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finclintermed - sau86198_ch01.qxd 8:52 PM CHAPTER Page 3...

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C H A P T E R O N E Why Are Financial Intermediaries Special? Introduction The major themes of this book are the measurement and management of the risks of financial institutions. Financial institutions (e.g., banks, credit unions, insurance com- panies, and mutual funds) perform the essential function of channeling funds from those with surplus funds (suppliers of funds) to those with shortages of funds (users of funds). As of the end of 2000, U.S. FIs held assets totaling over $14.75 trillion. In con- trast, the U.S. motor vehicle and parts industry (e.g., General Motors and Ford Motor Corp.) held total assets of $0.71 trillion. Although we might categorize or group FIs as life insurance companies, banks, finance companies, and so on, they face many common risks. Specifically, all FIs described in this chapter and Chapters 2 through 6 (1) hold some assets that are poten- tially subject to default or credit risk and (2) tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. In addition, most FIs are exposed to some type of underwriting risk, whether through the sale of securities or the issue of various types of credit guarantees on or off the balance sheet. Finally, all FIs are exposed to operating cost risks because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services). Because of these risks and the special role that FIs play in the financial system, FIs are singled out for special regulatory attention. 1 In this chapter, we first examine questions related to this specialness. In particular, what are the special functions that FIs—both depository institutions (banks, savings institutions, and credit unions) and nondepository institutions (insurance companies, securities firms, investment banks, finance companies, and mutual funds)—provide? How do these functions benefit the economy? Second, we investigate what makes some FIs more special than others. Third, we look at how unique and long-lived the special functions of FIs really are. 1 Some public utility suppliers such as gas, electric, telephone, and water companies are also singled out for regulation because of the special nature of their services and the costs imposed on society if they fail.
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Financial Intermediaries’ Specialness To understand the important economic function of FIs, imagine a simple world in which FIs do not exist. In such a world, households generating excess savings by con- suming less than they earn would have the basic choice: They could hold cash as an as- set or invest in the securities issued by corporations. In general, corporations issue securities to finance their investments in real assets and cover the gap between their in- vestment plans and their internally generated savings such as retained earnings.
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