6-Deposit Taking Institutions

Financial Intermediary
Depository & Non Depository
DEPOSIT TAKING AND NON DEPOSIT TAKING INTERMEDIARIES
• A bank can accept deposits. Such deposits of the customers can be withdrawn by cheque
or otherwise (withdrawal slip, letter and voucher) on demand, or repayable on maturity to the
customers.
• The bank lends or invests the funds collected from its customers,.
• Acceptance of deposits and lending the same are thus core functions of a bank. The above
process is known as intermediation.
INTERMEDIATION
• The principle of intermediation is closely related to the core banking functions, taking of
deposit and extending of credit.
• Banks are ‘financial intermediaries’ because they invest or lend the funds of depositors
who themselves are unable to lend their funds to others due to risk and other factors involved in
direct lending.
INTERMEDIATION….Cont’d
 Banks assume the credit and other risks involved in direct lending to those who need
funds (borrowers) because of their expertise and administrative abilities to manage such risks.
 Thus banks mediate between the depositors (savers of money) and borrowers (users of
money) and earn interest spread as a reward for risk taking and also for meeting administrative
expenses and making provision for some portions of loans that turn bad or difficult to recover
(termed as ‘non-performing assets’ or NPAs).
DISINTERMEDIATION
• The term ‘disintermediation’ means the reversal of the intermediation process involved in
banking. An investment by a person in certain stocks of a company is a direct exposure or risk
taking by the investor in the particular company.
• In this example of dis-intermediation, the investor may or may not get back the capital
invested in the company when he wants, as he has assumed the risk involved in direct
investment.
DIAGRAM ON INTERMEDIATION
THE COMMON CHARACTERISTICS OF ALL FINANCIAL INTERMEDIARIES
 First, they take money from those who seek to save, whether it be in exchange for a
deposit account bearing interest or in exchange for a paper financial claim.
 Secondly, they lend the money provided by those savers to borrowers, who may issue a
paper asset in return.
 Thirdly, in exchange for such lending they acquire a portfolio of paper assets (claims on
borrowers) which will pay an income to the intermediary and which it may ‘manage’ by buying
and selling the assets on financial markets in order to yield further profits for itself.
Financial Intermediary
Advantages of Financial Intermediaries
 Pooling of small savings.

 Diversification of risks.
 Economies of scale in monitoring information and evaluating risks.
 Lower transactions costs.
 Financial consultancy, offered to the investors and capital users;
 The possibility of better gathering and valuing the existing information on the market;
 Additional facilities offered to the users and capital owners, a part of these being taken
over by intermediation institutions.
The disadvantages of financial intermediation
−big transaction costs, due to collection of taxes, fees and commissions;

−the loss of direct contact with the international financial market, therefore some investors
aren’t sensitive anymore to the markets’ signs;
−the existence of a routine in the relationship with the financial intermediary, many markets
being led according to the solutions offered over the time by important intermediary firms.
Function of Financial
Intermediaries (FIs)
• Financial Intermediaries
• Engage in process of indirect finance
• More important source of finance than securities markets
• Needed because of transactions costs and asymmetric information

Function of Financial Intermediaries
• Transactions Costs
• Financial intermediaries make profits by reducing transactions costs
• Reduce transactions costs by developing expertise and taking advantage of economies of

scale
• A financial intermediary’s low transaction costs mean that it can provide its customers
with liquidity services, services that make it easier for customers to conduct transactions
• Banks provide depositors with checking accounts that enable them to pay their bills
easily
• Depositors can earn interest on checking and savings accounts and yet still convert them
into goods and services whenever necessary.
• Another benefit made possible by the FI’s low transaction costs is that they can help
reduce the exposure of investors to risk, through a process known as risk sharing
– FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from another party
– This process is referred to as asset transformation, because in a sense risky assets are
turned into safer assets for investors
Asymmetric Information:
Adverse Selection and Moral Hazard
• Adverse Selection
• Before transaction occurs
• Potential borrowers most likely to produce adverse outcome are ones most likely to seek
loan and be selected
• Moral Hazard
• After transaction occurs
• Hazard that borrower has incentives to engage in undesirable (immoral) activities making
it more likely that won't pay loan back
• Financial intermediaries reduce adverse selection and moral hazard problems, enabling
them to make profits.
Why have financial intermediaries grown so rapidly?
 Financial intermediaries satisfy portfolio preferences of lenders and borrowers: For the
lenders, they diversify the portfolio, particularly, the credit/ default risk. For the borrowers, they
offer a much wider choice of (tailor-made) credit than the ultimate lender would have been able
to provide. They get more choice in maturity, size of loan, interest rates.
 2. Cost advantages: There is cost involved in a borrower locating a lender, in the

lender getting information on the borrower. FIs specialize in these tasks.
 3. Risk reduction: Particularly for the lender (diversification acts as a hedge).
Why have financial intermediaries grown so rapidly?

