Lecture 3: Nature of Financial Intermediaries PDF

Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry...

Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry 3(c): Case Study - Enron Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process 3(b): Information Asymmetry 3(c): Case Study - Enron Financial Intermediaries & Markets Lecture 3: Topic 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process Reading Materials: 1. The Theory of Financial Intermediation by Scholtens & Wensveen 2. The theory of Financial Intermediation by Allen & Santomero 3. Theories regarding Financial Intermediation - A survey by Andries 4. World Bank GFDR 2016  Financial Intermediation From a Financial Institution Point of View- What does financial intermediation mean? (1 bonus)  Financial Intermediation From a Financial Institution Point of View- What does financial intermediation mean? – The processing of: Risk & its complement Information  Financial Intermediation Processing of Risks Information Financial Intermediation – Financial Intermediaries produces information for 2 kinds of applications 1. To match transactors – Brokerage: Like marriage broker 2. To manage risks & transform assets – Qualitative Asset Transformer: E.g. banks producers credit information to control borrower’s credit risk Financial Intermediation – Financial Intermediaries produces information for 2 kinds of applications 1. To match transactors – Brokerage: Like marriage broker 2. To manage risks & transform assets – Qualitative Asset Transformer: E.g. banks producers credit information to control borrower’s credit risk  The Brokerage Function Bringing transactors together Borrowers Lenders Is there any relationship between them? (1 bonus)  The Brokerage Function Bringing transactors together relationship Unfamiliar to But complementary each other to each other  The Brokerage Function Bringing transactors together Brokerage Service: – Recall: its stock-in-trade is information  The Brokerage Function Bringing transactors together Brokerage Service: – Recall: its stock-in-trade is information Special skills in interpreting subtle signals Re-usability of information Matching transactors DO NOT engage the brokers as principal agents (i.e. they do not buy, own or sell the assets) Broker service fee – payable by both parties  The Brokerage Function Bringing transactors together Brokerage Service: – Recall: its stock-in-trade is information Special skills in interpreting subtle signals Re-usability of information Just like real estate agent Matching transactors DO NOT engage the brokers as principal agents (i.e. they do not buy, own or sell the assets) Broker service fee – payable by both parties Is it different from a Marriage Is it different from a car agent (Agoa)?? dealer?? The Brokerage FunctionYes, car dealer buys No, same as real estate agents, marriage brokers do not own the vehicle, owns it the bride/groom before selling and then re-sell it Brokerage Service: – Recall: its stock-in-trade is information Special skills in interpreting subtle signals Just like real estate agent Re-usability of information Matching transactors DO NOT engage the broker as a principal agent (i.e. he does not buy, own or sell the asset)  The Brokerage Function Once a broker serves as a principal, i.e. buys (sells) the asset for eventual resell (repurchase), it accepts the risk that the market may reprice the asset. i.e. it acts like a dealer  The Brokerage Function The broker transcends the more limited role of a matchmaker Consider the following example  The Brokerage Function Re-suability of Information – reduces costs Example: 100 men & 100 women searching for “perfect” marriage partners – To become fully informed, each of the 100 men (women) needs to evaluate each of the 100 women (men) – Assume each evaluation cost $25 – Total cost = ?? (1 bonus) = cost incurred by men to evaluate women + cost incurred by men to evaluate women = 100*100*$25 + 100*100*$25 = 2*100*100*$25 = $ 500,000  The Brokerage Function Re-suability of Information – reduces costs Example: 100 men x & 100 women searching for “perfect” marriage partners – To become fully informed, each of the 100 men (women) needs to evaluate each of the 100 women (men) – Assume each evaluation cost $25 c – Total cost = ?? = cost incurred by men to evaluate women + cost incurred by men to evaluate women = 100*100*$25 + 100*100*$25 = 2*100*100*$25 = $ 500,000  The Brokerage Function Re-suability of Information – reduces costs Now enter the broker – Assume each evaluation cost remains unchanged @ $25 – The broker however, needs to evaluate each participant only once – Total cost = ?? = cost incurred by broker to evaluate women + cost incurred by broker to evaluate women = 100*$25 + 100*$25 = 2*100*$25 = $ 