Unformatted text preview: allows an FI to predict more
accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk-free return on its assets. As a result, it
can credibly fulfill its promise to households to supply highly liquid claims with little
price or capital value risk. A good example of this is the ability of a bank to offer
highly liquid demand deposits—with a fixed principal value—as liabilities, while at
the same time investing in risky loans as assets. As long as an FI is sufficiently large to
gain from diversification and monitoring, its financial claims are likely to be viewed as
liquid and attractive to small savers compared to direct investments in the capital market. The smaller and the less diversified an FI becomes, the less able it is to credibly
promise household savers that its financial claims are highly liquid and of low capital
risk. Specifically, the less diversified the FI, the higher the probability that it will default on its liability obligations and the more risky and illiquid its claims.5 In reality,
the majority of financial institution fa...
View Full Document
This document was uploaded on 03/09/2014 for the course ACC 301 at HELP University.
- Spring '09