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Unformatted text preview: Chapter 01 - Why Are Financial Institutions Special? Chapter One Why Are Financial Institutions Special? Chapter Outline Introduction Financial Institutions Specialness FIs Function as Brokers FIs Function as Asset Transformers Information Costs Liquidity and Price Risk Other Special Services Other Aspects of Specialness The Transmission of Monetary Policy Credit Allocation Intergenerational Wealth Transfers or Time Intermediation Payment Services Denomination Intermediation Specialness and Regulation Safety and Soundness Regulation Monetary Policy Regulation Credit Allocation Regulation Consumer Protection Regulation Investor Protection Regulation Entry Regulation The Changing Dynamics of Specialness Trends in the United States Global Issues Summary Appendix 1A: The Financial Crisis: The Failure of Financial Institution Specialness Appendix 1B: Monetary Policy Tools ( www.mhhe.com/saunders7e ) 1-1 Chapter 01 - Why Are Financial Institutions Special? Solutions for End-of-Chapter Questions and Problems 1. What are five risks common to financial institutions? Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets 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 institutions. In a world without FIs the users of corporate funds in the economy would have to directly approach 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 identification 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 loan's life span. The net result would be an imperfect allocation of resources in an economy. 3. Identify and explain three economic disincentives that probably dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial institutions. Investors generally are averse to directly purchasing securities 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 monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities 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 returns which may be...
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This note was uploaded on 05/26/2011 for the course FIN 5530 taught by Professor Lee during the Three '11 term at University of New South Wales.
- Three '11