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Topic 1

3. Identify and explain three economic disincentives that probably dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world
without financial institutions.
Investors generally are averse to directly purchasing securities because of (a) monitoring costs, (b)
liquidity costs, and (c) price risk.
Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result,
households would prefer to leave this activity to others, and by definition, the resulting lack of
monitoring would increase the riskiness of investing in corporate debt and equity markets.
The long-term nature of corporate equity and debt securities would likely eliminate at least a
portion of those households willing to lend money, as the preference of many for near-cash
liquidity would dominate the extra returns which may be available.
Third, the price risk of transactions on the secondary markets would increase without the
information flows and services generated by high volume.
4. Identify and explain the two functions FIs perform that would enable the smooth flow of
funds from household savers to corporate users.
FIs serve as conduits between users and savers of funds by providing a brokerage function and by
engaging in an asset transformation function.
The brokerage function can benefit both savers and users of funds and can vary according to the
firm. 1FIs may provide only transaction services, such as discount brokerages, 2or they also
may offer advisory services which help reduce information costs, such as full-line firms like
Merrill Lynch.
The asset transformation function is accomplished by issuing their own securities, such as deposits
and insurance policies that are more attractive to household savers, and using the proceeds to
purchase the primary securities of corporations. Thus, FIs take on the costs associated with
the purchase of securities.
5. In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives,
to the savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real
assets. These financial claims, which are considered primary securities, are purchased by FIs
whose financial claims therefore are considered secondary securities. Savers who invest in the
financial claims of FIs are indirectly investing in the primary securities of commercial
corporations. However, the information gathering and evaluation expenses, monitoring expenses,
liquidity costs, and price risk of placing the investments directly with the commercial corporation
are reduced because of the efficiencies of the FI.
8. What are agency costs? How do FIs solve the information and related agency costs when
household savers invest directly in securities issued by corporations?
Agency costs occur when owners or managers take actions that are not in the best interests of the
equity investor or lender. These costs typically result from the failure to adequately monitor the
activities of the borrower. If no other lender performs these tasks, the lender is subject to agency
costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests

the funds of many small savers, the FI has a greater incentive to collect information and monitor
the activities of the borrower.
9. How do large financial institutions solve the problem of high information collection costs
for lenders, borrowers, and financial markets in general?
One way financial institutions solve this problem is that they develop of secondary securities that
allow for improvements in the monitoring process. An example is the bank loan that is renewed
more quickly than long-term debt. The renewal process updates the financial and operating
information of the firm more frequently, thereby reducing the need for restrictive bond covenants
that may be difficult and costly to implement.
10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy
securities issued by corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial
banks, for example, offer deposits that can be withdrawn at any time.
Yet, the banks make long-term loans or invest in illiquid assets because they are able to diversify
their portfolios and better monitor the performance of firms that have borrowed or issued
securities. Thus, individual investors are able to realize the benefits of investing in primary assets
without accepting the liquidity risk of direct investment.
11. How do financial institutions help individual savers diversify their portfolio risks?
Which type of financial institution is best able to achieve this goal?
Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government customers.
Insurance companies have investments in many different types of assets. Investments in a mutual
fund may generate the greatest diversification benefit because of the funds investment in a wide
array of stocks and fixed income securities.
12. How can financial institutions invest in high-risk assets with funding provided by lowrisk liabilities from savers?
Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an
FI will be less than the average risk of the individual assets in which it has invested. Thus,
individual investors realize some of the returns of high-risk assets without accepting the
corresponding risk characteristics.
21. What is negative externality? In what ways do the existence of negative externalities
justify the extra regulatory attention received by financial institutions?
A negative externality refers to the action by one party that has an adverse effect on some third
party who is not part of the original transaction. For example, in an industrial setting, smoke from
a factory that lowers surrounding property values may be viewed as a negative externality. For
financial institutions, one concern is the contagion effect that can arise when the failure of one FI
can cast doubt on the solvency of other institutions in that industry.
25.

