Unit_2.pdf

DFA1035 Y Fundamentals of Finance and Practice UNIT 2 FINANCIAL INTERMEDIARIES Unit Structure 2.0 Overview 2.1 Learning Outcomes 2.2 Financial Institutions 2.3 Role of Financial Intermediaries 2.3.1 Maturit...

DFA1035 Y Fundamentals of Finance and Practice UNIT 2 FINANCIAL INTERMEDIARIES Unit Structure 2.0 Overview 2.1 Learning Outcomes 2.2 Financial Institutions 2.3 Role of Financial Intermediaries 2.3.1 Maturity Intermediation 2.3.2 Reducing Risks via diversification 2.3.3 Reducing the cost of contracting and information processing 2.3.4 Proving a Payments Mechanism 2.4 Asset Management Firms 2.5 Depository Institutions 2.5.1 Credit or Default Risks 2.5.2 Regulatory Risks 2.5.3 Interest Rate Risks 2.5.4 Liquidity Risks 2.6 Activities 2.7 Summary 2.8 Suggested Readings 2.9 Useful Links 2.0 OVERVIEW Businesses provide financial and non-financial services. To this effect, there are financial and non- financial enterprises. In this unit, we focus on financial enterprises. One of the main financial enterprises includes financial intermediaries. Financial intermediaries have several economic functions within a financial system. To this effect, the objective of this unit is to help students to understand the roles of financial intermediaries, the different types of services which they can provide and the basic risks pertaining to depository institutions. Unit 2 1  DFA1035 Y Fundamentals of Finance and Practice 2.1 LEARNING OUTCOMES By the end of this Unit, you should be able to do the following: 1. Explain the roles of the financial intermediaries. 2. Define the process of transformation. 3. Discuss how financial intermediaries offer investors diversification. 4. Assess how financial intermediaries reduce the costs of information. 5. Explain the basic functions of asset management firms. 6. Explain the characteristics of depository institutions. 2.2 FINANCIAL INSTITUTIONS Read: Chapter Two, Page 23, Financial Institutions- Book FFMI, 4th Ed. Firms can be categorized as nonfinancial and financial enterprises. Nonfinancial enterprises are related to the production of goods such as car, computers, garments etc and also provide non financial services such as transportation. On the other hand, financial enterprises, known as financial institutions, provide a list of services. [You are required to refer to the text for the list of services provided] Financial institutions are financial firms that offer services related to one or more of the following: · Transform financial assets acquired through the market and convert them into a different type of asset, · Exchange financial assets on behalf of customers or for their own accounts, · Help in the creation of new financial assets for their customers, and then trade those financial assets to new market participants (underwriting), · Offer investment guidance, and · Manage and be in charge of their investment portfolios or that of their clients. One of the most important financial institutions includes financial intermediaries which transform assets acquired through the market into suitable type of asset. Financial intermediaries can be depository institutions such as commercial banks, credit unions, etc. Alternatively, financial intermediaries can be insurance companies, pension funds and finance companies. Unit 2 2  DFA1035 Y Fundamentals of Finance and Practice 2.3 ROLE OF FINANCIAL INTERMEDIARIES Read: Chapter Two, Page 24, Role of financial intermediaries- Book FFMI, 4th Ed. The surplus agents typically save or invest for different purposes. For instance, some households will save for retirement purposes while others might save for the purchase of a house. Similarly, businesses can set aside cash to meet future contingencies, for expansion or for acquiring a new firm amongst others. Governments can also save to finance future social benefits. Deficits agents also borrow for a number of reasons. These might range from house purchase, financing education, financing investment projects to financing infrastructural projects, amongst others. Thus individuals, businesses and governments have different needs. In order to meet those demands, there exist different financial institutions or intermediaries. Some financial institutions offer a standard product while others provide a specialised tailor-made financial product to meet the needs of the agents. To highlight the basic functions of financial intermediaries, we distinguish between direct and indirect finance. · The direct finance occurs when there is a direct link between the surplus and deficit agent. The deficit agent knows the surplus agent and vice-versa. For instance, if an individual invests in a stock market, he or she knows the company and the company knows the shareholders. To this effect, there is a direct link between the originators of the funds (the investor) and the recipients of the funds (the company). · Indirect finance involves the use of financial intermediaries between the surplus agent and the deficit agent. For instance, an individual who lends money to a bank does not know who will be taking that money as a loan. For example, a bank which acts as the financial intermediary raises funds by borrowing (taking in deposits) and lending that money to (purchasing the loans of) other borrowers. To this effect, financial intermediaries are firms that sell their own liabilities to raise funds that are used to purchase liabilities of other corporations. In particular, financial intermediaries can be commercial banks, savings and loan associations, insurance companies, investment companies, pension funds amongst others. These financial intermediaries offer a sound and reasonably low-cost flow of funds to eventual users or investors by first and foremost Unit 2 3  DFA1035 Y Fundamentals of Finance and Practice accepting deposits from those who have surplus funds and transferring these funds to those who are in shortage of funds. We have seen that financial intermediaries help to process the transfer of funds from surplus agents to deficit agents. To this effect, financial intermediaries fulfil the following economic roles: 1. Maturity Intermediation 2. Reducing Risks via diversification 3. Reducing the cost of contracting and information processing, and 4. Proving a Payments Mechanism. 