Lecture 1
Chapter 1
Definition
Financial Institutions (FIs) - are independent market participants that create financial products
whose value added is the transformation of financial risk
Types of Fis
Without FIs
Situation:
What is the problem? -> Low level of fund flows. Why?
1. Information costs /monitoring costs
• Collecting information on corporations is too costly for any given household.
• They also need to keep monitoring
2. Less liquidity
• Investing directly in corporations dries up liquidity among households.
• They need it for a car or for their house.
3. Substantial price risk
• Risk of loss when selling equity and debt of corporations (price can go down) and
they can’t diversify. There is also no guarantee they get their money back.
With FIs
,Functions of FIs
1. Function as Brokers: acts as an agent for the saver by providing information and transaction
services (i.e investment research)
Results in economies of scale by reducing transaction costs and information costs,
thus encouraging higher rate of savings (/makes investing more attractive).
2. Function as Asset Transformers: FI issues financial claims that are far more attractive to
household savers than the claims issued by corporations
-> FIs purchase Primary Securities issued by corporations and sell financial claims to
household investors as Secondary Securities. The value added is that the risk is
transformed.
They can resolve the shortcomings from the financial market. They reduce the cost of
information, provide liquid assets and they lower the price risk.
Roles of FIs
1. Role as Delegated Monitor: FIs act on behalf of smaller agents collecting information of
firms and thus decreasing agency costs
-> Average costs of collecting information is lower
2. Role as Information Producer: FIs different contract with firms allows them to extract
different information from corporations (i.e previous loan contracts reveals firms future credit
score)
->shorter term debt contracts are easier to monitor than bonds, because every time they
renew the short term debt contract the bank gets new information.
Other benefits/characteristics:
. FIs financial products are more liquid than corporations’
i. FIs products are less risky due to their ability to diversify. They have a fixed principal
value and a guaranteed interest rate.
ii. FIs reduce transaction costs through bulk buying
iii. FIs are capable of maturity intermediation - produce long term contracts while raising
funds with short-term contracts
iv. FIs are capable of transmitting monetary policy
v. FIs are necessary for credit allocation in special interest areas (i.e real estate)
, vi. FIs enables intergenerational wealth transfers and time intermediation (i.e pension
funds)
vii. FIs facilitates payment services
viii. FIs allow for Denomination Intermediation - enabling small investors to access high
denominated investments through reduced price
The effect of FI on the economy
->Levine, Zervos, 1998, Stock Markets, Banks, and Economic Growth, The American
Economic Review, Vol. 88, No. 3, pp. 537-558
->Do well functioning stock markets and banks promote long-run economic growth?
• Yes
Specialness and regulation
Potential Problems
->What happens if FIs take excessive risk and fail?
• Loss of households’ savings
• Disruption in capital provision for businesses
• Household’s exposure to catastrophic illnesses, drops in income, and other disasters.
->But isn’t their failure efficient?
• Macro instability
• Financial crisis
• Too big to fail
-> FIs also pose negative externalities to society in the case of failure and/or excessive risk
taking
Regulating Financial Intermediaries
-> Regulation is one solution to excessive risk taking behavior of FIs
-> Basel III: in late 2009 in response to the financial crisis.
• International banking supervision
• Capital requirement, stress testing, liquidity risk
->Solvency II for the EU insurers
->Cost of regulation (regulatory tax)
• Private cost for the individual FIs (lower profit)
• Shift to less-regulated alternatives
• Who is paying the regulatory tax? Low income households and small/medium FIs
Chapter 1
Definition
Financial Institutions (FIs) - are independent market participants that create financial products
whose value added is the transformation of financial risk
Types of Fis
Without FIs
Situation:
What is the problem? -> Low level of fund flows. Why?
1. Information costs /monitoring costs
• Collecting information on corporations is too costly for any given household.
• They also need to keep monitoring
2. Less liquidity
• Investing directly in corporations dries up liquidity among households.
• They need it for a car or for their house.
3. Substantial price risk
• Risk of loss when selling equity and debt of corporations (price can go down) and
they can’t diversify. There is also no guarantee they get their money back.
With FIs
,Functions of FIs
1. Function as Brokers: acts as an agent for the saver by providing information and transaction
services (i.e investment research)
Results in economies of scale by reducing transaction costs and information costs,
thus encouraging higher rate of savings (/makes investing more attractive).
2. Function as Asset Transformers: FI issues financial claims that are far more attractive to
household savers than the claims issued by corporations
-> FIs purchase Primary Securities issued by corporations and sell financial claims to
household investors as Secondary Securities. The value added is that the risk is
transformed.
They can resolve the shortcomings from the financial market. They reduce the cost of
information, provide liquid assets and they lower the price risk.
Roles of FIs
1. Role as Delegated Monitor: FIs act on behalf of smaller agents collecting information of
firms and thus decreasing agency costs
-> Average costs of collecting information is lower
2. Role as Information Producer: FIs different contract with firms allows them to extract
different information from corporations (i.e previous loan contracts reveals firms future credit
score)
->shorter term debt contracts are easier to monitor than bonds, because every time they
renew the short term debt contract the bank gets new information.
Other benefits/characteristics:
. FIs financial products are more liquid than corporations’
i. FIs products are less risky due to their ability to diversify. They have a fixed principal
value and a guaranteed interest rate.
ii. FIs reduce transaction costs through bulk buying
iii. FIs are capable of maturity intermediation - produce long term contracts while raising
funds with short-term contracts
iv. FIs are capable of transmitting monetary policy
v. FIs are necessary for credit allocation in special interest areas (i.e real estate)
, vi. FIs enables intergenerational wealth transfers and time intermediation (i.e pension
funds)
vii. FIs facilitates payment services
viii. FIs allow for Denomination Intermediation - enabling small investors to access high
denominated investments through reduced price
The effect of FI on the economy
->Levine, Zervos, 1998, Stock Markets, Banks, and Economic Growth, The American
Economic Review, Vol. 88, No. 3, pp. 537-558
->Do well functioning stock markets and banks promote long-run economic growth?
• Yes
Specialness and regulation
Potential Problems
->What happens if FIs take excessive risk and fail?
• Loss of households’ savings
• Disruption in capital provision for businesses
• Household’s exposure to catastrophic illnesses, drops in income, and other disasters.
->But isn’t their failure efficient?
• Macro instability
• Financial crisis
• Too big to fail
-> FIs also pose negative externalities to society in the case of failure and/or excessive risk
taking
Regulating Financial Intermediaries
-> Regulation is one solution to excessive risk taking behavior of FIs
-> Basel III: in late 2009 in response to the financial crisis.
• International banking supervision
• Capital requirement, stress testing, liquidity risk
->Solvency II for the EU insurers
->Cost of regulation (regulatory tax)
• Private cost for the individual FIs (lower profit)
• Shift to less-regulated alternatives
• Who is paying the regulatory tax? Low income households and small/medium FIs
