Ch 1 2012 - 1 Chapter 1 Why Are Financial Intermediaries...

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Chapter 1 Why Are Financial Intermediaries Special? 1
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Why Are Financial Intermediaries Special? Objectives: 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 (too-important-to-fail). 2
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Households (net savers) Cash Equity & Debt Without FIs Corporations or Firms (net borrowers) 3
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1) Adverse Selection Prior to purchasing a firm’s debt or equity, each individual must incur costs to investigate its quality. If not, the poorest (adverse) quality firms have the greatest incentive to issue securities to unwary investors. 3 Potential Problems When FIs Are Absent 4
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2) Moral Hazard After purchasing a firm’s securities, each individual needs to monitor the firm’s managers. Once managers have control of other people’s money, they may have the incentive to spend it on excessively risky projects or perquisite consumption. Managers may also exert less effort than promised unless they are closely monitored. 3 Potential Problems When FIs Are Absent 5
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3) Risk, Maturity, Liquidity and Denomination Mismatches The firm’s debt or equity may have risk characteristics, maturities, liquidity, and denominations that may not be attractive to particular individuals. 3 Potential Problems When FIs Are Absent 6
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1) Broker By acting as a broker, a FI can provide information to individuals about the quality of security issues. Only a single entity, the FI broker, needs to incur costs to screen the quality of the firm’s securities. This is an efficient way to produce information and resolve adverse selection. 2 Major Functions of FIs 7
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2) Asset Transformer – transform primary securities (e.g., loan to steel mill) issued by firms into secondary securities (e.g., bank deposit) issued by the FIs themselves. By acting as an asset transformer, a FI may solve at least 4 types of problems: A. The FI can function as a delegated monitor to efficiently produce information on a borrowing firm’s ongoing activities and reduce moral hazard. B. The FI can pool risks, thereby providing diversification. 2 Major Functions of FIs 8
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2) Asset Transformer cont’d C. The FI can split the cash flows of its underlying assets, creating new securities whose risks and denominations may be more attractive to different investor clienteles. D. The FI can provide maturity intermediation: the maturities of its assets may differ from the maturities of its liabilities. This can be one way of creating liquidity (household can have securities with shorter maturity). 2 Major Functions of FIs 9
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Without FIs: Low level of fund flows. High information costs: Economies of scale reduce costs for FIs to screen and monitor borrowers.
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