1、1FinancialIntermediationWritten by: Fang Xiao 方晓 201048950203 Finish Date: Dec 9, 20112Contents1 Introduction12 The Process of financial intermediation22.1 The nature and classification of financial intermediation22.2 The functions of financial intermediation.32.3 The position of financial intermedi
2、ation in economy.32.4 The operation process of financial intermediation32.5 Risk control of financial intermediation.33 Deposit-taking financial intermediaries43.1 Introduction to deposit-taking financial intermediaries43.2 Commercial banks facilitate the transfer of liquidity.4 4 Non-deposit-taking
3、 financial intermediaries64.1 Introduction to non-deposit-taking financial intermediaries64.2 Insurance companies facilitate the transfer of liquidity.65 Conclusions.86 References.931 IntroductionThis essay will describe the process of financial intermediation and how the deposit-taking and non-depo
4、sit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units in the economy.In recent years numerous studies have demonstrated the finance, financial intermediation and economic growth is closely linked. In a market economy, the transformation process from s
5、avings to investment is around financial intermediaries, and financial intermediation is the basic transformation process arrangement of saving-investment system. This makes financial intermediation became the center of the economic growth. Financial intermediaries get money from consumer (surplus u
6、nits) and lent money to invest enterprise (deficit units). Essentially, the financial intermediation is the basic transformation process arrangement of surplus-deficit system. However, more fundamental problems such as why financial intermediation exists, why financial intermediary so popular and ho
7、w they facilitate the transfer of liquidity from surplus to deficit units will be explained and discussed in this paper.We will illustrate on the financial intermediation (key in the commercial banks and insurance companies) in savings, investment in the process of transformation function and differ
8、ent kinds of financial intermediaries influence on financing.2 The Process of financial intermediation2.1 The nature and classification of financial intermediationWhen talk about the process of financial intermediation, we should define what financial intermediation is. Freixas insert a third party
9、between the final borrowers and final lenders. If we make a conclusion about what is financial intermediation, I think we could define it like this: Any person or organization who acts as a bridge or intermediary between surplus units (savers) and deficit units (borrowers) in the financial market fi
10、nancing process.The classification of financial intermediation is usually based on if the intermediary takes deposit or not. So we can briefly divide financial intermediation into two types: deposit-takers and non-deposit-takers. Deposit-takers include 4Commercial banks, Finance houses etc. and non-
11、deposit-takers include Insurance companies, Pension funds etc. 2.2 The functions of financial intermediationFinancial intermediation has varieties of functions in economy. Generally, it acts as transactor who bringing together surplus and deficit units, and transform the funds properly in order to t
12、he varying needs of both sides.Further functions: produce liquidity for economies, keep investment safe, and make financing more simply and convenient.Financial intermediaries perform gradually more flexible functions in the modern more and more complex economy. Despite the ongoing perfection, indic
13、ating a declining price of information, asymmetric information and transaction costs seem to be still important elements in intermediation processes. This suggests that there is something extra that is relevant for financial intermediation. I consider that risk management has become a prominent func
14、tion of financial intermediation. 2.3 The position of financial intermediation in economyBecause financial markets are not perfect, financial intermediaries make savers and investors have the perfect information to find each other directly, immediately and without any obstacles, so with less cost. F
15、inancial intermediaries have functions on market transparency and efficiency. Therefore, despite globalization, the information revolution and a much more prominent role of public markets, financial intermediaries appear to survive. Financial intermediaries become more and more important in economy
16、as time goes by.2.4 The operation process of financial intermediationIt is important to know that what savers and borrowers needs before we discuss the operation process of financial intermediation. Their needs are usually different, for example, savers want to minimize risks while borrowers dont mi