4. Liquidity intermediation: The lenders are able to withdraw their funds when required, at a
small cost.
5. Government regulation: These include: Banking Act, capital adequacy requirements,
reserve requirements, regulations regarding investment, auditing and examinations, lender of last
resort privilege. These enhance the image of FIs in the eyes of the lenders.
Further, there has been a more rapid expansion of unregulated FIs compared with regulated FIs.
These (unregulated) FIs compensate the depositors for the higher risk with higher rates of return.
Two theories of financial intermediation:

Old theory:
 This holds that the services offered by financial intermediaries are primarily the
transformation of assets.
New theory:
 i) It isolates three types of financial intermediaries: broker, mutual fund and deposit-
taking intermediary.
 ii) Financial intermediaries actively manage their portfolios through the application
of resources to reduce costs.
 iii) Financial intermediaries play a more important role in developing economies than
in developed ones.
THE ROLE OF FINANCIAL INTERMEDIARIES
Brokerage
A broker is an intermediary who brings together lenders and borrowers who have complementary
needs and does this by assessing and evaluating information. The lender may have neither the
time nor the ability to undertake search activities in order to assess whether a potential
borrower is trustworthy. Household avoids such information gathering, monitoring and
evaluation costs,
Maturity Transformation
Intermediaries hold liabilities (e.g. deposits) that have a shorter term to maturity than their
assets (e.g. loans), i.e. they borrow short and lend long. E.g., a building society will typically
hold around 70% of its liabilities in the form of deposits repayable ‘on demand’, i.e. which can
be withdrawn at any time without penalty. In contrast, around 75% of its assets are repayable
only after five years or more. maturity transformation function in part because of the ‘law of
large numbers’,.
Risk Transformation
This involves the financial intermediaries in shifting the burden of risk from the lender to
themselves. Their ability to do so depends largely on economies of scale in risk management.
The large amounts of deposits (liabilities) the financial intermediaries collect allow them to
diversify their assets across a wide variety of types and sectors. ‘Pooling’ risk and reward in this
way means that no individual is exposed to a situation in which the default of one or more
borrowers is likely to have a significant effect.
Collection and parcelling
Financial intermediaries also transform the nature of their assets through the collection of a large
number of small amounts of funds from depositors and their parcelling into larger amounts
required by borrowers. Often the financial intermediaries have relied on obtaining many small
deposits from conveniently located branches of their operations. This process is known as ‘size
intermediation’ and benefits borrowers because they obtain one large loan from one source, thus
reducing transaction costs. Of course this loan is an asset to the financial intermediary and a
liability to the borrower.
Financial Intermediaries
Types of Financial Intermediaries
• Depository Institutions (Banks)
– Commercial banks, Savings & Loan Associations (S&Ls), Mutual Savings Banks in US
– Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence

banks, deposit-taking companies in Hong Kong (collectively known as AI: Authorized
Institutions)
• Contractual Savings Institutions
– Life insurance companies
– Fire & casualty insurance companies

– Pension funds, government retirement funds
(e.g. Mandatory Provident Fund Scheme in Hong Kong)
• Investment Intermediaries
– Finance companies
– Mutual funds
– Money market mutual funds

Depository Institutions (Banks)
Commercial Banks
– Raise funds primarily by issuing checkable, savings, and time deposits which are used to
make commercial, consumer and mortgage loans
– Collectively, these banks comprise the largest financial intermediary and have the most
diversified asset portfolios
Commercial Banks
• Most prominent financial institution
• Range in size from huge (BankAmerica) to small (local banks)
• Major sources of funds
– used to be demand deposits of public
– now rely more on “other liabilities”
– also accept savings and time deposits
• Uses of funds
– short-term government securities
– long-term business loans

