Lecture 1: An Overview of Financial Institutions

Dr Lixiong Guo
Semester 2, 2015

Topics for Today

The goals of the financial system and the importance of a well-

functioning financial system.

Why financial institutions develop and how they help to achieve
the goals of the financial system.
FIs function as asset transformers
What make asset transformation possible.
Information problems in investing and why FIs provide an efficient
solution.

FIs function as brokers.

An overview of different types of FIs.
Regulation of FIs.

An Overview of the Financial System

The financial system has five parts, each of which plays a

fundamental role in our economy.

Money: Medium of exchange, unit of account, store of value.
Financial instruments: legal contracts used to transfer resources
and risks between suppliers of funds and users of funds.
Financial markets: places to buy and sell financial instruments.
Financial institutions: institutions that provide a myriad of services
that facilitate the flow of funds from savers to investors.

Central bank: monitor and stabilize the economy.

The financial system plays two important roles:

The first is to channel savings to investments.
The second is to allow economic agents to share risks.

The two are often closely related.

An Overview of the Financial System

Why is the channelling of savings to investments so important to

the economy?
The answer is that it produces an efficient allocation of capital,
which contributes to higher production and efficiency for the
overall economy.
Suppose you have saved $1,000 this year and you do not have
any investment opportunities yourself. If there is no financial
markets, you will just hold on to the $1,000 and earn no interest.
However, Carl the carpenter can use your $1,000 to purchase a
new tool that will shorten the time it takes him to build a house,
thereby earning an extra $200 per year. If there is a financial
market, you can lend him the $1,000 at a fee of $100 per year,
both of you would be better off.
You would earn $100 on your $1,000 and Carl would earn $100
more income per year.

Funds Flow Through the Financial System

Direct Finance
Primary
Securities
Funds

Financial
Markets

Borrowers-Spenders
(Mostly Firms and
Governments)

Lender-Savers
(Primarily households)

Funds
Secondary
Securities

Financial
Institutions
Indirect Finance

Primary
Securities
Funds

Funds
Primary
Securities

Direct Finance
In direct finance, corporations borrow funds directly from

households in financial markets by selling them securities, which

are claims on the corporations future income or assets.
We call these securities the primary securities.

A balance sheet view of direct finance

Corporations

Households

Household savers face several costs and risk when they invest

directly in corporations.
Information and monitoring costs:
High cost of information collection before the transaction.
High cost of monitoring after the transaction.
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Direct Finance (cont.)

Liquidity cost:
The relative long-term nature of corporate equity and debt, and the lack
of liquid secondary markets in which households can sell these
securities, creates a disincentive for household investors to directly
invest in corporations.

Price risk:
Even if financial markets exist to provide liquidity services, household
investors face the risk that the sale price of the direct claim will be lower
than the purchase price of that claim. This is another disincentive for
household to invest directly in corporations because household savers
are usually more concerned with preserving the value of their saving
than earning high returns.
Given the usually small size of household investments, they do not
have the scale to diversify the price risk.

Direct Finance
Transaction costs:
Household investors often face prohibitively high transaction costs
when investing directly in corporations because of the usually small size
of their investments.
In our previous example of the carpenter, suppose you need to pay a
lawyer $500 to write up the loan contract to protect yourself. When you
figure in this transaction costs for making the loan, you realize that you
cannot earn enough from the deal and will regrettably tell Carl to look
somewhere else.

As a result, in a world with only direct finance, many households

may prefer either not to save or to save in the form of cash.

Indirect Finance
However, the economy has developed an alternative way to

channel household savings to investments indirect finance.

In indirect finance, financial institutions (FIs) stand between the
lender and the borrower, borrowing from the lender and then
providing the funds to the borrower.
By pooling savings from a large number of individual households,
the FI can take advantage of economy of scale to significantly
reduce the information and monitoring costs and transaction
costs.
For example, suppose it costs $100 to buy a brokers report. For a
small investor with a $10,000 investment, this cost may seem to be
inordinately high. The average cost is $1 per $100 investment.
However, for an FI with $10 million investments, the average cost
is only 0.1 cents per $100 investment.

Indirect Finance (cont.)

In our previous example of the carpenter, instead of a loan contract

costing $500, an FI can hire a topflight lawyer for $5,000 to draw

up a loan contract that can be used for 2,000 loans at a cost of
$2.5 per loan. At a cost of $2.5 per loan, it now becomes profitable
for the FI to lend Carl the $1,000.

How does the FIs solve the problems of liquidity costs and price

risk?
The securities the FI buys are the primary securities issued by
corporations but the securities the FI issues to household lenders
are what we call the secondary securities.
Although the secondary securities are backed by the primary
securities the FI holds, they are claims on the FIs future income
and assets not that of the corporations that have issued the
primary securities.
The secondary securities are designed to appeal to households.
For example, they are highly liquid and have very low price risk.
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Indirect Finance (cont.)

e.g. Bank deposits are almost risk free and can have very short maturities.

