Financial Intermediaries Overview

Primary Assets and Liabilities of Financial Intermediaries

• Financial intermediaries play a central role in the US financial system by bridging savers and borrowers.
• Depository institutions, like banks, rely primarily on deposits as liabilities to fund assets such as loans and securities.
• Commercial banks provide business and consumer loans and hold government and municipal bonds as their primary assets.
• Savings and loan associations and mutual savings banks predominantly issue mortgages as their key assets.
• Credit unions focus on consumer loans as their major asset while relying heavily on member deposits.
• Life insurance companies obtain funding from policy premiums, investing primarily in corporate bonds and mortgages.
• Fire and casualty insurance companies also collect premiums and invest in municipal bonds, corporate bonds, and stocks.

Asymmetric Information Problems

• Adverse selection arises when private information affects the market, mitigated through information production and government regulation.
• Financial intermediation helps reduce adverse selection by helping allocate and manage risks between parties.
• Moral hazard, particularly in equity contracts, can escalate through inadequate monitoring; government regulation aims to enhance information accuracy.
• For debt contracts, monitoring, collateral, and net worth are crucial in managing risks associated with moral hazard.

Banking Structure and Regulation

• Understanding the balance sheets of banks and their asset and liability management is vital to comprehend their liquidity management.
• Regulation of the banking sector is critical to prevent crises, as seen in the Global Financial Crisis of 2007-2008.

Liquidity Management

• Banks may face liquidity shortages following significant deposit outflows, highlighting the need for effective liquidity strategies.
• Four key liquidity management options include borrowing from other banks, selling securities, borrowing from the central bank, and calling in or selling loans.

Asset Management Challenges

• Banks must identify borrowers who offer high interest with low risk, purchase high-return securities, mitigate credit risk, and satisfy liquidity needs.
• Diversification is essential in asset management to balance risk and returns.

Managing Credit Risk

• Techniques for managing credit risk include rigorous screening, monitoring contracts, developing relationships with borrowers, and offering loan commitments.
• Credit rationing is employed to encourage prudent use of funds, requiring borrowers to contribute a portion of private funds.

Interest-Rate Risk Management

• Interest-rate risk involves the sensitivity of bank profits to changes in interest rates, assessed through gap analysis and duration analysis.
• Gap analysis evaluates the impact of interest rate changes on profits by comparing rate-sensitive assets and liabilities.
• Duration analysis measures how the value of assets and liabilities shifts with interest rate fluctuations, affecting bank capital.

Interest-Rate Risk Strategies

• Banks mitigate interest-rate risks by aligning the maturities and sensitivities of their assets and liabilities.
• Financial derivatives, such as interest-rate swaps and futures, can be employed to alleviate potential risks.

Liability Management

• Modern banks increasingly utilize various funding sources, such as interbank borrowing and certificates of deposit, in addition to traditional deposits.
• The primary goal of liability management is to minimize funding costs, necessitating a coordinated approach to asset and liability management (ALM).

This quiz covers the primary assets and liabilities of financial intermediaries in the United States, specifically focusing on depository institutions and commercial banks. Understand the sources of funds such as deposits and the uses including various types of loans and securities. Test your knowledge on the fundamental roles these institutions play in the economy.