2.3.1 Maturity Intermediation Financial intermediaries convert their short term liabilities into long term assets. This process is known as maturity transformation. This helps the different borrowing and investment needs of deficit and surplus agents. For instance, a commercial bank accepts deposits from surplus agents which are generally short term while simultaneously providing long term loans to deficit agents. There are two implications for the financial markets. First, investors are being provided with more choices with regards to the maturity of their investments. Likewise, borrowers can choose the length of their debt obligations. Secondly, cost of long term borrowing will be significantly reduced. 2.3.2 Reducing Risks via Diversification Small investors or individuals find it difficult to achieve some degree of diversification due to their limited financial means. For instance, small investors will not be able to pay a team of financial analysts. However, investment companies, being a financial intermediary between the investors and the market, pool large funds from different parties before investing into different assets. The role of investment companies is to pool small funds to attain a cost-effective diversification. In fact, the investment company benefits from economies of scale due to their huge financial resources. 2.3.3 Reducing costs of Contracting and Information Processing For surplus agents willing to do business with deficit agents, they need to have sufficient information. For instance, lenders need to know the credit-worthiness of borrowers. However, acquiring such information involves a cost and even if this information is obtained, there will be an opportunity cost Unit 2 4  DFA1035 Y Fundamentals of Finance and Practice of time when processing that information. In particular, the information processing costs can be relatively higher for individual agents such that the transfer of funds between the surplus agents to the deficit agents is being compromised. As such, financial intermediaries with huge financial means can easily manage this information processing costs by hiring a team of financial analysts. In particular, financial intermediaries benefits from economies of scale in contracting and processing information about financial assets. Hence, the benefits of the economies of scale are to some extent shared with borrowers and lenders in the market. 2.3.4 Providing a Payment Mechanism In most developed and developing countries, payment is effected using non-cash means such as cheques, credit cards, debit cards and electronic transfer of funds. Without financial intermediaries, investors will resort to cash as a payment mechanism. The ability to make payments without the use of cash is essential for the running of a financial market. Undoubtedly, financial intermediaries, through non-cash means, create an effective payments system not only between domestic agents but also between local and foreign residents. Unit 2 5  DFA1035 Y Fundamentals of Finance and Practice 2.4 ASSET MANAGEMENT FIRMS Read: Chapter Two, Page 31, Asset Management firms- Book FFMI, 4th Ed. Asset management firms are also referred as money management firm or fund management firms where they manage the funds for individuals or private or public organisations. Those who manage the funds are referred as asset managers, money managers, fund managers and portfolio managers. In return for managing the funds for others, the asset management firms earn a management fees based on the value of the investment. However, some asset management firms earn their fees based on performance rather than a fixed percentage on the value of the investments. Typically, the asset management firms can investment in a range of assets which include common stocks, bonds, real estate, currencies amongst others. As such, we have different types of funds with different specific objectives. For instance, if the asset management firm decides to invest solely on common stocks or equities, this will be known as an equity fund. A portfolio manager can also decide to create a hedge fund which engages in a variety of investments. Question for thought- refer to the text and other sources (for instance the company’s website) for the historical background and role of largest US asset management firms. 2.5 DEPOSITORY INSTITUTIONS Read: Chapter Three, Page 42, Asset/liability Problem of Depository Institution- Book FFMI, 4th Ed. Deposit Institutions create their liabilities by accepting deposits from surplus agents and then subsequently create their assets by making loans or investments to deficit agents. Commercial banks are the major type of deposit institutions. However, there are also non-bank depository institutions such as savings institutions. Due to their significant role within the financial system, depository institutions are highly regulated. Their sources of profit depend on the difference between (1) the cost of their deposits and other sources of funding and (2) the return from their assets i.e., loans or other investments and fee income. Unit 2 6  DFA1035 Y Fundamentals of Finance and Practice In particular, the difference between the assets of the institutions and the costs of funding is referred as the spread income or margin. However, depository institutions face a number of risks in generating a fair amount of profit on its capital. The main risks of depository institutions are as follows: · Credit or default Risks · Regulatory Risks · Interest Rate Risks · Liquidity Risks 2.5.1 Credit or Default Risks As the institutions provide loans to borrowers, there will always be the concerns that counterparties might default, that is, fail to pay or honour their obligations. Similarly, when making investments, there is the risk that the issuer of a security might go bankrupt and as such, is unable to honour its obligations. In this respect, depository institutions have devised several mechanisms to counter those credit risks. One of the main tools to mitigate credit risks is the use of collaterals or guarantees by the depository institutions. However, in some cases, there might still be losses in case default occurs as the value of the collaterals might not be sufficient to cover all the current debt obligations. Unit 2 7  DFA1035 Y Fundamentals of Finance and Practice 2.5.2 Regulatory Risks The profitability of the institution can be adversely affected as regulators might change the rules or the regulatory framework of the institution. A change in laws or regulations made by the government or a regulatory body can add to the costs of operating or lower revenue for the institution. As an example, the regulator could ask depository institutions to raise their regulatory capital. The regulatory capital represents the amount which the depository institution has to hold as defined by the regulator. It will be a cost or revenue loss for the institutions as higher regulatory capital lowers the total amount of lending or investments of the institution. 2.5.3 Interest Rate Risks Interest rate risks are movements in interest rates which might adversely impact on the institution’s profits. As an illustration, suppose a commercial bank pays a variable interest rate of 6% to its depositors and receives a fixed income of 8% from lending. The spread income (difference between what the bank pays and receives) will be a rough amount of 2% (8%-6%). However, if interest rate increases in the future, say at 9%, the institution will be paying more its funds than it will earn on the funds invested. In short, the spread will fall as interest rate increases. Alternatively, the institution can choose to pay a fixed interest rate of 6% and set a variable rate of 8% on its lending. However, a fall interest rate will mean a lower spread in this case. In particular, if interest rate falls say to 5%, there will be a negative spread of 1% (5%-6%). In this situation, the spread will fall as interest rate falls. All institutions face this type of interest rate risks. The institutions need to be aware of the expected future direction of interest rates: this will provide managers some guidance to set up policies to benefit from these expectations. 2.5.4 Liquidity Risks Deposit-taking institutions are faced with liquidity risks due to the maturity structure of their assets and liabilities. In particular, deposits which are the institutions’ liabilities are generally short term while the loans or investments being the institutions’ assets are usually long term. As such, there is a mismatch between the institution’s assets and liabilities. In particular, the institutions could be short of funds in the event there is a sudden large withdrawal by depositors. However, there are a number of ways through which this liquidity risk could be managed. Essentially, the institutions can attract new deposits, hold cash reserves, borrow on a short term basis from the central bank or a federal agency, Unit 2 8  DFA1035 Y Fundamentals of Finance and Practice borrow funds from the money market, sell existing securities which it owns or raise interest rates to discourage deposit withdrawals. 2.6 ACTIVITIES Activity 1 “Financial intermediary reduces the cost of contracting and information processing”. Discuss. Activity 2 With reference to your own country, you are required to discuss the functions and activities of regulators of banking services. Hint: you are required to consult the website of Bank of Mauritius- (www.bom.mu) Activity 3 With reference to your own country, you are required to discuss the functions and activities of regulators of non-banking services. Hint: you are required to consult the website of financial services commission- (http://www.fscmauritius.org/) Activity 4 “Depository institutions are faced with an inherent number of risks”. Discuss. 2.7 SUMMARY · The transfer of funds is largely assisted by the existence of financial intermediaries. · Direct finance occurs when there is a direct link between the surplus and deficit agent. · Indirect finance involves the use of financial intermediaries between the surplus agent and the deficit agent. · Financial intermediaries convert their short term liabilities into long term assets and this process is known as maturity transformation. · Financial intermediaries decrease risks for the investor through diversification. Unit 2 9  DFA1035 Y Fundamentals of Finance and Practice · Financial intermediaries with huge financial means can easily manage this information processing costs by hiring a team of financial analysts. · Financial intermediaries, through non-cash means, create an effective payments system not only between domestic agents but also between local and foreign residents. · Some financial institutions offer a standard product while others provide a specialised tailor-made financial product to meet the needs of the agents. · Deposit Institutions create their liabilities by accepting deposits from surplus agents and then subsequently create their assets by making loans or investments to deficit agents. 2.8 SUGGESTED READINGS · Fabozzi, F.J., Modigliani, F., Jones, F.J., and Ferri, M.J., “Foundations of Financial Markets and Institutions”, Fourth or Latest Edition · Keith Pilbeam “Finance and Financial Markets” Second or Latest Edition by Palgrave · J. Rutterford ,1996, “Introduction to Stock Exchange Investment” Latest Edition 2.9 Useful Links · Allen, Franklin, and Anthony M. Santomero. "What do financial intermediaries do?." Journal of Banking & Finance 25.2 (2001): 271-294. Available at: http://pascal.iseg.utl.pt/~aafonso/eif/pdf/1534.pdf · Mauritius bankers Association Ltd- http://www.mba.mu/ · The African Insurance Organisation (AIO)- http://www.african-insurance.org/about.php · The Financial Services Commission- http://www.fscmauritius.org/ · The Bank of Mauritius-https://www.bom.mu/ Unit 2 10