FINANCIAL MARKETS AND INSTITUTIONS
OVERVIEW OF FINANCIAL INSTITUTIONS
Financial institutions (e.g., commercial and savings banks, credit unions, insurance companies,
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). Chapters 11 through 18 discuss
the various types of FIs in today’s economy, including (1) the size, structure, and composition of
each type, (2) their balance sheets and recent trends, (3) FI performance, and (4) the regulators who
oversee each type. Table 1–5 lists and summarizes the FIs discussed in detail in later chapters.
To understand the important economic function financial institutions play in the operation of
financial markets, imagine a simple world in which FIs did not exist. In such a world, suppliers of
funds (e.g., households), generating excess savings by consuming less than they earn, would have a
basic choice: They could either hold cash as an asset or directly invest that cash in the securities
issued by users of funds (e.g., corporations or households). In general, users of funds issue financial
claims (e.g., equity and debt securities) to finance the gap between their investment expenditures and
their internally generated savings such as retained earnings. As shown in Figure 1–5 , in such a
world we have a direct transfer of funds (money) from suppliers of funds to users of funds. In return,
financial claims would flow directly from users of funds to suppliers of funds.
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
In this economy without financial institutions, the level of funds flowing between suppliers of funds
(who want to maximize the return on their funds subject to risk) and users of funds (who want to
minimize their cost of borrowing subject to risk) is likely to be quite low. There are several reasons
for this. First, once they have lent money in exchange for financial claims, suppliers of funds need to
monitor continuously the use of their funds. They must be sure that the user of funds neither steals
the funds outright nor wastes the funds on projects that have low or negative returns, since this
would lower the chances of being repaid and/or earning a positive return on their investment (such
as through the receipt of dividends or interest). Such monitoring is often extremely costly for any
given fund supplier because it requires considerable time, expense, and effort to collect this
information relative to the size of the average fund supplier’s investment. 7 Given this, fund
suppliers would likely prefer to leave, or delegate, the monitoring of fund borrowers to others. The
resulting lack of monitoring increases the risk of directly investing in financial claims.
Second, the relatively long-term nature of many financial claims (e.g., mortgages, corporate stock,
and bonds) creates another disincentive for suppliers of funds to hold the direct financial claims
issued by users of funds. Specifically, given the choice between holding cash and long-term
securities, fund suppliers may well choose to hold cash for liquidity reasons, especially if they plan
to use their savings to finance consumption expenditures in the near future and financial markets are
not very developed, or deep, in terms of the number of active buyers and sellers in the market.
Third, even though real-world financial markets provide some liquidity services, by allowing fund
suppliers to trade financial securities among themselves, fund suppliers face a price risk upon the
sale of securities. In addition, the secondary market trading of securities involves various transaction
costs. The price at which investors can sell a security on secondary markets such as the New York
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
Stock Exchange (NYSE) may well differ from the price they initially paid for the security either
because investors change their valuation of the security between the time it was bought and when it
was sold and/or because dealers, acting as intermediaries between buyers and sellers, charge
transaction costs for completing a trade.
Unique Economic Functions Performed by Financial Institutions
Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average investor in a
world without FIs would likely view direct investment in financial claims and markets as an
unattractive proposition and prefer to hold cash. As a result, financial market activity (and therefore
savings and investment) would likely remain quite low.
However, the financial system has developed an alternative and indirect way for investors (or fund
suppliers) to channel funds to users of funds. 9 This is the indirect transfer of funds to the ultimate
user of funds via FIs. Due to the costs of monitoring, liquidity risk, and price risk, as well as for
other reasons explained later, fund suppliers often prefer to hold the financial claims issued by FIs
rather than those directly issued by the ultimate users of funds. Consider Figure 1–6 , which is a
closer representation than Figure 1–5 of the world in which we live and the way funds flow in the
U.S. financial system. Notice how financial intermediaries or institutions are standing, or
intermediating between, the suppliers and users of funds—that is, channeling funds from ultimate
suppliers to ultimate users of funds.
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
How can a financial institution reduce the monitoring costs, liquidity risks, and price risks facing the
suppliers of funds compared to when they directly invest in financial claims? We look at how FIs
resolve these cost and risk issues next and summarize them in Table 1–6.
Monitoring Costs.
