continuation part2

• Differentiate between primary and secondary markets
• Differentiate between money and capital markets
• Understand what derivative security markets are
• Understand what foreign exchange markets are
• Distinguish between the different types of financial institutions
• Know the services financial institutions perform
• Know the risks financial institutions face
• Know the reasons why financial institutions are regulated
• Recognize that financial markets are becoming increasingly global
• Unique Economic Functions Performed by Financial Institutions (FIs)
• Services Benefiting Suppliers of Funds
• Monitoring costs

  • Aggregation of funds in an FI provides greater incentive to collect a firm’s information and monitor actions at a lower average cost (economies of scale)
  • Fund suppliers appoint the financial institution as a delegated monitor to act on their behalf
• Liquidity and price risk

  • FIs provide financial claims to household savers with superior liquidity attributes and lower price risk
• Transaction cost services

  • An FI’s size can result in economies of scale in transaction costs
  • Economies of scale are cost advantages companies experience when production becomes efficient
• Maturity intermediation

  • FIs can better bear the risk of mismatching the maturities of their assets and liabilities
  • Example: When a financial institution borrows money from certificates of deposit or demand deposits and then loans that money out as a 30-year mortgage, it engages in maturity intermediation
• Denomination intermediation

  • FIs such as mutual funds allow small investors to overcome constraints to buying assets imposed by large minimum denomination size
  • Small investors can purchase pieces of assets that are normally sold only in large denominations
• Services Benefiting the Overall Economy
• Money supply transmission

  • Depository institutions are the conduit through which monetary policy actions impact the financial system and the economy
  • The monetary transmission mechanism affects asset prices and general economic conditions to influence aggregate demand, interest rates, and money and credit amounts
• Credit Allocation

  • FIs are often the major source of financing for sectors like farming and residential real estate
• Intergenerational wealth transfers

  • Life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next
• Payment services

  • Efficient payment services provided by depository institutions directly benefit the economy
• Risks that Financial Institutions face
• Credit risk

  • Risk that the FI’s assets are subject to default or credit risk
• Foreign exchange risk

  • Risk of losing money on international trade due to currency fluctuations
• Country or sovereign risk

  • Risk of a government defaulting on its debt or other obligations, associated with investing in a particular country
• Interest rate risk

  • Risk caused by unexpected fluctuations in interest rates
• Market risk or Asset price risk

  • Risk of incurring losses due to factors affecting the overall performance of financial markets
• Liquidity risk

  • Risk that an FI might not meet its obligations, requiring sufficient funds to be available at a reasonable cost
• Technology risk

  • Potential for technology failure to disrupt business operations
• Operational risk

  • Risk of losses due to flawed processes, policies, systems, or events disrupting business operations
• Insolvency risk

  • Risk that an FI may not have enough capital reserves to offset sudden losses incurred from the risks it faces