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Intro to Financial Intermediaries (FI functions (Depository institutions;…
Intro to Financial Intermediaries
Financial Systems
Parts
Financial markets; place to buy/sell financial instruments
Financial institutions; service to facilitate flow of funds from savers to investors
Financial instruments; contract to transfer resources and risks between suppliers/users of funds
Central bank; monitor/stabilise the economy
Money; value store/unit/exchange medium
Roles
Channel savings to investments
Efficient allocation of capital
Allow economic agents to share risks
Direct finance (primary securities); corporations borrow directly from households
Risks
Price risk; fluctuation of claim price conflicts with household goals to preserve savings. Also households lack size to diversify price risk
Transaction costs; costs to protect households when dealing with corporations relatively high compared to size of investment
Liquidity cost; corporate debt/equity relatively long time horizon and no liquid secondary markets to sell securities | incompatible with household liquidity needs
Information/monitoring costs; costs of collecting information on borrowers before and after lending
Indirect Finance (FIs channel household savings to investments)
Asset transformation; purchase primary securities from corporations|offer secondary securities i.e. deposits to households**
Risk transformation
Pool of funds allows FIs to hold a diversified portfolio that offers stabilised return
Liquidity transformation; diversified source of funds means that FIs can predict expected withdrawals and set aside reserves to meet those needs without liquidating long-term investments
Information problems in investing
Information asymmetry; lack of information about lenders/investors before and after the transaction occurs
Adverse selection (before); unable to distinguish between good/bad borrowers beforehand
Solution; screening (FIs better because expertise | economy of scales lowers average cost of information collection | collateral)
Moral hazard (after); risk that borrower engages in excessively risky activity from lender's point of view for personal opportunity after loan is approved
Solution; monitoring (FIs do this more efficiently)
FI functions
Brokers; agents assisting in direct finance by providing information and transaction services more efficiently for a fee
Depository institutions; accept deposits from individuals and institutions and make loans. DIs liabilites significant component of money supply impacting inflation so key role in transmission of CB monetary policy to economy
US- commercial banks, savings institutions, credit unions
AUS- authorised depository institutions (ADIs) including banks, building societies, credit unions
Finance companies; raise funds by selling short-term debt instruments and issuing stocks and bond
Mutual funds; acquire funds by selling shares to many individuals and using proceeds to purchase diversified portfolios. Pooling funds allows for greater diversification and lower transaction costs
Insurance companies
Life insurance; funds from premium to keep policies to insure people against financial hazard. Mainly purchase corporate bonds/mortgages and restricted amounts of stocks
Property-causality; policy insured against theft, fire and accidents. Greater premiums obtained but greater possibility of loss of funds if major disasters occur so more liquid assets relative to life insurance companies
Security firms/investment banks; help net fund suppliers transfer funds to net fund users at low cost/ max efficiency
Investment banking; raise debt/equity securities for corporations/government (origination, underwriting, security placements, capital markets for issuers
Security services; assist in trading of securities in secondary markets (brokerage and/or market making)
Full-service brokers; advice/recommendations on investment plans
Non-advisory brokers; no recommendations or advice
FI Regulation
Necessary because of associated negative externalities (actions of economic agent imposing costs on other economic agents)
Safety/soundness; diversification requirements, capital adequacy requirements
Investor protection regulation; disclosure, insider trading
Post Wallis Inquiry Regulatory Framework
Australian Prudential Regulation Authority (APRA); prudential regulation of: deposit-taking institutions, life/general insurance, superannuation
Australian Securities and Investment Commission (ASIC); market integrity. consumer protection, corporations
Reserve Bank of Australia (RBA); monetary policy, systematic stability, payment system regulation