As mentioned above, a supplier of funds who directly invests in a fund user’s financial claims faces
a high cost of monitoring the fund user’s actions in a timely and complete fashion. One solution to
this problem is for a large number of small investors to group their funds together by holding the
claims issued by a financial institution. In turn the FI invests in the direct financial claims issued by
fund users. This aggregation of funds by fund suppliers in a financial institution resolves a number
of problems.
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
BY: MEHTAB ISMAIL KUMBHAR
FINANCIAL MARKETS AND INSTITUTIONS
First, the “large” FI now has a much greater incentive to hire employees with superior skills and
training in monitoring. This expertise can be used to collect information and monitor the ultimate
fund user’s actions because the FI has far more at stake than any small individual fund supplier.
Second, the monitoring function performed by the FI alleviates the “free-rider” problem that exists
when small fund suppliers leave it to each other to collect information and monitor a fund user. In an
economic sense, fund suppliers have appointed the financial institution as a delegated monitor to act
on their behalf. For example, full-service securities firms such as Morgan Stanley carry out
investment research on new issues and make investment recommendations for their retail clients (or
investors), while commercial banks collect deposits from fund suppliers and lend these funds to
ultimate users such as corporations. An important part of these FIs’ functions is their ability and
incentive to monitor ultimate fund users.
Liquidity and Price Risk.
In addition to improving the quality and quantity of information, FIs provide further claims to fund
suppliers, thus acting as asset transformers. Financial institutions purchase the financial claims
issued by users of funds—primary securities such as mortgages, bonds, and stocks—and finance
these purchases by selling financial claims to household investors and other fund suppliers in the
form of deposits, insurance policies, or other secondary securities .
Often claims issued by financial institutions have liquidity attributes that are superior to those of
primary securities. For example, banks and thrift institutions (e.g., savings associations) issue
transaction account deposit contracts with a fixed principal value and often a guaranteed interest rate
that can be withdrawn immediately, on demand, by investors. Money market mutual funds issue
shares to household savers that allow them to enjoy almost fixed principal (deposit like) contracts
while earning higher interest rates than on bank deposits, and that can be withdrawn immediately by
writing a check. Even life insurance companies allow policyholders to borrow against their policies
held with the company at very short notice. Notice that in reducing the liquidity risk of investing
funds for fund suppliers, the FI transfers this risk to its own balance sheet. That is, FIs such as
depository institutions offer highly liquid, low price-risk securities to fund suppliers on the liability
side of their balance sheets, while investing in relatively less liquid and higher price-risk securities—
such as the debt and equity—issued by fund users on the asset side. Three questions arise here. First,
how can FIs provide these liquidity services? Furthermore, how can FIs be confident enough to
guarantee that they can provide liquidity services to fund suppliers when they themselves invest in
risky assets? Indeed, why should fund suppliers believe FIs’ promises regarding the liquidity and
safety of their investments?
The answers to these three questions lie in financial institutions’ ability to diversify away some, but
not all, of their investment risk. The concept of diversification is familiar to all students of finance.
Basically, as long as the returns on different investments are not perfectly positively correlated, by
spreading their investments across a number of assets, FIs can diversify away significant amounts of
their portfolio risk. (We discuss the mechanics of diversification in the loan portfolio in Chapter
20 .) Indeed, experiments have shown that diversifying across just 15 securities can bring significant
diversification benefits to FIs and portfolio managers. Further, for equal investments in different
securities, as the number of securities in an FI’s asset portfolio increases, portfolio risk falls, albeit at
a diminishing rate. What is really going on here is that FIs can exploit the law of large numbers in
making their investment decisions, whereas because of their smaller wealth size, individual fund
suppliers are constrained to holding relatively undiversified portfolios. As a result, diversification
allows an FI to predict more accurately its expected return and risk on its investment portfolio so
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FINANCIAL MARKETS AND INSTITUTIONS
that it can credibly fulfill its promises to the suppliers of funds to provide highly liquid claims with
little price risk. A good example of this is a bank’s ability to offer highly liquid, instantly
withdrawable demand deposits as liabilities while investing in risky, nontradable, and often illiquid
loans as assets. As long as an FI is large enough to gain from diversification and monitoring on the
asset side of its balance sheet, its financial claims (its liabilities) are likely to be viewed as liquid and
attractive to small savers—especially when compared to direct investments in the capital market.
BY: MEHTAB ISMAIL KUMBHAR