– home mortgages
NATIONAL SAVINGS
 Savings Institutions exist in the Country to complement the commercial banks and
finance companies as the major deposit taking institutions. The main savings institutions are the
National Savings and Credit Bank and cooperative Societies.
 These Savings institutions promote savings among middle and lower income groups in
the rural areas that are not adequately served by the Commercial Banks and finance Companies.
 The national Saving Banks’s principal activity is to carry out the functions of a national
savings bank, namely to accept deposits and to provide retail loans to small borrowers. The
government guarantees all deposits. Funds raised through the premiums saving certificates are
unique to this bank. Attractive prizes for lucky draw winners and payment of dividends
contributed to the growth of these deposits.
 Other deposit products are savings deposits, fixed deposits and Giro deposits and save-as-
you-earn deposits. The Giro savings scheme is attractive due to its features, which enable
depositors to remit funds and make payments while earning an interest. Lending is channeled to
housing, credit cards, hire-purchase and corporate loan.
Contractual Savings
Institutions(CSIs)
• All CSIs acquire funds from clients at periodic intervals on a contractual basis and have
fairly predictable future payout requirements.
– Life Insurance Companies receive funds from policy premiums, can invest in less liquid
corporate securities and mortgages,
since actual benefit pay outs are close to those predicted by actuarial analysis
– Fire and Casualty Insurance Companies receive funds from policy premiums, must
invest most in liquid government and corporate securities, since loss events are harder to predict
Insurance Companies
• Life insurance.
• Casualty insurance.
• Insurance companies are large investors in fixed income securities.
• Adverse selection.
• Moral hazard. Coinsurance.

Life Insurance Companies
• Insure against death
• Receive funds in form of premiums
• Use of funds is based on mortality statistics—predict when funds will be needed
• Invest in long-term securities—high yield
– Long-term corporate bonds
– Long-term commercial mortgages

Pension Funds
• Defined benefit plans. Dollars paid out usually set by some formula, e.g., Pension = (#
Years)(Average) (X%). Pension Benefit Guarantee Corporation. Employer bears the
reinvestment risk.
• Defined contribution plans. Dollars paid in are specified. Dollars paid out depend upon
returns. Employee bears the reinvestment risk.
Pension Funds Cash Flows
Pension Benefit Guaranty Corporation
• Insures pensions of private defined benefit plans.
• Does not ensure government defined benefit plans.
• Collects premiums from covered plans.

• Underfunded.
• Limited benefits.
Pension and Retirement Funds
• Concerned with long run
• Receive funds from working individuals building “nest-egg”
• Accurate prediction of future use of funds
• Invest mainly in long-term corporate bonds and high-grade stock

Contractual Savings
Institutions (CSIs)
– Pension and Government Retirement Funds hosted by corporations and state and local
governments acquire funds through employee and employer payroll contributions, invest in
corporate securities, and provide retirement income via annuities
Investment Financial Intermediary
Finance Companies
• sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise
funds to lend to consumers to buy durable goods, and to small businesses for operations
FINANCE HOUSES
• Investment intermediaries provide a mechanism through which small savers pool funds to
purchase a variety of financial assets rather than just one or two. An example of how pooling
works can be seen by considering a mutual fund company, which is one type of investment
intermediary.
• A finance Company is another type of investment intermediary. Finance Companies make
loans to individuals and businesses, as do banks, but instead of holding deposits, as banks do,
finance companies borrow the money they lend. They borrow from individuals by selling them
bonds and commercial paper. Commercial paper is a short-term promissory note that a certain
amount of money plus interest will be paid back on demand.
Investment Banking
• Investment banking is the marketing of securities when they are initially sold.
• Some securities are sold to private buyers. Others are sold to the public. The exact
difference is a technical legal issue.
• Public offerings must be registered with the Securities and Exchange Commission (SEC).
Public Offerings
• Investment banking firms sell public offerings. They are essentially marketers of
securities and charge a fee for their services. This is often called an underwriting fee.
• Syndicates of investment banks are often involved in public offerings. This spreads the
resale risk.
Types of Public Offerings
• Firm Commitments. The investment banker purchases the security issue outright and
bears the resale risk.
• Best Efforts. The investment bankers sell whatever they’re able.
• Fees for firm commitments are much higher. Most bond issues are sold by firm
commitment.
• Shelf Registration.
– Some securities are sold by shelf registration. This is essentially a pre- registration of a
security issue. Anytime during the next two years the securities can be brought to market very
rapidly.
• Rule 144A.
– They do not have to be registered with the SEC and can be resold to other qualified
financial institutions.
Securities Firms and Investment Banks (IBs)
• Investment banks (IBs) help corporations and governments raise capital through debt
and equity security issues in the primary market
– underwriting is assisting in the issue of new securities
– IBs also advise on mergers and acquisitions (M&As) and corporate restructuring
• Securities firms assist in the trading of securities in secondary markets
– broker-dealers assist in the trading of existing securities

Securities Firms and
Investment Banks (IBs)
• The size of the industry is usually measured by the equity capital of firms rather than total
asset size
– the largest firm in 1987 had $3.2 billion in total capital
– the largest firm in 2007 had $114.2 billion in total capital
• The number of firms in the industry usually follows the overall condition of the economy
– 5,248 firms in 1980
– 9,515 firms in 1987
– 5,808 firms in 2007
• As with commercial banks, consolidation has occurred through mergers and acquisitions
• The largest firms in the industry are diversified financial service firms or national full-
service IBs
– service both retail and wholesale customers by acting as broker-dealers
– service corporate customers by underwriting security issues
• The second largest group of firms are full-service firms that specialize in corporate
finance or primary market activity (i.e., focus less on secondary market activities)
• A third group of firms includes the rest of the industry and is further divided into five
subgroups
– IB subsidiaries of commercial banks (i.e., Section 20 subsidiaries)
– discount brokers
– regional securities firms
– specialized electronic trading firms
– venture capital firms

• Investment banking
– first time debt and equity issues occur through initial public offerings (IPOs)
– new issues from a firm whose debt or equity is already traded are called seasoned equity
offerings (SEOs)
– a private placement is a securities issue that is placed with one or a few large
institutional investors
– public offerings are offered to the public at large

– IBs act only as an agent in best efforts underwriting
– IBs act as principals in firm commitments

• Market making involves the creation of secondary markets for an issue of securities
– agency transactions are two-way transactions on behalf of customers
– with principal transactions market makers seek to profit for their own accounts
• Trading involves taking an active net position in an asset
– position trading involves relatively long-term positions in assets

– pure arbitrage involves attempts to profit from price discrepancies
– risk arbitrage involves attempts to profit by forecasting information releases
– program trading is the simultaneous buying and selling of at least 15 different stocks
valued at $1 million or more
– stock brokerage involves trading on behalf of customers
– electronic brokerage offers customers direct access, via the internet, to the trading floor
• Investing involves managing pools of assets such as closed- and open-end mutual funds
– as agents
– as principals
• Cash management involves deposit-like accounts such as money market mutual funds
(MMMFs) that offer check writing privileges
• Merger and acquisition (M&A) assistance

• Venture capital (VC) is a professionally managed pool of money used to finance new
(i.e., start-up) and often high-risk firms
– VC usually purchases an equity stake in the start-up
– usually become active in management of the start-up
– institutional venture capital firms find and fund the most promising new firms
• venture capital limited partnerships
• financial venture capital firms
• corporate venture capital firms

• Industry trends depend heavily on the state of the stock market
– commission income declined markedly after the 1987 stock market crash and the 2001-2
stock market decline
– improvements in the U.S. economy in the mid-2000s led to increases in commission

income
– income fell with the stock market in 2006-8 because of rising oil prices and the subprime
mortgage collapse
Balance Sheets of Securities Firms
and Investment Banks (IBs) (2007)
• Long positions in securities and commodities represent 24.1% of assets
• Securities purchased under agreement to resell represent 21.6% of total assets

• Securities sold under agreement to repurchase represent 41.5% of total liabilities and
equity
• Equity capital amounted to 3.0% of total liabilities and equity
– compares to 10.1% for commercial banks
– SEC requires minimum net worth to assets of 2%

Regulation of Securities Firms
and Investment Banks (IBs)
• The Securities and Exchange Commission (SEC) is the primary regulator of the
securities industry
• The National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed

federal (over state) authority
– even so, state attorneys general intervene through securities-related investigations that
have led to many highly publicized criminal cases
• The Sarbanes-Oxley Act (SOX) of 2002
– created an independent auditing oversight board under the SEC
– increased penalties for corporate wrongdoers
– forced faster and more extensive financial disclosure
– created avenues of recourse for aggrieved shareholders

• The SEC sets rules governing underwriting and trading activity
– SEC Rule 144A defines boundaries between public offerings and private placements
– SEC Rule 415 allows shelf registration
• allows firms that plan to offer multiple issues of stock over a two-year period to submit
one registration statement summarizing the firm’s financing plans for the period
• Two self-regulatory organizations oversee the day-to-day regulation of trading practices
– the New York Stock Exchange (NYSE)
– the National Association of Securities Dealers (NASD)
• The U.S.A. Patriot Act became effective in 2003
– firms must verify identities of customers
– firms must maintain records of identities of customers
– firms must verify customers are not on suspected terrorist lists

• Industry is protected by the Securities Investor Protection Corporation (SIPC)
– protects investors against losses of up to $500,000 due to securities firm failures (but not
against poor investment decisions)
– created following passage of the Securities Investor Protection Act in 1970

Global Issues
• Securities firms and investment banks are by far the most global of any group of financial
institutions
• U.S. firms are increasingly looking to expand their business abroad—particularly into
China an India
Investment Banking Services
 Investment banking firms (IBFs) assist in raising capital for corporations and state and
municipal governments
 IBF’s serve both financing entities and investors:
 Serve as an intermediary buying securities (promise to pay) from issuing companies and
selling them (securities) to investors
 Generate fees for services rather than interest income
 Sell investing services to institutional and other investors
 Advise companies on mergers and acquisitions
 Value companies for sale or purchase
 In recent years, loaned funds for mergers and acquisitions
Investment Banking Services

How IBFs Facilitate New Stock Issues
 Origination
 Company wishes to issue additional stock or issue stock for the first time contacts IBF
 Gets advice on the amount to issue
 Helps determine stock price for first-time issues
 IBF assists with SEC filings
 Registration statement
 Prospectus—summary of registration statement given to prospective investors

 Underwriting stock
 Issuer and investment bank negotiate the underwriting spread
 The difference between the net price given the company and the selling price to investors
 Incentive to under-price IPO’s
 The lead investment bank usually forms an underwriting syndicate

 Other IBFs underwrite a part of the security offering
 Helps spread the underwriting risk among IBFs
 Distribution of stock
 Full underwriting vs. best efforts
 IBFs in the syndicate have retail brokerage operations
 Other IBF added as part of selling group
 Corporation incurs flotation costs
 Underwriting spread
 Direct issuance costs—accounting, legal fees, etc.

 Advising
 The IBF acts as an advisor throughout the process
 Corporations do not have the in-house expertise
 Includes advice on:
 Timing
 Amount
 Terms
 Type of financing
How IBFs Facilitate New Bond Issues
 Origination
 IBF may suggest a maximum amount of bonds that should be issued based on firm
characteristics
 Decisions on coupon rate, maturity
 Benchmark with market prices of bonds of similar risk
 Credit rating
 Bond issuers must register with the SEC
 Registration Statement
 Prospectus
 Underwriting bonds
 Public utilities often use competitive bids to select an IBF, versus…..
 Corporations typically select an IBF based on reputation and prior working experience
 The underwriting spread on bonds is lower than that for stocks
 Can place large blocks with institutional investors
 Less market risk

 Distribution of bonds
 Prospectus
 Advertisements to public
 Flotation costs are typically in the range of 0.5 percent to 3 percent of face value
 Private placement of bonds
 Avoids underwriting and SEC registration expenses
 Potential purchaser may buy the entire issue
 Insurance companies
 mutual funds
 commercial banks
 pension funds
 Demand may not be as strong, so price may be less, resulting in a higher cost for issuing
firm
 Investment banks may be involved to provide advice and find potential purchasers
How IBFs Facilitate Leveraged Buyouts
 IBFs facilitate LBOs in three ways:
 They assess the market value of the LBO firm
 They arrange financing
 Purchase outstanding stock held by public
 Often invest in the deal themselves
 Provide advice
How IBFs Facilitate Arbitrage
 Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price
 IBFs work with arbitrage firms to search for undervalued firms
 Asset stripping
 A firm is acquired, and then its individual divisions are sold off
 Sum of the parts is greater than the whole
 Kohlberg, Kravis, and Roberts

 IBFs generate fee income from advising arbitrage firms as well as a commission on the
bonds issued to support arbitrage activity
 IBFs also provide bridge loans
 When fund raising is not expected to be complete when the acquisition is initiated
 IBFs provide advice on takeover defense maneuvers

 History of arbitrage activity
 Greenmail is when a target company buys back stock from arbitrage firm at a premium
over market price
 Arbitrage activity has been criticized
 Results in excessive financial leverage and risk for corporations
 Restructuring sometimes results in layoffs
 Arbitrage helps remove managerial inefficiencies
 Target shareholders can benefit from higher share prices

Brokerage Services
 Full-service versus discount brokerage services
 Full-service firms provide investment advice as well as executing transactions
 Discount brokerage firms only execute security transactions upon request
 Online brokerage firms

Allocation of Revenue Sources
 Importance of brokerage commissions has declined in recent years
 Largest source of revenue has been trading and investment profits
 Underwriting and margin interest also make up a significant portion of revenue
 Revenue from fees earned on advising and executing acquisitions has increased over time
 Regulated by the National Association of Securities Dealers (NASD) and securities

exchanges
 The SEC regulates the issuance of securities and specifies disclosure rules for issuers
 Also regulates exchanges and brokerage firms
 SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory
duties
 The Federal Reserve determines the credit limits (margin requirements) on securities
purchased
 The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage

accounts
 Insured up to $500,000
 Brokers pay premiums to SIPC to maintain the fund
 Boosts investor confidence, increasing economic efficiency

