Financial Institutions Chapter 1
What events resulted in banks' shift from the traditional banking model of "originate and hold" to a model of "originate and distribute?"
As FIs adjusted to regulatory changes brought about by the likes of the FSM Act, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of "originate and hold" to "originate to distribute." In the traditional model, banks take short term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial service holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, and interest rate risks of traditional banking, they had little incentive to screen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk measurement and management.
Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?
By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. In this sense, depositors have delegated the FI to act as a monitor on their behalf. Further, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy.
What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide?
Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy which are considered to be socially important. These may include housing and farming. Presumably the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society.
What is denomination intermediation? How do FIs assist in this process?
Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are sold only in large denominations. Individual savers often invest small amounts in mutual funds. The mutual funds pool these small amounts and purchase a well diversified portfolio of assets. Therefore, small investors can benefit in the returns and low risk which these assets typically offer.
How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers?
Diversification of risk occurs with investments in assets whose returns 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 assets in which the individual has invested. Thus, individual investors realize some of the returns of high-risk assets without accepting the corresponding risk characteristics.
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. FIs may provide only transaction services, such as discount brokerages, or 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.
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.
Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.
In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs. This process would be extremely costly because of the up-front information costs faced by potential lenders. Cost inefficiencies would arise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities, and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan's life span. The net result would be an imperfect allocation of resources in an economy.
Identify and explain three economic disincentives that would 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. Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.
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 fund's investment in a wide array of stocks and fixed income securities.
How do large financial institutions solve the problem of high information collection costs for lenders, borrowers, and financial markets?
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.
What legislation has been passed specifically to protect investors who use investment banks directly or indirectly to purchase securities? Give some examples of the types of abuses for which protection is provided.
The Securities Acts of 1933 and 1934 and the Investment Company Act of 1940 were passed by Congress to protect investors against possible abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities.
How did the boom in the housing market in the early and mid-2000s exacerbate FI's transition away from their role as specialists in risk measurement and management?
The boom ("bubble") in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term money market rate that banks and other financial institutions pay in the Federal funds market and even made lender of last resort funds available to non-bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by Central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the "subprime market," banks and other mortgage-supplying institutions often offered relatively low "teaser" rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate-to-distribute model of banking, asset securitization and loan syndication allowed banks to retain little or no part of the loans, and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan's issuance and the loans were sold or securitized without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage.