MAS 100: Financial Intermediaries and Other Participants

• Income received by a party or entity does not match required expenditures results to deficits
• Deficits may be resolved by transferring funds from funds from fund providers to fund demanders
• A special type of financial entity called financial intermediaries were formed to facilitate indirect financing.
• Financial intermediaries were formed during the time when market conditions make it hard for lenders f funds to transact directly with borrowers of funds.
• Financial intermediation is the process of indirect financing using financial intermediaries as the main route to transfer funds from lenders to borrowers.
• Examples of financial intermediaries are depository institutions, insurance companies, asset management firms, regulated investment companies, and investment banks.
• Fund providers use financial intermediaries to transfer funds to fund demanders.
• Financial intermediaries also serve a savings and wealth storage function, allowing parties with excess funds to store their funds in risk-free/low risk financial instruments.
• To ensure efficient allocation, financial intermediaries manage asymmetric information to a certain degree in its operation.
• Asymmetric information occurs when potential borrowers have more information about the transaction compared to the bank.
• Asymmetric information may lead to two further problems: adverse selection and moral hazard.
• Adverse selection means that high-risk borrowers who would tend to default are more likely to be more active in borrowing funds than low-risk borrowers who pay on time.
• Moral hazard occurs when borrowers have to tendency to take undesirable or immoral risks with the money, once they receive it, not disclosed during the loan granting process.
• Adverse selection usually occurs before a transaction takes place.
• Moral hazard happens after the loan is granted.
• Financial intermediaries, specifically banks, allow creation of money through its bank loan services.
• Banks act as the conduit that lessens the constraint of limited income over spending, permitting consumers to spend while expecting future incomes and business to get physical capital.
• Price discovery is the process of setting a price which is acceptable for the buyer and the seller.
• Financial intermediaries play the role of experts and facilitators to enable to assign of values to financial instruments based on different factors.
• The financial system, specifically the banking sector, also significantly influences the discovery of interest rates.
• Interest rates are factored in fair market valuation of financial instruments.
• Financial intermediaries can manage cash from different lenders through immediately encashable products such as current and savings deposits and at the same time offer non-marketable financial products such as mortgages, leases, and credit contracts.
• Price risk means that prices of financial instruments may vary over time.
• Risk sharing happens when financial intermediaries create and sell financial assets with risk profile that their clients are comfortable to invest on.
• Risk sharing can also be called as asset formation, since in essence, risky assets are converted into safer assets for the investors.
• Diversification is the process of investing funds in a portfolio of assets that have individual returns that do not move at the same direction together.
• Risk refers to the uncertainty regarding the return of an investor will earn on their invested assets.
• Low transaction costs allow financial intermediaries to offer diversification.
• Economies of scale occurs when fixed costs are optimized per unit as a result of sheer volume of transactions.
• Cost per transaction is reduced as the number of transaction increases.
• two main economies of scale: transaction costs and research costs.
• Transactions costs pertain to cost associated with trading or managing funds and investment transaction.
• Research costs refer to costs incurred to monitor the performance of potential companies to be invested in through economic, industry, and financial analysis and look for other investment opportunities that will pay off in the long run.
• The financial system serves as the main structure for making payments for any goods, service, or securities that are purchased.
• Most common financial assets that are accepted as payment are bank notes, coins, and bank deposits.
• Risk may also pertain to the uncertainty that something untoward or damaging may occur to a person or entity.
• The two-step process by financial intermediaries:

  1. obtaining of funds from fund providers
  2. Lending or investing fund obtained to the fund demanders
• The funds that they invest or lend out to other market players are recognized as assets of the financial intermediary.
• In exchange of facilitating indirect financing, financial intermediaries receive a fee as cost of providing the service.
• Converting financial assets into another financial asset has 3 economic functions:

  1. Maturity intermediation
  2. Risk reduction via diversification
  3. Cost reduction of contracting and information processing