IF1204
Week 1 - The Modern Financial System
Modern Financial System and Roles of Financial Intermediaries:
Week 1 Slides:
● The financial systems exists to channel the funds from the surplus units to the deficit units
● Financial assets are a claim for a payment in the future of a sum of money or a periodic payment of money
- The issuer of the financial asset claim is obligated to receive interest periodically and collect the claim at
a stated value
- The issuer of the claim is thus said to have financial liability, as they are at risk of not receiving their
payment (in full).
A non exhaustive Financial System Overview:
Surplus Units: Lenders
- economic agents with an excess of funds
- Households, Treasury management of corporations, multinational companies
Lenders Requirements:
● Minimised risk, minimised cost
● Liquidity
● Invest for shortest amount of time possible with highest possible returns
Deficit Units: Borrowers
- economic agents with deficit or negative funds
- Corporations, Governments
Borrower’s Requirements:
● Specified date, period of time
● Lowest possible cost (Interest)
● Hold funds for as long as possible with the lowest costs possible
Non intermediated financing:
- Surplus and deficit units meet informally in the market to arrange a transaction without intermediaries
- Doing so removes costs associated with financial intermediation, however interests must align between both
parties
Financial Intermediaries:
● Depository Institutions: Generally banks, institutions funded by deposits
● Finance Companies: Companies that mostly provides loans to consumers, popular as it lends when banks cannot
● Mutual Funds: Highly diversified investments with expertise
● Insurance companies: Companies that profit from taking risk away from the customer.
- Out of 100 people, if 2 are statistically exposed to some risk, the insurance company collects a fee to
cover the risk from all 100 people, but must only pay the 2 people affected by the risk. And thus makes a
profit.
● Government and Central Banks: FIs are highly regulated to protect the system against a disruption in the
provision of the financial services and the costs this would impose on the economy and society at large. Central
banks through monetary policy oversee the financial system, banks in particular, from a macro perspective.
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● Regulators and Supervisors: the former defines the set of rules the FIs have to comply with (i.e. rules on capital)
and the latter monitors the actual compliance with these rules while ensuring the soundness of the FIs from a
micro perspective.
Financial institutions fulfil the following main functions:
● The brokerage function: financial intermediaries match transactors, provide transactions and other services. As a
result, they reduce transaction costs and remove information costs.
● The asset transformation function: financial institutions issue claims that are far more attractive to savers (in terms
of lower monitoring costs, lower liquidity costs and lower price risk) than the claims issued directly by
corporations.
Pool Savings:
The most straightforward economic function of a financial intermediary is to pool the resources of many small savers. By
accepting many small deposits, banks empower themselves to make large loans. In order to do this, the intermediary:
● Must attract substantial numbers of savers, and
● Must convince potential depositors of the institution’s soundness.
Text Book Chapter 1 - Introduction to Banking
Week 1 Material
A financial claim is a claim to the payment of a future sum of money and/or a periodic payment of money. More
generally, a financial claim carries an obligation on the issuer to pay interest periodically and to redeem the claim at a
stated value in one of three ways:
1. on demand
2. after giving a stated period of notice
3. on a definite date or within a range of dates.
The borrowing–lending process illustrated in Figure 1.2 does not require the existence of financial intermediaries.
However, two types of barriers can be identified to the direct financing process:
1. The difficulty and expense of matching the complex needs of individual borrowers and lenders.
2. The incompatibility of the financial needs of borrowers and lenders. Lenders are looking for safety and liquidity.
Borrowers may find it difficult to promise either.
Transaction costs relate to the costs of searching for a counterparty to a financial transaction; the costs of obtaining
information about them; the costs of negotiating the contract; the costs of monitoring the borrowers; and the eventual
enforcement costs should the borrower not fulfil its commitments.
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Prior to the 2007–2009 financial turmoil, banks also engaged in a wide process of securitisation (i.e. the pooling and
repackaging of illiquid financial assets into marketable securities) thus creating an extra layer of intermediation, as
illustrated in Figure 1.4.
Deposits typically have the characteristics of being small-size, low-risk and high-liquidity. Loans are of larger-size,
higher-risk and illiquid. Banks bridge the gap between the needs of lenders and borrowers by performing a transformation
function:
● size transformation;
● maturity transformation;
● risk transformation.
Size transformation:
Generally, savers/depositors are willing to lend smaller amounts of money than the amounts required by borrowers. For
example, think about the difference between your savings account and the money you would need to buy a house!
- Banks collect funds from savers in the form of small-size deposits and repackage them into larger size loans.
- Banks perform this size transformation function exploiting economies of scale associated with the
lending/borrowing function, because they have access to a larger number of depositors than any individual
borrower
Maturity transformation:
Banks transform funds lent for a short period of time into medium- and long-term loans. For example, they convert
demand deposits (i.e. funds deposited that can be withdrawn on demand) into 25-year residential mortgages.
- Banks’ liabilities (i.e. the funds collected from savers) are mainly repayable on demand or at relatively short
notice. Meanwhile, banks’ assets (funds lent to borrowers) are normally repayable in the medium to long term.
- Banks are said to be ‘borrowing short and lending long’ and in this process they are said to ‘mismatch’ their assets
and liabilities.
- This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough liquid funds
to meet one’s liabilities.
Risk transformation:
Individual borrowers carry a risk of default (known as credit risk), which is the risk that they might not be able to repay
the amount of money they borrowed. Savers, meanwhile, wish to minimise risk and prefer their money to be safe.
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- Banks are able to minimise the risk of individual loans by diversifying their investments, pooling risks, screening
and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses.
Week 2 - Information Economies and Theories of Financial Intermediaries
Week 2 Slides -
● Costs for searching for a counterpart to a financial transaction
● Cost of obtaining information about them
● Cost of negotiating the contract
● The cost of monitoring the borrowers
● The cost of enforcement should the borrower violate or not fulfil its commitments.
Transaction costs can be measured in time and money spent in carrying out a financial transaction.
Economies of scale:
FIs reduce transaction costs by exploiting economies of scale: by increasing the volume of transactions, the cost per unit
of transaction decreases.
FIs have expertise in screening and monitoring Deficit Units as the time and costs associated with these processes are
reduced compared to an individual lender.
Economies of scope:
FIs reduce transaction costs by exploiting the economies deriving from the joint supply of (two) services so that the total
cost is lower than the cost to produce/provide them separately.
● Financial intermediaries benefit by carrying risk at relatively low transaction costs. Since higher risk assets on
average earn a higher return, financial intermediaries can earn a profit on a diversified portfolio of risky assets.
● Risk to individual investors is lowered through the pooling of assets by the financial intermediary.
● Individual investors benefit by earning returns on a pooled collection of assets issued by financial intermediaries
at lower risk.
● Financial firms that provide multiple types of financial services can be more efficient through economies of scope,
that is, by lowering the cost of information production.
● An example, for a bank, would be that the acquiring of information about a client opening a bank account is then
used for their mortgage application in the future.
Information Asymmetries:
Information is at the heart of all financial transactions. But information is not symmetrically distributed across all agents
in the financial system.
● Not everyone has the same information
