Chapter One
Why Are Financial Institutions Special?
Learning Objectives
LO1: Discuss the special functions that financial institutions provide.
LO2: Illustrate how financial institutions act as brokers and asset transformers.
LO3: Explain the types of regulations that are applied to financial institutions as a result of their
specialness.
LO4: Discuss the impact of the financial crisis on financial institutions.
LO5: Discuss the actions taken by governments to support the financial system during the financial
crisis.
Chapter Outline
Introduction
Financial Institutions’ Specialness
FIs Function as Brokers
FIs Function as Asset Transformers
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 Canada
Risk Measurement and the Financial Crisis
Global Issues
Appendix 1A The Financial Crisis: The Failure of Financial Services Institution Specialness
Internet Exercise
Go to the website of the Office of the Superintendent of Financial Institutions (OSFI) at
http://www.osfi-bsif.gc.ca/ and compare the reports of the different types of FIs that OSFI
regulates. Click on “Financial Institutions” to see the drop-down menu. Under the heading, “View
,Institutions”, click on “Financial Data”. Scroll down and click on “Banks.” Click on “Submit” to
download the latest Consolidated Balance Sheet. Repeat the process for the other regulated FIs that
are listed.
Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all FIs?
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 risks.
2. Explain how economic transactions between household savers of funds and corporate
users of funds would occur in a world without FIs.
In a world without FIs the users of corporate funds in the economy would have to directly approach
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 FIs.
Investors generally are averse to directly purchasing securities 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 securities 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. Finally, 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 would 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 an 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 BMO Financial Group. 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 purchase of securities.
5. In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does the
transformation process, or intermediation, reduce the risk, or economic disincentives, to the
savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real
assets. These financial claims, which are considered primary securities, are purchased by FIs whose
financial claims therefore are considered secondary securities. Savers who invest in the financial
claims of FIs are indirectly investing in the primary securities of commercial corporations.
However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs,
and price risk of placing the investments directly with the commercial corporation are reduced
because of the efficiencies of the FI.
6. Explain how FIs act as delegated monitors. What secondary benefits often accrue to the entire
financial system because of this monitoring process?
By putting excess funds into FIs, individual investors give to the FIs the responsibility of deciding
who should receive the money and of ensuring that the money is utilized properly by the borrower.
In this sense the depositors have delegated the FI to act as a monitor on their behalf. Further, the FI
can collect information more efficiently than individual investors. The FI can utilize this information
Why Are Financial Institutions Special?
Learning Objectives
LO1: Discuss the special functions that financial institutions provide.
LO2: Illustrate how financial institutions act as brokers and asset transformers.
LO3: Explain the types of regulations that are applied to financial institutions as a result of their
specialness.
LO4: Discuss the impact of the financial crisis on financial institutions.
LO5: Discuss the actions taken by governments to support the financial system during the financial
crisis.
Chapter Outline
Introduction
Financial Institutions’ Specialness
FIs Function as Brokers
FIs Function as Asset Transformers
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 Canada
Risk Measurement and the Financial Crisis
Global Issues
Appendix 1A The Financial Crisis: The Failure of Financial Services Institution Specialness
Internet Exercise
Go to the website of the Office of the Superintendent of Financial Institutions (OSFI) at
http://www.osfi-bsif.gc.ca/ and compare the reports of the different types of FIs that OSFI
regulates. Click on “Financial Institutions” to see the drop-down menu. Under the heading, “View
,Institutions”, click on “Financial Data”. Scroll down and click on “Banks.” Click on “Submit” to
download the latest Consolidated Balance Sheet. Repeat the process for the other regulated FIs that
are listed.
Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all FIs?
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 risks.
2. Explain how economic transactions between household savers of funds and corporate
users of funds would occur in a world without FIs.
In a world without FIs the users of corporate funds in the economy would have to directly approach
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 FIs.
Investors generally are averse to directly purchasing securities 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 securities 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. Finally, 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 would 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 an 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 BMO Financial Group. 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 purchase of securities.
5. In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does the
transformation process, or intermediation, reduce the risk, or economic disincentives, to the
savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real
assets. These financial claims, which are considered primary securities, are purchased by FIs whose
financial claims therefore are considered secondary securities. Savers who invest in the financial
claims of FIs are indirectly investing in the primary securities of commercial corporations.
However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs,
and price risk of placing the investments directly with the commercial corporation are reduced
because of the efficiencies of the FI.
6. Explain how FIs act as delegated monitors. What secondary benefits often accrue to the entire
financial system because of this monitoring process?
By putting excess funds into FIs, individual investors give to the FIs the responsibility of deciding
who should receive the money and of ensuring that the money is utilized properly by the borrower.
In this sense the depositors have delegated the FI to act as a monitor on their behalf. Further, the FI
can collect information more efficiently than individual investors. The FI can utilize this information