5,000  The Brokerage Function Re-suability of Information – reduces costs Savings associated with having a broker increase: – Exponentially with the size of the grid x & – Linearly with the sampling cost per unit c – Therefore, at the margin ,savings increases as the size of the grid expands. This is shown mathematically using differentiation This extraordinary re-usability of information is what makes it compelling to have a broker And the larger the grid, the greater the potential for savings  The Brokerage Function Re-suability of Information – reduces costs Is cross-sectional Is inter-temporal i.e the same information i.e the same information can be utilized across a can be re-utilized through number of users time This extraordinary re-usability of information is what makes it compelling to have a broker And the larger the grid, the greater the potential for savings Recall Qualitative Asset Transformation Function Processing/ Managing Risks These 2 QAT components work together Transforming Nature of Claim Qualitative Asset Transformation Function How does QAT work? – Think of a world without intermediaries – Assume you wish to buy a real estate (e.g. house) You will need to borrow i.e. you need to find a lender This lender must be willing to hold a mortgage No active secondary market Therefore, (i) Liquidity Issue, and (ii) wide A mortgage has a bid-ask spread number of less Large & irregular unit sizes desirable attributes Long & uncertain duration Default Risk Managing the collateral is expensive Qualitative Asset Transformation Function Enter Financial Intermediary – It purchases the mortgage Finances it with the issuance of deposit Almost infinitely divisible Highly Liquid Little Default Risk No active secondary market Therefore, (i) Liquidity Issue, and (ii) wide A mortgage has a bid-ask spread number of less Large & irregular unit sizes desirable attributes Long & uncertain duration Default Risk Managing the collateral is expensive Qualitative Asset Transformation Function Enter Financial Intermediary – It purchases the mortgage Finances it with the issuance of deposit Almost infinitely divisible Highly Liquid Little Default Risk The F.I. effectively swaps deposits for mortgages, thereby modifying/ transformed the claim held by its clientele Qualitative Asset Transformation Function What asset attributes are mostly transformed? The F.I. effectively swaps deposits for mortgages, thereby modifying/ transforming the claim held by its clientele Qualitative Asset Transformation Function Amongst the asset attributes most commonly transformed are: – Duration (term-to-maturity) – Divisibility (unit size) – Liquidity – Credit risk (risk of default) – Numeraire (currency)  Game: Brokerage v/s QAT Functions  Origination Liquidity Issuance Creation Transactions Monitoring Financial Management GuaranteeingAdvice & Claims Services Expertise Transformation E.g. e.g. An E.g Check-writing, Bank where A bank taking venture insurance monitors initiating to a security Invest? capitalist company borrower’s abuying/selling loan offering , portfolio running toproviding a to borrower compliance a market firm E.g.loan Brokerage v/s QAT Functions securities, for management insurance bank making safekeeping illiquid & so loans on and transforming them into deposit claims that are liquid Transactions Services e.g. Check-writing, buying/selling securities, safekeeping Financial Advice E.g. where to Invest? , portfolio management Brokerage Origination E.g. bank initiating a loan to a borrower Issuance E.g. taking a security offering to a market Financial Intermediary Monitoring e.g. Bank monitors borrower’s compliance for loan Management Expertise E.g. A venture capitalist running a firm Guaranteeing QAT E.g An insurance company providing insurance Liquidity Creation & Claims Transformation E.g. bank making illiquid loans and transforming them into deposit claims that are liquid  Brokerage v/s QAT Functions Transactions Services e.g. Check-writing, buying/selling securities, safekeeping Financial Advice Think of returns Brokerage E.g. where to Invest? , portfolio management in terms of fees Origination E.g. bank initiating a loan to a borrower Issuance E.g. taking a security offering to a market Financial Intermediary Monitoring e.g. Bank monitors borrower’s compliance for loan Management Expertise E.g. A venture capitalist running a firm Guaranteeing Think of returns QAT E.g An insurance company providing insurance in terms of Liquidity Creation & Claims Transformation interest rates & E.g. bank making illiquid loans and transforming them into deposit claims that are liquid Commissions Financial Intermediaries & Markets Lecture 3: Nature of Financial Intermediaries 3(a): Financial Intermediation – The Process End of 3(a)