What forms of protection and regulation do regulators of FIs impose to ensure their
safety and soundness?

Regulators have issued several guidelines to insure the safety and soundness of FIs:
a.

FIs are required to diversify their assets. For example, banks cannot lend more than 10
percent of their equity to a single borrower.

b.
c.
d.

FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.
In the case of banks, the Basle standards require a minimum core and supplementary capital
based on the size of an FIs risk-adjusted assets.
Regulators have set up guaranty funds such as DIF for commercial banks, SIPC for
securities firms, and state guaranty funds for insurance firms to protect individual investors.
Regulators also engage in periodic monitoring and surveillance , such as on-site
examinations, and request periodic information from the FIs.

Topic 5 Liquidity Risk

1. How does the degree of liquidity risk differ for different types of financial
institutions?
Due to the nature of their asset and liability contracts, depository institutions are the
FIs most exposed to liquidity risk. Mutual funds, hedge funds, pension funds, and PC
insurance companies are the least exposed. In the middle are life insurance
companies.
2. What are the two reasons liquidity risk arises? How does liquidity risk
arising from the liability side of the balance sheet differ from liquidity risk
arising from the asset side of the balance sheet? What is meant by fire-sale
prices?
Liquidity risk occurs because of situations that develop from economic and financial
transactions that are reflected on either the asset side of the balance sheet or the
liability side of the balance sheet of an FI.
Asset side risk arises from transactions that result in a transfer of cash to some other
asset, such as the exercise of a loan commitment or a line of credit.
Liability side risk arises from transactions whereby a creditor, depositor, or other
claim holder demands cash in exchange for the claim. The withdrawal of funds from a
bank is an example of such a transaction.
Another type of asset side liquidity risk arises from the FIs investment portfolio.
During the sell-off, liquidity dries up and investment securities can be sold only at
fire-sale prices. A fire-sale price refers to the price of an asset that is less than the
normal market price because of the need or desire to sell the asset immediately under
conditions of financial distress.
3. What are core deposits? What role do core deposits play in predicting the
probability distribution of net deposit drains?
Core deposits are those deposits that will stay with the DI over an extended period of
time. These deposits are relatively stable sources of funds and consist mainly of
demand, savings, and retail time deposits. Because of their stability, a higher level of
core deposits will increase the predictability of forecasting net deposit drains from the
DI.

7. What are two ways a DI can offset the effects of asset-side liquidity risk such
as the drawing down of a loan commitment?
A DI can use either purchased liquidity management or stored liquidity management.
Purchased liquidity management involves borrowing funds in the money/purchased
funds market.
Stored liquidity management involves selling cash-type assets, such as Treasury bills,
or simply reducing excess cash reserves to the minimum level required to meet
regulatory imposed reserve requirements.
11. Define each of the following four measures of liquidity risk. Explain how
each measure would be implemented and utilized by a DI.
a.

Sources and uses of liquidity.


This statement identifies the total sources of liquidity as the amount of cash-type
assets that can be sold with little price risk and at low cost, the amount of funds
the DI can borrow in the money/purchased funds market, and any excess cash
reserves over the necessary reserve requirements. The statement also identifies
the amount of each category the DI has utilized. The difference is the amount of
liquidity available for the DI. This amount can be tracked on a day-to-day basis.
b. Peer group ratio comparisons.
DIs can easily compare their liquidity with peer group institutions by looking at
several easy to calculate ratios. High levels of the loan to deposit and borrowed
funds to total asset ratios will identify reliance on borrowed funds markets,
while heavy amounts of loan commitments to assets may reflect a heavy amount
of potential liquidity need in the future.
c. Liquidity index.
The liquidity index measures the amount of potential losses suffered by a DI
from a fire-sale of assets compared to a fair market value established under the
conditions of normal sale. The lower is the index, the less liquidity the DI has on
its balance sheet. The index should always be a value between 0 and 1.
d. Financing gap and financing requirement.
The financing gap can be defined as average loans minus average deposits,
or alternatively, as negative liquid assets plus borrowed funds.