The process looks as if the FIs have transformed primary

securities, which are not attractive to an average household

saver, into secondary securities, which are very attractive.
This role of the FI is called asset transformation and the FI
playing this role is also called an asset transformer.
A balance sheet view of indirect finance
Corporations

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Households

FI

Assets

Liabilities

Assets

Liabilities

Assets

Real
Assets

Primary
securities

Primary
securities

Secondary
securities

Secondary
securities

Liabilities

Risk Transformation
The real puzzle is how FIs can offer highly liquid and low price

risk contracts to savers on the liability side of their balance sheet

while investing in relatively illiquid and higher price risk securities
issued by corporations on the asset side.
There are two transformations here: risk and liquidity.

The answer for risk transformation lies in the ability of the FIs to

diversify away some but not all of their portfolio risk.

Due to their small size, many household savers are constrained to
holding relatively undiversified portfolios and thus are unable to
achieve the same diversification effect as the FIs.

Instead, the FIs can invest in many different firms at the same

time. As long as the returns on different investments are no

perfectly positively correlated, FIs can diversify away significant
amount of firm-specific risk.
This allows the FI to predict more accurately its expected return
on its asset portfolio.
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A Review of Statistics
Suppose there are two assets, A and B. The variances of the

returns be 2 and 2 , respectively, and the correlation between

the two returns be . The proportion of the portfolio value
invested in A and B are and . Then the variance of the
portfolio return is
2 = 2 2 + 2 + 2 2

If =1, then = +
If =0, then 2 = 2 2 + 2 2
If =1, then = . If we choose the portfolio weight

to be

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then = 0.

Diversification
Suppose we have N assets available, the variance of the i-th

asset is 2 , all returns are uncorrelated with each other. The

1
proportion of the portfolio value invested in i-th asset is . Then

the variance of the portfolio return is

2 =
=1

Define the maximum of 2 is 2 , then

2
=1

2
=

As N increases, 2 diminishes, and, in the limit, as N goes to

infinity, 2 goes to zero.

Thus, if we have sufficiently many assets with uncorrelated

returns, we can drive portfolio risk as low as we wish and make

returns as predictable as desired.
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Liquidity Transformation
Liquidity transformation exposes modern banks to a potential

catastrophe insolvency of the bank.

Lets look at the following balance sheet of a bank
Assets

Liabilities

Reserves $100,000

Demand Deposits $1,000,000

Loans

$900,000

The liabilities of $1 million exceed the banks ability to satisfy

them in the unlikely event that all depositors should seek to

withdraw simultaneously. This potential failure is because loans
are illiquid.
Suppose all $1 million deposits come from one depositor and the
probability that the deposit will be withdrawn after one period is
= 0.1. Is it prudent to keep $100,000 reserve?

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Liquidity Transformation
What about having 1,000 depositors of $1,000 each, assuming

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the probability of withdraw of each depositor is still 0.1 and the

depositors are independent?
What about having 1 million depositors with $1 deposit each?
As the number of depositors increases, assuming independence,
the withdrawal of 10% becomes more predictable; in the limit, a
10% cash holding will almost certainly satisfy deposit
withdrawals.
Hence, the answer for liquidity transformation lies in the ability of
the FIs to diversify the source of their funds.
By diversifying its source of funds, the FI can predict more
accurately its expected daily withdrawals and set aside cash to
meet these withdrawals without liquidating its entire long-term
investments at loss.

Information Problems in Investing

An important economic function of the FIs is to solve the problem

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of asymmetric information, that is the issuers of financial

instruments know much more about their business prospects and
their willingness to work than potential lenders or investors.
Lack of information creates problems in the financial system on
two fronts: before the transaction is entered into and after.
Adverse selection is the problem created by asymmetric
information before the transaction occurs.
Adverse selection in financial markets occurs when the potential
borrowers who are the most likely to produce an undesirable
(adverse) outcomethe bad credit riskare the ones who most
actively seek out a loan and are thus most likely to be selected.
Because adverse selection makes it more likely that loans might
be made to bad credit risks, lenders may decide not to make
loans even though there are good credit risk in the marketplace.

Adverse Selection
Suppose there are two firms in the economy, one has a safe

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project and the other has a risky project.

If you lend $1,000 to the safe firm, the project generates a sure
profit of $1050 for the firm and the firm is willing to give it all to
you as loan repayment.
If you lend $1,000 to the risky firm, the project will generate a
profit of either $10,000 or $0 for the firm with equal probabilities.
Suppose you only want to lend to the safe firm but cannot tell the
difference.
If you charge an interest rate of 5% or lower, both firms are willing
to borrow. This rate is too low for you because you might pick the
risky firm.
If you charge an interest rate above 5%, the safe firm will not
borrow, so it will withdraw from the market, leaving only the risky
firm, which you dont want to lend to.

Adverse Selection
As a result, if you do not have the information to distinguish the

two firms, you may decide not to make a loan to any firm.
However, if you know which firm is safe and which is risky, you
would not have the problem and the safe firm will be funded.
One solution to adverse selection is screening. This requires the
lenders to be good at collecting and analysing information.
FIs have a distinct advantage over individual households in this
aspect because:
They have developed expertise in information collection and
screening.
They can take advantage of economy of scale to significantly lower
the average cost of information collection.

