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topic09_detailed_note - U NIVERSITY OF E SSEX D EPARTMENT...

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U NIVERSITY OF E SSEX D EPARTMENT OF E CONOMICS EC372 Economics of Bond and Derivatives Markets Financial Intermediation, I: Fundamentals Overview This note provides an overview of financial intermediation, with a particular emphasis on the microe- conomics of banking. It begins by reviewing the functions of financial intermediaries in section 1, followed by an analysis of banking risks from the perspective of a bank’s Balance Sheet in sec- tion 2. Section 3 studies the process of securitisation creating ‘asset backed securities’, a process that expanded greatly in the decade prior to the onset of the crisis in 2007. One of the main questions addressed in the theory of financial intermediation is why some capital is channeled from borrowers to lenders via marketable instruments (e.g. bonds) while some is passed indirectly from lender to borrower via an intermediary. While detailed study of the question is left for next week, section 4 discusses one approach, based on the role of banks in screening potential borrowers (firms) to separate those which are creditworthy from those which are not. 1. Functions of Financial Intermediaries Here is a classification of the functions typically performed by financial intermediaries: 1 1. Payments system – provides a mechanism allowing debtors to settle with creditors, i.e., a mech- anism for the transfer of cash, via bank deposits. 2. Risk sharing – enables separate investors to hold fractions of assets that would otherwise be too risky or too large (indivisible) for any one of them. 3. Risk pooling – to take advantage of the ‘law of large numbers’, rendering predictable uncer- tain events (e.g., insurance contracts) the outcomes of which are, individually, open to wide prediction error. 4. Delegated monitoring – managing the incentives of borrowers (including potential borrowers). This function is studied in section 4 and – in depth – next week. 5. Dissemination of information – collecting and presenting information that might otherwise be difficult or costly to obtain, e.g., ‘price discovery’ that identifies prices at which assets can be traded. Institutions that deliver some/all of these functions evolve over time – institutions adapt to changing circumstances while the functions tend to stay much the same. The commonest enduring interme- diary is a ‘bank’, though they exist in several varieties (e.g. commercial banks, investment banks, savings banks, central banks) the functions of which tend to differ across time and location. Other financial intermediaries include insurance companies, ‘shadow’ banks, hedge funds, private equity funds, and many other institutions. Arguably, financial futures and options exchanges should also be classed as financial intermediaries inasmuch as they act as guarantors of trades that they process.
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