BIF 3

Financial Intermediaries

• Financial Intermediaries (FIs) are institutions that channel funds from suppliers of funds to users of funds.
• They provide various services, including:
  • Transaction Cost Services: reduction of costs due to economies of scale in financial transactions.
  • Maturity Intermediation: the ability to bear the risk associated with mismatched maturities of assets and liabilities.
  • Credit Allocation: directing of funds to particular sectors deemed important for economic development.
  • Payment Services: services like check clearing, crucial for the economy's efficiency.
  • Monetary Policy Transmission: how actions by a central bank are passed through depository institutions to the financial system and economy.
  • Intergenerational Wealth Transfers: services allowing wealth to be passed from one generation to the next.
  • Denomination Intermediation: allowing small investors to overcome the minimum denomination size of certain assets.

Financial Concepts and Ratios

• Cost-Income Ratio (C/I): the ratio of a bank's operating costs to its total income. Formula: C/I = Non-interest Expenses / Total Operating Income.
• Return on Assets (ROA): how efficiently a bank uses its assets to generate profits. Formula: ROA = Net Income / Total Assets.
• Return on Equity (ROE): the amount of net income returned as a percentage of shareholders' equity. Formula: ROE = Net Income / Shareholder's Equity.
• Equity Multiplier (EM): indicates the level of a bank's leverage. Formula: EM = Total Assets / Shareholder's Equity.

Interest Rate Risk Management

• Interest Rate Risk: the risk to earnings or capital from the movement of interest rates.
• Refinancing Risk: the risk of a rise in interest rates making it more expensive to refinance debt.
• Reinvestment Risk: the risk of lower returns on reinvesting funds due to falling interest rates.
• Market Value Risk: the risk that the market value of assets or liabilities decreases if interest rates rise.
• Repricing Model: assesses the effect of interest rate changes on net interest income. Formula: ΔNII = GAP × ΔR.
• Rate-Sensitive Assets (RSAs) and Liabilities (RSLs): assets and liabilities that will be repriced due to market rate changes within a specific timeframe.
• Cumulative Gap (CGAP): the total gap between RSAs and RSLs across different maturity buckets. Formula: CGAP = Sum of GAPs across buckets.
• Gap Ratio: measures interest rate sensitivity relative to the bank's assets. Formula: Gap Ratio = CGAP / Total Assets.
• Duration: the weighted average time to receive cash flows from an asset or liability. Formula: Duration = Weighted average of time periods using present value of cash flows as weights.
• Duration Gap: the difference between the duration of assets and the leveraged duration of liabilities. Formula: Duration Gap = Duration of Assets - (Liabilities/Assets) × Duration of Liabilities.
• Net Interest Income (NII): income from interest-earning assets minus expenses on interest-bearing liabilities.
• Change in Net Interest Income (ΔNII): the variation in NII due to a change in interest rates for a specific bucket. Formula: ΔNII = GAP × ΔR.
• Change in Market Value (ΔMV): the change in value of assets or liabilities due to a change in interest rates. Formula: ΔMV = -Duration × MV × ΔR / (1 + R).
• Net Worth Sensitivity: the sensitivity of an FI's equity to changes in interest rates. Formula: ΔEquity = -Duration Gap × Assets × ΔR / (1 + R).

Other Financial Concepts

• Delegated Monitors: FIs that act as monitors of borrower behavior on behalf of small investors.
• Asset and Maturity Transformers: FIs that transform the characteristics of assets to create better matches with investors' preferences.
• Brokers: agents that arrange transactions between buyers and sellers for a commission.
• Investment Banking: the segment of banking that deals with the creation of capital for other companies and governments.
• Venture Capital: funds used to finance new and often high-risk ventures in exchange for equity.
• Market Making: creating a secondary market by providing liquidity and setting bid-ask spreads for securities.
• Trading: the act of buying and selling securities, either for clients or for the institution's own account.
• Investing: managing pooled assets like mutual or pension funds to beat performance benchmarks.
• Cash Management: services like check writing against mutual fund accounts offered by brokerage firms.
• Mergers and Acquisitions (M&A): services involving the joining of two companies into one or the purchase of one company by another.