The financial markets have also developed other solutions to

adverse selection, for example, the use of collaterals. If a loan is

insured in some way, then the borrower isnt a bad credit risk.
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Moral Hazard
Moral hazard is the problem created by asymmetric information

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after the transaction occurs.

Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral)
from the lenders point of view, because they make it less likely
that the loan will be paid back.
The information problem is that the borrower knows more than
the lender about the way borrowed funds will be used and the
effort that will go into the project.
Because debt contracts allow owners to keep all the profits in
excess of the loan payments, they encourage risk taking. Lenders
need to find ways to make sure borrowers dont take too much
risk.
The solution is monitoring. Again, the FIs can do this more
efficiently than household savers.

FIs Function As Brokers

Besides asset transformation, FIs also assist with direct finance

as brokers.
The FIs are involved as agents not principals and are usually
compensated with a fee for performing the services.
The FIs mainly provide information and transaction services.
The FIs can perform these services more efficiently than
individuals can because of economy of scale.

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Depository Institutions
There are many different types of FIs, each plays one or more

functions we just discussed.

Depository institutions (DIs) are FIs that accept deposits from
individuals and institutions and make loans. They make up the
largest group of FIs by size of balance sheet.
In the U.S., these institutions include commercial banks, savings
institutions, credit unions.
In Australia, these institutions are called authorized depository
institutions (ADIs), including banks, building societies, credit
unions.
DIs provide important payment services to the economy.
Because the liabilities of DIs are a significant component of the
money supply that impacts the rate of inflation, DIs play a key role
in the transmission of monetary policy from the central bank to the
rest of the economy.
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Finance Companies, Mutual Funds

Finance Companies: finance companies raise funds by selling

commercial paper (a short-term debt instrument) and by issuing

stocks and bonds. They lend these funds to consumers, who
make purchase of home appliances or automobiles and to small
businesses. Some finance companies are organized by a parent
corporation to help sell its product.
Mutual funds: they acquire funds by selling shares to many
individuals and use the proceeds to purchase diversified portfolios
of stocks and bonds. Mutual funds allow shareholders to pool
their resources so that they can take advantage of lower
transaction costs when buying large blocks of stocks or bonds. In
addition, mutual funds allow shareholders to hold ore diversified
portfolios than they otherwise would.

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Insurance Companies
Life insurance companies insure people against financial hazards

following a death and sell annuities. They acquire funds from the
premiums that people pay to keep their policies in force and use
them mainly to buy corporate bonds and mortgages. They also
purchase stocks, but are restricted in the amount that they can
hold.
Property-causality insurance companies insure their policy
holders against loss from theft, fire, and accidents. They are very
much like life insurance companies, receiving funds through
premiums fro their policies, but they have a greater possibility of
loss of funds if major disasters occur. For this reasons, they use
their funds to buy more liquid assets than life insurance
companies do.

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Security Firms and Investment Banks

Security firms and investment banks primarily help net suppliers

of funds transfer funds to net users of funds at a low cost and with
a maximum degree of efficiency.
Unlike other types of FIs, securities firms and investment banks
do not transform the securities issued by the net users of funds
into claims that may be more attractive to the net suppliers of
funds. Rather, they serve as brokers intermediating between fund
suppliers and users.
Investment banking involves the raising of debt and equity
securities for corporations or governments. This include the
origination, underwriting, and placement of securities in money
and capital markets for corporate or government issuers.
Security services involve assistance in the trading of securities in
the secondary markets (brokerage services and/or market
making).
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Security Firms and Investment Banks

The main difference between brokers is whether they offer advice

or not, they are either

Full-service brokers: Offering advice on buying and selling
securities, make recommendations, provide research and compile
tailored investment plans.
Non-advisory brokers: Offering no recommendations or advice
regarding the appropriateness of your decision

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Regulations of FIs
FIs are special because the services they provide are crucial to

the economy. Failure to provide these services or a breakdown in

their efficient provision can be costly to both the ultimate sources
and users of the savings.
The negative externalities when something goes wrong in the
financial sector make a case for regulation.
Negative externality: Actions by an economic agent imposing costs
on other economic agents.

Safety and soundness regulations

Diversification requirement, Capital adequacy requirement
Investor protection regulations
Disclosure, Insider trading

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Financial Regulatory Framework in Australia

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Financial Regulators in Australia

APRA = Australian Prudential Regulation Authority.

Responsible for the prudential regulation and supervision of the
finance services industry.
ASIC = Australia Securities and Investments Commission
Responsible for market integrity and consumer protection across
the financial systems.
Set standards for financial market behavior with aim to protect
investor and consumer confidence.
Administers the Corporate Law to promote honesty and fairness in
companies and markets.

RBA = Reserve Bank of Australia

Responsible for the development and implementation of monetary
policy and for overall financial stability.

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