Monitoring Costs (Solution)

- A large number of small investors group their funds together by holding the claims issued by a
financial institution. In turn the Fi invests in the direct financial claims issued by fund users.
- In turn, FI invests in the direct financial claims issued by fund users.
Problems solved:
- Large FIs has a much greater incentive to hire employees with superior skills and training in
monitoring
 Creates incentives because FIs have more at stake than any small individua fund supplier
- FI alleviates the “free-rider” problem
Free-rider
- Exists when small fund suppliers leave it to each other to collect information and monitor a fund
user
 Fund suppliers appoint FIs as a delegated monitor to act on their behalf
Delegated Monitor
- Economic agent; appointer by fund suppliers to act in behalf of small investors in collecting
information and/or investing funds

Liquidity and Price Risk (Solution)

- FIs provide further claims to fund suppliers, thus acting as asset transformers
- Financial institutions purchase financial claims issued by users of funds (i.e., mortgages, bonds,
and stocks) and finance these purchases by selling financial claims in the form of deposits,
insurance policies, or other secondary securities
- Claims issued by financial institutions have liquidity attributes that are superior to those of
primary securities
- FI transfers liquidity risk to its own balance sheet
- FIs offer highly liquid, low price-risk securities to fund suppliers on the liability side of their
balance sheet, while investing in relatively less liquid and higher price securities
Financial Institutions have the ability to diversify away some but not all of their investment risks
- Reduce risk by holding a number of securities in a portfolio
Asset transformers
- Financial claims issued by an FI that are more attractive to investors than are the claims directly
issued by corporations
Additional Benefits
Reduced Transaction Cost
- Average cist of collecting relevant information is lower than for the individual investor
(economies of scale)
Economies of Scale
- Cost reduction as a result from increases efficiency when FIs perform their services
e-trade
- Buying and selling shares on the internet
Maturity Intermediation
- FIs bear risk of mismatching the maturities of their assets and liabilities
Denomination Intermediation
- FIs provide services relating to denomination intermediation
 Read again ☹

Economic Functions FIs Provide to the Financial System as a Whole

The Transmission of Monetary Policy
- Depositary institutions are instrumental in determining the size and growth of the money supply
 Conduit through which Federal Reserve conducts monetary policy
Credit Allocation
- FIs are the major source of financing for particular sectors of the economy
Intergenerational Wealth Transfers or Time Intermediation
- Ability of savers to transfer wealth from their youth to old age as well as across generations
- Special taxation relief and other subsidy encourages investments by savers in life insurance,
annuities, and pension funds.
Payment Services
- FIs are special in that the efficiency with which they provide payment services directly benefits
the economy
- Check-clearing and wire transfer
Risks Incurred by Financial Institutions
Regulation of Financial Institutions
- FIs are regulated in an attempt to prevent market failures and the costs that would impose on
the economy
 Regulations also impose private costs, or a regulatory burden, on individual FI owners and
managers
 Regulators attempt to maximize social welfare while minimizing the burden imposed by
regulation