 Financial Services Modernization Act of 1999
 Permitted banking, securities activities, and insurance to be offered by a single firm
 Varied financial services organized as subsidiaries under special holding company
 Financial holding companies regulated by the Federal Reserve
Risks of Securities Firms

 Market risk
 Securities firms’ activities are linked to stock market conditions

 When stock prices are rising:
 Greater volume of stock offerings
 Increased secondary market transactions
 More mutual fund activity
 Securities firms take equity positions which are bolstered when prices rise
 Interest rate risk
 Performance of securities firms can be sensitive to interest rate movements because:
 Market values of bonds held as investments increase as interest rates fall
 Lower rates can encourage investors to withdraw money from banks and invest in stocks
 Exchange rate risk
 Operations in foreign countries
 Investments in securities denominated in foreign currency

Valuation of Securities Firms
 Value of a securities firm depends on its expected cash flows and required rate of return
 Factors that affect cash flows

 Investors required rate of return

Interaction With Other Financial Institutions
 Offer investment advice and execute security transactions for financial institutions that
maintain security portfolios
 Compete against financial institutions that have brokerage subsidiaries

 Glass-Steagall Act of 1933 separated the functions of commercial banks and investment
banking firms
 Financial Services Modernization Act of 1999
 Effectively repealed Glass-Steagall
 Commercial banks, securities firms, and insurance companies will increasingly offer
similar services
Globalization of Securities Firms
 Securities firms have increased their presence in foreign countries
 Merrill Lynch has more than 500 offices spread across the world
 Allows them to place securities in various markets for corporations or governments
 International M&A
 Ability to handle transactions with foreign securities

Globalization of Securities Firms
 Growth in international securities transactions
 Created more business for large securities firms
 International stock offerings
 Increased liquidity for issuing firm, avoiding downward price pressure
 Growth in Latin America
 Increased business due to NAFTA
 Growth in Japan
 Some barriers to foreign securities firms still exist

Mutual Funds
• Mutual Funds acquire funds by selling shares to individual investors (many of whose
shares are held in retirement accounts) and use the proceeds to purchase large, diversified
portfolios of stocks and bonds
Investment Intermediaries
• Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to
individual investors and use the proceeds to purchase highly liquid and safe short-term money
market instruments
Mutual Funds
• Stock or bond market related institutions
• Pool funds from many people
• Invest in wide variety of securities—minimize risk
Money Market Mutual Funds
• Individuals purchase shares in the fund
• Fund invests in highly liquid short-term money market instruments
– Large-size negotiable CD’s
– Treasury bills
– High-grade commercial paper

Mutual Funds
• Mutual funds represent a pooling of funds by many investors.
• Open-end vs. closed-end funds.
• Net Asset Value (NAV) = liquidating value.
• For closed end funds, typically Price < NAV.
Advantages of Mutual Funds
• Information Economies.
• Diversification.
• Lower transactions costs.

Mutual Fund Costs
Sales Fees
Front End Load
Rear End Load
12b-1 Fees (Annual)
Mutual Fund Costs
Expense ratio includes:
Management fee.
Administrative fee.
Other fees.
Additional Costs:
Brokerage commissions.
Savings and Loan Associations (S&L’s)
• Traditionally acquired funds through savings deposits
• Used funds to make home mortgage loans
• Now perform same functions as commercial banks
– issue checking accounts
– make consumer and business loans

Regulation Reason: Ensure Soundness
of Financial Intermediaries
• Because providers of funds to financial intermediaries may not be able to assess

whether the institutions holding their funds are sound or not, if they have doubts about the
overall health of financial intermediaries, they may want to pull their funds out of both sound
and unsound institutions, with the possible outcome of a financial panic that produces large
losses for the public and causes serious damage to the economy.
of Financial Intermediaries (cont.)
• To protect the public and the economy from financial panics, the government has
implemented six types of regulations:
– Restrictions on Entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates

Regulation of Financial Markets
• Three Main Reasons for Regulation
• Increase Information to Investors
• Ensure the Soundness of Financial Intermediaries
• Improve Monetary Control

FIN 444
Financial Institutions in Hong Kong
Week 1 Introduction:
Financial System and Financial Intermediation
Mishkin (2006): Chapter 2

