the Southwest.
Agriculture, small businesses and home ownership in particular, have received special treatment in terms of loan subsidies and guarantees and other liquidity improving activities. One of the key impediments to allowing non-FIs to act as banks, has been the fear of allowing non-FIs to gain access to the payment system. The arguments remain compelling even though some non-FIs have made inroads into the traditional business lines of banks in particular. Protection of the payment system is paramount, in terms of the role of FI regulators.
The CRA has been widely criticized as imposing a greater regulatory burden than the sum of any social benefits. Hedge funds are also coming under far greater scrutiny since the Long Term Capital Management crisis.
Regulations affecting the scope of activities vary widely across countries. New Zealand for example, has historically had very few restrictions. Most countries however, are reluctant to allow the commingling of industrial and banking activities due to the inherent risks to the banking system and the potential for cross subsidization of the industrial activities by the bank.