Finance Management

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Chapter One
Why Are Financial Intermediaries Special?

Chapter Outline

Introduction

Financial Intermediaries’ Specialness

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
• Future Trends
• Global Issues

Summary

Solutions for End-of-Chapter Questions and Problems: Chapter One

1.Identify and briefly explain the 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 intermediaries (FIs).

In a world without FIs the users of corporate funds in the economy would have to approach directly 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 would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries.

Investors generally are averse to purchasing securities directly 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 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 available. Third, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

4.Identify and explain the two functions in which FIs may specialize that enable the smooth flow of funds from household savers to corporate users.

FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in the asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also may offer advisory services which help reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the...
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