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Chapter 2.

Financial Intermediaries & Financial Innovation

financial institutions role of financial intermediaries asset/liability management financial innovation

I. Financial Institutions

provide financial services

transforming financial assets (own one type, issue another type) trade financial assets create & sell assets on behalf of others investment advice & management

depository institutions
acquire funds mostly from deposits nondepository institutions acquire funds from other sources

II. Role of Financial Intermediaries

raise funds FOR direct investment their assets stock, bonds, loans raise funds BY indirect investment issue their own liabilities accept deposits, sell insurance policies sell mutual funds shares

indirect investments allow investors

choice of desired maturity

maturity intermediation diversification w/ small amount of capital lower transactions costs alternative payment mechanisms

III. Asset/liability Managment

liabilties = claims on financial

institution liabilities differ in the certainty about their amount and timing

Type I Liabilities

timing and amount is certain

fixed rate bank CD GIC (guaranteed investment contract) (principal and fixed interest payment due on specified date)

Type II Liabilities

amount is certain, timing is not

term life insurance policy (amount of policy is known, but timing of death is not)

Type III Liabilities

amount not certain, but timing is

variable rate bank CD (know the maturity date, but not size of interest payment)

Type IV Liabilities

amount and timing uncertain

auto insurance policy property insurance policy (how much is the damage? when will damage occur?)

type of liabilities issued determines

the types of assets bought & held long-term or short-term? risk?

IV. Financial Innovation

creation of new financial assets new ways to use financial assets dramatic in past 30 years

why does it happen?

changing times/ new risks

increased volatility in -- interest rates -- stock prices -- exchange rates led to development of derivatives

advances in technology
rapid flow of information rapid calculation of risks and prices rapid trading competition among institutions for products for strategies


regulations, tax laws NOW accounts in 1970s selling short against the box sophistication of market professionals devise & use complex securities price complex securities

Asset securitization

take individual loans pool them together issue & sell securities w/ cash flow
back by the loan pool payments

old way: bank originates mortgage bank holds mortgage & collects payments until loan is paid new way: bank originates mortgage bank sells mortgage to Fannie Mae bank gets fee for servicing mortgage Fannie Mae issues securities


bank capital not tied up in loans institutions specialize in part of

process pool of loans is diversified (less risk) loans are more liquid easier to get cheaper to get