LESSON 1

MGMT 3076
MANAGING FINANCIAL
INSTITUTIONS

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Class outline

 Introductions
 Course Overview
 Overview of the nature and role of the
Financial System

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 Introduction to Financial Institutions

LEARNING OBJECTIVES:
• This lecture provides an Introduction to Financial Institutions
(FIs);
• By the end of this lecture students will be able to:
• describe the special functions that Financial Institutions
provide;
• distinguish between the different types of Financial
Institutions;
• discuss the services which Financial Institutions perform;
• describe the key risks which Financial Institutions face;
and
• appreciate why financial institutions are regulated.
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Introduction to Financial Institutions

A World Without FIs

To help us 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 consuming less than they earn could
i) hold cash as an asset or
ii) invest in the securities issued by corporations (this is direct
financing).

Excess Excess
supply demand
Equity & Debt
Households Corporations
Cash
(net savers) (net borrowers)
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 Introduction to Financial Institutions

A World Without FIs cont’d

• In this world without FIs, the level of fund flows between

household savers and the corporate sectors is likely to be
very low.
• This is because once they have lent money to a firm by
buying its financial claims (i.e. stock and/or bonds),
households need to monitor, or check, the actions of that
firm.
• Essentially, they must ensure that the firm’s management
neither absconds with, nor wastes the funds on any
projects with low or negative net present values.
• However, for the individual household monitoring is
extremely costly and this leads to a low level of monitoring
1-5 which increases risk.

Introduction to Financial Institutions

A World Without FIs cont’d

• Furthermore, the long-term nature of corporate equity and

debt, and the lack of a secondary market in which
households can sell these securities, creates a second
disincentive for household investors to hold the direct
financial claims issued by corporations.
• Specifically, given the choice between holding cash and
holding long-term securities, households may well choose
to hold cash for liquidity reasons, especially if they plan to
use savings to finance consumption expenditures in the
near future.

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 Introduction to Financial Institutions
A World Without FIs cont’d

• Finally, even if financial markets existed (without FIs to

operate them) to provide liquidity services by allowing
households to trade corporate debt and equity securities
among themselves, investors also face a price risk on
sale of securities.
• In addition, the secondary market trading of securities
involves various transaction costs.

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Introduction to Financial Institutions

A World Without FIs cont’d

• All told, because of

1. monitoring costs,
2. liquidity costs, and
3. price risk,
• the average household saver may view direct
investment in corporate securities as an unattractive
proposition and prefer either not to save or to save in
the form of cash.

What does this mean for the corporate sectors and the
economy as a whole?

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 Introduction to Financial Institutions

A World With FIs

• Thankfully, the economy has developed an alternative and
indirect way to channel household savings to the corporate
sector.
• This is to channel savings via FIs.
• Because of the costs of monitoring, liquidity, and price
risk, as well as for some other reasons, savers often prefer
to hold the financial claims issued by FIs rather than those
issued by corporations.

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Introduction to Financial Institutions

A World With FIs

FI

Households (Brokers)
Corporations

FI (Asset
Cash Equity & Debt
Transformers)

Deposits/Insurance Cash
Policies

Notice how financial institutions or intermediaries are

standing, or intermediating, between households and
corporate sectors.
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 Introduction to Financial Institutions
Functions of FIs
 FIs as Brokers
• When acting as a broker, a FI acts as an agent for the
investor (i.e. the saver), hence they provide them with
information and transaction services:
• e.g. BOA Merrill Lynch make investment
recommendations and conduct purchases and/or sales in
exchange for fees
• By executing transactions for hundreds of clients, FIs
reduce costs (e.g. transaction costs) through economies
of scale
• In so doing, FIs, encourages higher rate of savings
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Introduction to Financial Institutions

Functions of FIs cont’d

 FIs as Asset Transformer

• When acting as an asset transformer, the FI issues
financial claims (e.g. deposits and/or insurance policies)
that are far more attractive to household savers than the
claims directly issued by corporations (e.g. equity and/or
bonds).
• FIs purchase the financial claims issued by corporations ,
which are also called primary securities —and finance
these purchases by selling financial claims to household,
which are also known as secondary securities.

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 Introduction to Financial Institutions
Functions of FIs cont’d

 FIs as Asset Transformer

• Hence, FIs purchase primary securities by selling
secondary securities to households
• These secondary securities are often more marketable
• Thus, FIs create financial products whose value added to
their clients is the transformation of financial risk

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Introduction to Financial Institutions

Role of FIs in Reducing
Information Costs
 Information costs:
• Investors are exposed to agency costs as savers (the so-
called principals) could be harmed by the actions taken by
managers at the borrowing firm (the so-called agent).
• Moreover, agency costs (e.g. monitoring costs) arise
whenever economic agents enter into contracts in a world
of incomplete information and thus costly information
collection.

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 Introduction to Financial Institutions
Role of FIs in Reducing
Information Costs
 Information costs:
Role of FI as Delegated Monitor
• FIs are likely to have an informational advantage, hence
one solution is for a large number of savers to place their
money with a single FI.
• This leads to economies of scale in obtaining information

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Introduction to Financial Institutions

Role of FIs in Reducing
Information Costs
 Information costs:
FI as an Information Producer
• Shorter term debt contracts are easier to monitor than
bonds
• Greater monitoring power and control
• Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders

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 Introduction to Financial Institutions

Role of FIs in Reducing

Liquidity and Price Risk
• In addition to improving the flow and quality of
information, FIs provide secondary claims that have
superior price and liquidity attributes compared with
those of primary securities such as corporate equity and
bonds.
• For example, banks and thrifts issue transaction account
deposit contracts with a fixed principal value (and often a
guaranteed interest rate) that can be withdrawn on
demand.

