1、 1Chapter OneWhy Are Financial Intermediaries Special?Chapter OutlineIntroductionFinancial Intermediaries Specialness Information Costs Liquidity and Price Risk Other Special ServicesOther Aspects of Specialness The Transmission of Monetary Policy Credit Allocation Intergenerational Wealth Transfers
2、 or Time Intermediation Payment Services Denomination IntermediationSpecialness and Regulation Safety and Soundness Regulation Monetary Policy Regulation Credit Allocation Regulation Consumer Protection Regulation Investor Protection Regulation Entry RegulationThe Changing Dynamics of Specialness Tr
3、ends in the United States Future Trends Global IssuesSummary2Solutions for End-of-Chapter Questions and Problems: Chapter One1. Identify and briefly explain the five risks common to financial institutions.Default or credit risk of assets, interest rate risk caused by maturity mismatches between asse
4、ts and liabilities, liability withdrawal or liquidity risk, underwriting risk, and operating cost risks.2. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial intermediaries (FIs).In a world without FIs the users o
5、f corporate funds in the economy would have to approach directly the household savers of funds in order to satisfy their borrowing needs. This process would be extremely costly because of the up-front information costs faced by potential lenders. Cost inefficiencies would arise with the identificati
6、on of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities, and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loans life span. The net result would be an im
7、perfect allocation of resources in an economy.3. Identify and explain three economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries.Investors generally are averse to purch
8、asing securities directly because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of
9、monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra
10、 returns which may be available. Third, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.4. Identify and explain the two functions in which FIs may specialize that enable the smooth flow of funds from household
11、 savers to corporate users.FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in the asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transa
12、ction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are m
13、ore attractive to household savers, and using the proceeds to purchase the primary securities of 3corporations. Thus, FIs take on the costs associated with the purchase of securities. 5. In what sense are the financial claims of FIs considered secondary securities, while the financial claims of comm
14、ercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?The funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claim
15、s, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering an
16、d evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.6. Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to t
17、he entire financial system because of this monitoring process?By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. In this sense the d
18、epositors have delegated the FI to act as a monitor on their behalf. The FI can collect information more efficiently than individual investors. Further, the FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. This more frequ
19、ent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate sources and users of funds in the economy.7. What are five general areas of FI specialness that are caused by providing
20、 various services to sectors of the economy?First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by div
21、ersifying the asset base FIs provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the
22、 introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.8. How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations? What are agency costs? Agency costs o
23、ccur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the 4activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the fi
24、rm may not satisfy the covenants in the lending agreement. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower.9. What often is the benefit to the lenders, borrowers, and financial markets in general
25、of the solution to the information problem provided by the large financial institutions?One benefit to the solution process is the development of new secondary securities that allow even further improvements in the monitoring process. An example is the bank loan that is renewed more quickly than lon
26、g-term debt. The renewal process updates the financial and operating information of the firm more frequently, thereby reducing the need for restrictive bond covenants that may be difficult and costly to implement.10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to i
27、nvest in the securities of corporations? Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial banks, for example, offer deposits that can be withdrawn at any time. Yet the banks make long-term loans or invest in illiquid assets because they are able to divers
28、ify their portfolios and better monitor the performance of firms that have borrowed or issued securities. Thus individual investors are able to realize the benefits of investing in primary assets without accepting the liquidity risk of direct investment. 11. How do financial institutions help indivi
29、dual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal?Money placed in any financial institution will result in a claim on a more diversified portfolio. Banks lend money to many different types of corporate, consumer, and government custome
30、rs, and insurance companies have investments in many different types of assets. Investment in a mutual fund may generate the greatest diversification benefit because of the funds investment in a wide array of stocks and fixed income securities.12. How can financial institutions invest in high-risk a
31、ssets with funding provided by low-risk liabilities from savers?Diversification of risk occurs with investments in assets that are not perfectly positively correlated. One result of extensive diversification is that the average risk of the asset base of an FI will be less than the average risk of th
32、e individual assets in which it has invested. Thus individual investors realize some of the returns of high-risk assets without accepting the corresponding risk characteristics.13. How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets?5
33、By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are designed to deal
34、in large volumes typically are more efficient than those activities designed for small volumes.14. What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial intermediaries?If net borrowers and net lenders have different optimal
35、time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. For example, the FI can offer the relatively short-term liabilities desired by households and also satisfy t
36、he demand for long-term loans such as home mortgages. By investing in a portfolio of long-and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using fut
37、ures, options, swaps, and other derivative products.15. What are five areas of institution-specific FI specialness, and which types of institutions are most likely to be the service providers?First, commercial banks and other depository institutions are key players for the transmission of monetary p
38、olicy from the central bank to the rest of the economy. Second, specific FIs often are identified as the major source of finance for certain sectors of the economy. For example, S others would argue that the ability to use these markets has caused the increased investor awareness. The growth in thes
39、e assets is inarguable.b. Recent episodes of financial distress in both the banking and insurance industries have led to an increase in regulation and governmental oversight, thereby increasing the net regulatory burden of “traditional” companies. As such, the costs of intermediation have increased,
40、 which increases the cost of providing services to customers.32. What are some of the methods which banking organizations have employed to reduce the net regulatory burden? What has been the effect on profitability?Through regulatory changes, FIs have begun changing the mix of business products offe
41、red to individual users and providers of funds. For example, banks have acquired mutual funds, have expanded their asset and pension fund management businesses, and have increased the security underwriting activities. In addition, legislation that allows banks to establish branches anywhere in the U
42、nited States has caused a wave of mergers. As the size of banks has grown, an expansion of possible product offerings has created the potential for lower service costs. Finally, the emphasis in recent years has been on products that generate increases in fee income, and the entire banking industry h
43、as benefited from increased profitability in recent years.1033. What characteristics of financial products are necessary for financial markets to become efficient alternatives to financial intermediaries? Can you give some examples of the commoditization of products which were previously the sole pr
44、operty of financial institutions?Financial markets can replace FIs in the delivery of products that (1) have standardized terms, (2) serve a large number of customers, and (3) are sufficiently understood for investors to be comfortable in assessing their prices. When these three characteristics are
45、met, the products often can be treated as commodities. One example of this process is the migration of over-the-counter options to the publicly traded option markets as trading volume grows and trading terms become standardized.34. In what way has Regulation 144A of the Securities and Exchange Commi
46、ssion provided an incentive to the process of financial disintermediation?Changing technology and a reduction in information costs are rapidly changing the nature of financial transactions, enabling savers to access issuers of securities directly. Section 144A of the SEC is a recent regulatory chang
47、e that will facilitate the process of disintermediation. The private placement of bonds and equities directly by the issuing firm is an example of a product that historically has been the domain of investment bankers. Although historically private placement assets had restrictions against trading, r
48、egulators have given permission for these assets to trade among large investors who have assets of more than $100 million. As the market grows, this minimum asset size restriction may be reduced.Chapter TwoThe Financial Services Industry: Depository InstitutionsChapter OutlineIntroductionCommercial Banks Size, Structure, and Composition of the Industry Balance Sheet and Recent Trends Other Fee-Generating Activities Regulation Industry Performance
