Financial Institutions - FINANCIAL INSTITUTIONS Fall 2006...

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F INANCIAL I NSTITUTIONS Fall 2006 I. INTRODUCTION A. Financial Intermediation 1. Theory (a) Smoothing – persons wish to spend/consume more than they earn/produce for a period of time and then pay back the borrowed funds at a later time (b) Productive Investment – persons have ideas that will add value (i.e. satisfy wants that currently go unsatisfied), but lack the funds to finance start-up costs, and would like to make use of surplus funds held and unconsumed by others to get the new operation up and running, with repayment plus compensation at later time 2. Market Inefficiencies (a) Search Costs – borrowers and lenders spend time/money searching for each other (b) Maturity-Matching Costs – matching amounts and maturities to borrow or lend (c) Agency Costs – lenders ensure that borrowers repay the loaned funds, investment funds are maximized for return, and risk of insufficient return minimized 3. Private Goods (a) Search Costs – surplus-holders go to intermediary to deposit/invest savings and surplus-searchers go to intermediary to borrow, sell debt or sell ownership stakes (b) Maturity-Matching Costs – if intermediary has enough on hand to cover all withdrawals, then there will be enough to liquidity to match those wishing to use x amount for y period with those ready to supply x amount for y period (c) Agency Costs – monitory is easier/cheaper because a single intermediary can monitor on behalf of many individuals and asset-price risk is lower because easier for investors to diversify investments over many enterprises, minimizing risk 4. Public Goods (a) Payment-Facilitation – payment system that minimizes the transacting costs of many transactions (i.e. giving payees direct claims on deposits held by payors) (b) Transmission of Government Monetary Policy – liquid conduit through which a nation’s central bank can effect monetary policy by contracting or expanding the money supply to influence economic growth or activity (e.g. changing discount rates, changing reserve requirements, conducting open-market allocations) (c) Credit Allocation – facilitates the channeling of credit to the markets that are considered special (e.g. farming, real estate) B. Regulation 1. Concerns (a) Investor-Protection – monitoring intermediaries themselves to mitigate collective- action problems and asymmetric access to information for investors (b) Society-Protection – assuring or maintaining the long-term health or solvency of intermediaries to ensure continued supply of liquidity 2. Forms (a) mandated disclosure (b) conflict of interest prevention (c) required standards of competency (d) capital-adequacy requirements
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(e) portfolio diversification requirements (f) consumer protection 3. Themes (a) Roe Thesis – historical suspicion/distrust of aggregated capital (b) Regulatory Convergence – increasingly difficult to draw clear lines between types of financial institution, financial product and financial service II. DEPOSITORY INSTITUTIONS
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Financial Institutions - FINANCIAL INSTITUTIONS Fall 2006...

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