Overview of the Financial System
Segments of Financial Markets
• Direct Finance
• Borrowers borrow directly from lenders in financial markets by selling financial

instruments which are claims on the borrower’s future income or assets
• Indirect Finance
• Borrowers borrow indirectly from lenders via financial intermediaries (established to
source both loanable funds and loan opportunities) by issuing financial instruments which are
claims on the borrower’s future income or assets
Function of Financial Markets
Classifications of Financial Markets
• Debt Markets
– Short-Term (maturity < 1 year) Money Market
– Long-Term (maturity > 1 year) Capital Market
• Equity Markets
– Common Stock
Characteristics of Debt Markets Instruments
• Debt instruments
– Buyers of debt instruments are suppliers (of capital) to the firm, not owners of the firm
– Debt instruments have a finite life or maturity date
– Advantage is that the debt instrument is a contractual promise to pay with legal rights to
enforce repayment
– Disadvantage is that return/profit is fixed or limited

Characteristics of Equity Markets Instruments
• Equity instruments (common stock is most prevalent equity instrument)
– Buyers of common stock are owners of the firm
– Common stock has no finite life or maturity date
– Advantage of common stock is potential high income since return is not fixed or limited
– Disadvantage is that debt payments must be made before equity payments can be made
• Primary Market
– New security issues sold to initial buyers
• Secondary Market
– Securities previously issued are bought

and sold
• Exchanges
– Trades conducted in central locations

(e.g., New York Stock Exchange,
The Stock Exchange of Hong Kong)
• Over-the-Counter Markets
– Dealers at different locations buy and sell

(e.g., The U.S. government bond market and Nasdaq OTC stock exchange in
US; Notes issued by Hong Kong Mortgage Corporation in Hong Kong)
Function of Financial
Intermediaries (FIs)
• Financial Intermediaries
• Engage in process of indirect finance
• More important source of finance than securities markets
• Needed because of transactions costs and asymmetric information

• Transactions Costs
• Financial intermediaries make profits by reducing transactions costs

• Reduce transactions costs by developing expertise and taking advantage of economies of
scale
• A financial intermediary’s low transaction costs mean that it can provide its customers
with liquidity services, services that make it easier for customers to conduct transactions
• Banks provide depositors with checking accounts that enable them to pay their bills
easily
• Depositors can earn interest on checking and savings accounts and yet still convert them
into goods and services whenever necessary
• Another benefit made possible by the FI’s low transaction costs is that they can help
reduce the exposure of investors to risk, through a process known as risk sharing
– FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from another party
– This process is referred to as asset transformation, because in a sense risky assets are
turned into safer assets for investors
• Adverse Selection
• Before transaction occurs
• Potential borrowers most likely to produce adverse outcome are ones most likely to seek
loan and be selected
• Moral Hazard
• After transaction occurs
• Hazard that borrower has incentives to engage in undesirable (immoral) activities making
it more likely that won't pay loan back
• Financial intermediaries reduce adverse selection and moral hazard problems, enabling
them to make profits.
Financial Intermediaries
• Depository Institutions (Banks)
– Commercial banks, Savings & Loan Associations (S&Ls), Mutual Savings Banks in US
– Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence

banks, deposit-taking companies in Hong Kong (collectively known as AI: Authorized
Institutions)
• Contractual Savings Institutions
– Life insurance companies
– Fire & casualty insurance companies
– Pension funds, government retirement funds

(e.g. Mandatory Provident Fund Scheme in Hong Kong)
• Investment Intermediaries
– Finance companies
– Mutual funds
– Money market mutual funds

Depository Institutions (Banks)
• Commercial banks
– Raise funds primarily by issuing checkable, savings, and time deposits which are used to
make commercial, consumer and mortgage loans
– Collectively, these banks comprise the largest financial intermediary and have the most
diversified asset portfolios
Contractual Savings
Institutions (CSIs)
– Life Insurance Companies receive funds from policy premiums, can invest in less liquid
corporate securities and mortgages,
since actual benefit pay outs are close to those predicted by actuarial analysis
– Fire and Casualty Insurance Companies receive funds from policy premiums, must
invest most in liquid government and corporate securities, since loss events are harder to predict
Contractual Savings
Institutions (CSIs)
– Pension and Government Retirement Funds hosted by corporations and state and local
governments acquire funds through employee and employer payroll contributions, invest in
corporate securities, and provide retirement income via annuities
• Finance Companies sell commercial paper (a short-term debt instrument) and issue
bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small
businesses for operations
• Mutual Funds acquire funds by selling shares to individual investors (many of whose
shares are held in retirement accounts) and use the proceeds to purchase large, diversified
portfolios of stocks and bonds
• Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to
individual investors and use the proceeds to purchase highly liquid and safe short-term money
market instruments
Regulation of Financial Markets
• Three Main Reasons for Regulation
• Increase Information to Investors
• Ensure the Soundness of Financial Intermediaries
• Improve Monetary Control