A negative financing gap implies that the DI must borrow funds or rely on liquid
assets to fund the non-liquid assets. Thus, the financing requirement can be
expressed as the financing gap plus liquid assets. This relationship implies
that some level of loans and core deposits as well as some amount of liquid
assets determine the need for the DI to borrow or purchase funds.

21.

How is the liquidity problem faced by investment funds different from that
faced by DIs and insurance companies? How does the liquidity risk of an
open-end mutual fund compare with that of a closed-end fund?

In the case of a liquidity crisis in DIs and insurance firms, there are incentives for
depositors and policyholders to withdraw their money or cash in their policies as early
as possible. Latecomers will be penalized because the financial institution may be out
of liquid assets. They will have to wait until the institution sells its assets at fire-sale
prices, resulting in a lower payout.
In the case of investment funds, the net asset value for all shareholders is lowered or
raised as the market value of assets change, so that everybody will receive the same
price if they decide to withdraw their funds. Hence, the incentive to engage in a run is
minimized.
Closed-end funds are traded directly on stock exchanges, and therefore little
liquidity risk exists since any fund owner can sell the shares on the exchange.
An open-end fund is exposed to more risk since those shares are sold back to the
fund which must provide cash to the seller.
Topic 6 Liability and Liquidity Management

1.

What are the benefits and costs to an FI of holding large amounts of liquid
assets? Why are Treasury securities considered good examples of liquid
assets?

A major benefit to an FI of holding a large amount of liquid assets is that it can offset
any unexpected and large withdrawals without reverting to asset sales or emergency
funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair
market value. It is more prudent to anticipate withdrawals and keep liquid assets to
meet the demand.
On the other hand, liquid assets provide lower yields, so the opportunity cost for
holding a large amount of liquid assets is high. FIs taking conservative positions by
holding large amounts of liquid assets will therefore have lower profits.
Treasury securities are considered good examples of liquid assets because they can be
converted into cash quickly with very little loss of value from current market levels.
2.

How is an FIs liability and liquidity risk management problem related to


the maturity of its assets relative to its liabilities?

For most FIs, the maturity of assets is greater than the maturity of liabilities. As the
difference in the average maturity between the assets and liabilities increases,
liquidity risk increases.
In the event that liabilities begin to leave the FI or are not reinvested by investors at
maturity, the FI may need to liquidate some of its assets at fire-sale prices. These

prices would tend to deviate further from their market value as the maturity of the
assets increase. Thus, the FI may sustain larger losses.
4.

What concerns motivate regulators to require DIs to hold minimum


amounts of liquid assets?
Regulators prefer DIs to hold more liquid assets because this ensures that they are
able to withstand unexpected and sudden withdrawals.
In addition, regulators are able to conduct monetary policy by influencing the money
supply through liquid assets held by DIs.
Finally, reserves held at the Fed by financial institutions also are a source of funds to
regulators, since they pay little interest on these deposits.
5.

How do liquid asset reserve requirements enhance the implementation of


monetary policy? How are reserve requirements a tax on DIs?

In the case of DIs, reserve requirements on demand deposits allow regulators to


increase or decrease the money supply in an economy. The reserve requirement
against deposits limits the ability of DIs to expand lending activity. Further, reserves
represent a form of tax that regulators can impose on DIs. By raising the reserve
requirements, regulators cause DIs to transfer more balances into non-earning assets.
This tax effect is even larger in cases where inflation is stronger.
15. What is the relationship between funding cost and funding or withdrawal
risk?
Liabilities that have a low cost often have the highest risk of withdrawal. Thus, a DI
that chooses to attract low cost deposits may have high withdrawal risk.
26.

What are the primary methods that insurance companies can use to reduce
their exposure to liquidity risk?

First, insurance companies can reduce their exposure by diversifying the


distribution of risk in the contracts they write. In addition, insurance companies can
meet liquidity needs by holding relatively marketable assets to cover claim
payments.

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