17、nd risks that much, another two things that mattered are term and return. Savers will prefer short-term facilities and high rate of return, whereas borrowers prefer long-term and low-cost funds. How to balance them? So financial intermediaries come, they intermediate between savers and borrowers and
18、 make their efforts to satisfied savers and borrowers. Financial intermediaries issue financial claims on themselves to savers and 5obtain funds to lend directly to borrowers (sometimes financial intermediaries also use funds to do investment). During this procession, financial intermediaries actual
19、ly created assets for savers and liabilities for borrowers, and intermediaries will gain some profit from this kind of financial activity.We can simply describe it as the following graph: Direct/ FinancingIndirect financing(Savers) (Borrowers)Fig.1. the operation process of financial intermediation
20、(Source: Barth et al., 1997).After seeing this graph, we can learn how does financial intermediaries works. Surplus units can lend their excess funds to deficit units by financial intermediaries.First, a surplus unit lends to a financial intermediary, or acquires a financial claim on it; and then fi
21、nancial intermediaries lend the money to deficit units by financing. During this process the financial intermediary usually act as principal. The financial intermediary gets a financial claim on the ultimate borrower (deficit unit). In fact there can be many financial intermediaries involved in this
22、 process. For instance, a unit trust buys shares in an investment trust company, and savers can buy the claims of the unit trust.Financial claims is the most popular thing that financial intermediation used to make funds flowed from surplus to deficit units. In direct lending, when financial claims
23、can be issued and sold on to other investors, liquidity of financial markets will be best met. And borrowers dont need to get cash. But lenders may undertake the market risk. Usually direct lending need liquidity of financial markets, but the liquidity may disturb by risk, term and amount etc.Furthe
24、rmore, an investor who will have neither capital gains nor losses if he or she lends through a deposit-taking financial intermediary like bank, building society, finance company or national savings bank, that have fixed money terms claims. And non-deposit-takers do not offer the liquidity and money
25、certainty that the deposit-takers do; we will discuss this question on the chapter3. 2.5 Risk control of financial intermediationFinancial intermediation can eliminate risks from a financial transaction, or at least substantially reduced, though risk transfer. Other market participants can buy or se
26、ll financial claims representing a portion of the state contingent payoffs to diversify or Surplus unitsFinancial intermediariesDeficit units6concentrate the risk in their portfolios. This is achieved through separate contracts offsetting certain state contingent payoffs such as swaps, or by the iss
27、uance of financial contracts which leaves some of the inherent risk of the transaction with the other party. Adjustable rate lending is a case in point. A theory of intermediation based on participation costs is thus consistent with the fact that intermediaries trade risk and undertake risk manageme
28、nt to such a large extent. See Santomero (1995b) and Babbel and Santomero (1996). By creating products with stable distributions of cash flows they can lower participation costs for their customers. In extreme cases this may involve creating low risk debt, but even with more risky securities the sta
29、bility of distributions is important in minimizing the costs of adjusting portfolios through time.A key requirement for the success of any financial intermediary is its ability to control both the actual and perceived default risk of its customer-held liabilities. Greater customer demand for service
30、 and greater complexity of products will intensify the attention given to this issue in the future. One implication is that the internal finance functions of financial intermediaries are likely to be expanded to cover not only the increased working capital needs of the firm but also the management o
31、f its counterparty credit exposure. Further development of this theme is far beyond the range of this paper. But perhaps the brief discussion here will serve to focus attention and stimulate further research on these issues of first-order importance to intermediaries involved in credit-sensitive act
32、ivities.3 Deposit-taking financial intermediaries3.1 Introduction to deposit-taking financial intermediariesDeposit-taking financial intermediaries are financial intermediaries that absorb deposit, including Commercial banks, Clearing banks, Merchant banks, foreign banks, National Savings Bank, Fina
33、nce houses, Building societies etc. And here I will discuss commercial banks most. And they provide a direct link between savers and borrowers3.2 Commercial banks facilitate the transfer of liquidityCommercial banks are very important part of deposit-financial intermediation, so I decide to explain