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Introduction to Financial Institutions

Role of FIs in Reducing

Liquidity and Price Risk
• Liquidity and Price Risk
• Secondary claims issued by FIs have less price risk
• Demand deposits and other claims are more liquid
• More attractive to small investors
• How are FIs able to do this when they invest in risky
assets? They can diversifying their investment
portfolios.

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 Introduction to Financial Institutions

Other Special Roles Played by FIs

• Reduced transactions costs as a result of increased
economies of scale
• Maturity intermediation
• Transmission of monetary policy
• Credit allocation to areas of special need such as home
mortgages and small business loans
• Intergenerational transfers or time intermediation
• Payment services (e.g. FedWire and CHIPS)
• Denomination intermediation

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Introduction to Financial Institutions

Types of Risk Faced by FIs

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:
1) hold some assets that are potentially subject to default or
credit risk;
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;
3) 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;

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 Introduction to Financial Institutions

Types of Risk Faced by FIs

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:
4) 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; and
5) finally, all FIs are exposed to operating risks because
the production of financial services requires the use of
real resources and back-office support systems (labour
and technology combined to provide services).

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Introduction to Financial Institutions

Regulation of FIs
• FIs receive special regulatory attention because:
• Negative externalities of FI failure affects householders
and firms
• Special services provided by FIs
• Institution-specific functions such as money supply
transmission (banks), credit allocation, payment
services (banks, thrifts), etc.

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Important features of regulatory policy:
• Protect ultimate sources and users of savings
• Including prevention of unfair practices such as
redlining and other discriminatory actions
• Primary role:
• Ensure soundness of the overall system

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Introduction to Financial Institutions

Regulation of FIs cont’d
• Regulation imposes private costs, or a regulatory burden,
on individual FI owners and managers.
• Consequently, regulation is an attempt to enhance the
social welfare benefits and mitigate the social costs of the
provision of FI services.
• The private costs of regulation relative to its private
benefits, for the producers of financial services, is called
the net regulatory burden.

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Six (6) types of regulation:
1. safety and soundness regulation;
2. monetary policy regulation;
3. credit allocation regulation;
4. consumer protection regulation;
5. investor protection regulation; and
6. entry and chartering regulation.

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Introduction to Financial Institutions

Regulation of FIs cont’d
Safety and soundness regulation:
• To protect depositors and borrowers against the risk of FI
failure.
• Regulations to increase diversification
• E.g. No more than 10 percent of equity to single
borrower
• Minimum capital requirements
• E.g. FI equity >=10% of risk weighted assets
• Guaranty funds:
• Deposit insurance fund (DIF)

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Safety and soundness regulation:
• To protect depositors and borrowers against the risk of FI
failure.
• Monitoring and surveillance:
• In the US the Federal Deposit Insurance Corporation
(FDIC) monitors and regulates DIF participants. In
Barbados the Central Bank plays this role while the
BDIC administers the DIF .
• Increased regulatory scrutiny following crises

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Introduction to Financial Institutions

Regulation of FIs cont’d
Monetary policy regulation
• The transmission of monetary policy from the central
bank (the Federal Reserve in the US) to the rest of the
economy.
• The central bank directly controls outside money—
i.e. the quantity of notes and coin in the economy
• However, the bulk of money supply is inside money—
i.e. deposits
• Thus, the reserve requirements facilitate transmission
of monetary policy

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Credit allocation regulation
• Supports socially important sectors such as housing and
farming
• Requirements for minimum amounts of assets in a
particular sector or maximum interest rates or fees
to subsidies certain sectors
• In the US there is the Qualified Thrift Lender Test
(QTL)
• Requires generally that 65 percent of assets
be held in residential mortgages or other
approved loans

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Introduction to Financial Institutions

Regulation of FIs cont’d
Credit allocation regulation
• Supports socially important sectors such as housing and
farming
• Loan interest rate restrictions e.g. anti-usury laws
(abolished in the US) and regulations (e.g.
Regulation Q) concerning maximums on time and
savings deposit interest rates

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Consumer protection regulation
• To protect consumers from unfair, deceptive, and
abusive practices
• In the US there are anti discrimination laws relating
to Bank lending practices
• E.g. Community Reinvestment Act (CRA) and the
Home Mortgage Disclosure Act (HMDA)
• Many observers believe that these laws are
imposing a greater regulatory burden than the sum
of any social benefits; however, they are likely to be
extended beyond the banking sector.

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Introduction to Financial Institutions

Regulation of FIs cont’d
Investor protection regulation
• Protections against abuses such as insider trading, lack
of disclosure, malfeasance, breach of fiduciary
responsibility
• Key legislation in the US include
• Securities Acts of 1933 & 1934
• Investment Company Act of 1940

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 Introduction to Financial Institutions
Regulation of FIs cont’d
Entry regulation
• Level of entry impediments affects profitability and the
value of charter
• Regulations define scope of permitted activities
• In the US for example, the Financial Services
Modernization Act of 1999 (repealing Glass-Steagall
which established barriers between banks, insurance,
and investment companies)
• These regulations affect the charter value of a FI and
size of its net regulatory burden

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Introduction to Financial Institutions

Recent trends
• Banks shifted from “originate and hold” to “originate and
distribute”
• Affects incentives to monitor and control risk
• Shift to off balance sheet risks
• Degraded quality and increased risk
• Led to US housing market bubble
• Encouraged subprime market and more exotic
mortgages

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 Introduction to Financial Institutions

A World in Financial Crisis

• Collapse in US home prices
• US Home prices plummeted in 2006-07
• Mortgage delinquencies rose
• Securitized mortgages led to large financial losses
• America entered a recessionary period
• Record budget deficits and GDP contractions
experienced in Caribbean economies as the crisis
spread worldwide

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