Regulation Reason:
Increase Investor Information
• Asymmetric information in financial markets means that investors may be subject to

adverse selection and moral hazard problems that may hinder the efficient operation of financial
markets and may also keep investors away from financial markets
• The Securities and Exchange Commission (SEC) (SEC in US; Securities and Futures
Commission, SFC in Hong Kong) requires corporations issuing securities to disclose certain
information about their sales, assets, and earnings to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation
Regulation Reason:
Increase Investor Information
• Such government regulation can reduce adverse selection and moral hazard problems in
financial markets and increase their efficiency by increasing the amount of information available
to investors
of Financial Intermediaries
• Because providers of funds to financial intermediaries may not be able to assess

whether the institutions holding their funds are sound or not, if they have doubts about the
overall health of financial intermediaries, they may want to pull their funds out of both sound
and unsound institutions, with the possible outcome of a financial panic that produces large
losses for the public and causes serious damage to the economy
of Financial Intermediaries (cont.)
• To protect the public and the economy from financial panics, the government has
implemented six types of regulations:
– Restrictions on Entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates

Regulation: Deposit Insurance
• The government can insure people providing funds to a financial intermediary from any
financial loss if the financial intermediary should fail
• The Federal Deposit Insurance Corporation (FDIC in US; Deposit Protection Scheme,
DPS managed by The Hong Kong Deposit Protection Board), insures each depositor at a
commercial bank or mutual savings bank up to a loss of $100,000 per account (HK$100,000 per
depositor per bank in Hong Kong)

6-Deposit Taking Institutions

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6-Deposit Taking Institutions

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Financial Intermediary

Depository & Non Depository

DEPOSIT TAKING AND NON DEPOSIT TAKING INTERMEDIARIES

 Pooling of small savings.

−big transaction costs, due to collection of taxes, fees and commissions;

• Engage in process of indirect finance

• More important source of finance than securities markets

• Needed because of transactions costs and asymmetric information

• Financial intermediaries make profits by reducing transactions costs

• Reduce transactions costs by developing expertise and taking advantage of economies of

– FIs create and sell assets with lesser risk to one

• Before transaction occurs

• After transaction occurs

 2. Cost advantages: There is cost involved in a borrower locating a lender, in the

 3. Risk reduction: Particularly for the lender (diversification acts as a hedge).

Why have financial intermediaries grown so rapidly?

Two theories of financial intermediation:

THE ROLE OF FINANCIAL INTERMEDIARIES

Collection and parcelling

Types of Financial Intermediaries

• Depository Institutions (Banks)

– Three-tier system of deposit-taking institutions, namely, licensed banks, restricted licence

• Contractual Savings Institutions

– Life insurance companies

– Fire & casualty insurance companies

– Money market mutual funds

• Most prominent financial institution

• Range in size from huge (BankAmerica) to small (local banks)

• Major sources of funds

– used to be demand deposits of public

– now rely more on “other liabilities”

– also accept savings and time deposits

– short-term government securities

– long-term business loans

• Insurance companies are large investors in fixed income securities.

• Moral hazard. Coinsurance.

• Insure against death

• Receive funds in form of premiums

• Use of funds is based on mortality statistics—predict when funds will be needed

• Invest in long-term securities—high yield

– Long-term corporate bonds

– Long-term commercial mortgages

• Insures pensions of private defined benefit plans.

• Does not ensure government defined benefit plans.

• Collects premiums from covered plans.

• Concerned with long run

• Receive funds from working individuals building “nest-egg”

• Accurate prediction of future use of funds

• Invest mainly in long-term corporate bonds and high-grade stock

• Best Efforts. The investment bankers sell whatever they’re able.

Securities Firms and Investment Banks (IBs)

– underwriting is assisting in the issue of new securities

• Securities firms assist in the trading of securities in secondary markets

– broker-dealers assist in the trading of existing securities

– the largest firm in 1987 had $3.2 billion in total capital

– the largest firm in 2007 had $114.2 billion in total capital

– 5,248 firms in 1980

– 9,515 firms in 1987

– 5,808 firms in 2007

– service both retail and wholesale customers by acting as broker-dealers

– service corporate customers by underwriting security issues

– IB subsidiaries of commercial banks (i.e., Section 20 subsidiaries)

– regional securities firms