34、how deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus units to deficit units by illustrating commercial banks procession. 7Mortgage loan is an important way for commercial banks to collect funds. A mortgage loan is a very common type of debt instrument, used t
35、o purchase real assets. Under this arrangement, the money is used to purchase the property. Commercial banks, however, are given security - a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to reposses
36、s the house and sell it, to recover sums owing to it.Fig.2.Mallon.J (2011) Introduction to the Banking and FinanceWe can be seen from the diagram that how commercial banks transfer funds. During this process commercial banks act just as creditor and debtor between the savers and borrowers. In direct
37、 lending, the situation will like this:Direct lendingLiability Asset TotalLender $100,000 $100,000Borrower $100,000 $100,000Fig.3. Allen, F. and D. Gale, 1994a, Financial Innovation and Risk Sharing.And if we using a commercial bank, things will be different:Using a commercial bankSavers commercial
38、bank BorrowerLiabilities Assets Liabilities Assets Liabilities Assets$8,000 $100,000 $100,000 $100,000$16,000$14,0008$22,000$20,000$12,000$8,000Total $100,000 $100,000 $100,000 $100,000Total Assets $200,000Total Liabilities $200,000Fig.4.Mallon.J (2011) Introduction to the Banking and FinanceLender
39、will take on all the risk in fund flow under direct lending. Commercial bank reduces the risk and makes lending and borrowing much more likely outcomes, and it will facilitate the transfer of liquidity from surplus to deficit units.4 Non-deposit-taking financial intermediaries4.1 Introduction to non
40、-deposit-taking financial intermediariesNon-deposit-taking financial intermediaries are financial intermediaries dont absorb deposits, including Insurance companies, Unit trusts, Investment Trusts, Pension Funds, Investment companies, Informal Financial Institutions etc. And here I will discuss Insu
41、rance companies most.Insurance companies are FIs that undertake business of assuring risks on behalf of their customers. They are contractual firms unlike deposit-taking institutions. They make a profit by charging premiums that are sufficient to cover expected claims to customers plus a mark-up. In
42、surance business is usually undertaking because of uncertainty of life.4.2 Insurance companies facilitate the transfer of liquidity9Fig.5. Mallon.J (2011) Introduction to the Banking and FinanceWe can be seen from the graph that there many kings of non-deposit-taking financial intermediaries, and th
43、ey all transfer funds to stock market but dont absorb deposit. Here we will discuss insurance company as an example. Insurance companies: The primary purpose of insurance is to spread risks among people or entities that typically are exposed to similar risks. When an insurance policy is issued, the
44、insured makes a payment in advance of the possible occurrence of an insured event.The flow of operations of a typical insurance company is as follows: 1. The company determines the appropriate premium, bills the insured, and collects the premium.2. Some of the premium is used to pay immediate expens
45、es, like commissions and operating costs.3. Most of the premium is invested to pay claims in the future.4. Investment income and proceeds from sales of investments are used to pay claims as incurred.5. Profits, if any, are returned in part to the stockholders or policyholders as dividends. Reference
46、:Diamond, D.W. and P. Dybvig, 1986, “Banking Theory, Deposit Insurance, and Bank Regulation,“ Journal of Business (January), 55-68.10The investment cycle includes buying and selling investments and receiving investment income, net of related investment expenses. Insurance companys investment cycle i
47、s the same as in other businesses that maintain investment portfolios; and insurance companies also push-off funding products to financial market. There are currently two main categories of risk funding products. At one end of the spectrum are catastrophe products that essentially provide statutory
48、capital when a loss occurs and are clearly financing in nature. An example of this is surplus notes, whereby an insurer sets up a “fund“ through the sale of notes that are backed by receivables or government securities. The insurer has the ability to access these funds for various purposes, includin
49、g catastrophic loss coverage. Investors are paid a premium over the treasury bill rate for the use of the funds; they assume the risk of loan default but no real insurance risk. From the insurers perspective, this type of product provides liquidity and protection and enhancement of regulatory surplus at interest rates, and with higher limits, that are theoretically more competitive than traditional catastrophe reinsurance. And it will also facilitate th
