Unit 5 :

Financial Intermediation

LEARNING OBJECTIVES

At the end of the chapter, the students should be able to:

1. discuss financial intermediation and identify the different financial intermediaries;

2. differentiate bank supervision from bank regulation and explain the use of the CAMEL rating;
3. appreciate the role financial intermediaries play in the socio-economic development of a nation;
4. explain the economic bases for financial intermediation;
5. detail the changing nature of financial intermediaries; and
6. discuss the different types of risk faced by financial intermediaries and investors n the business world.

INTRODUCTION

We have discussed in the previous unit the role of financial intermediaries in meeting the needs of surplus units and
deficit units. Financial intermediaries are the bridge that enables the meeting of investors or surplus units and borrowers or deficit
units. They are also instrumental in bringing about the different types of financial instruments or securities that we can find in the
financial market.

In this unit, the students will learn how deficit units, savings units, and intermediaries interplay in the business world.
Also, financial intermediation and the role the different financial intermediaries play in the business world will be discussed.
Similarly, the role savings units and deficit units play in the economy will be explored. Students will also learn what
disintermediation is and how it takes place including its effect on financial intermediaries. Furthermore, mismatching of securities
and how it works to the advantage and disadvantage of financial intermediaries will be explained. In addition, the different types
of risk faced by financial intermediaries and investors will be discussed. Bank supervision and bank regulation will be explained
and differentiated, and how the CAMEL rating is applied relative to bank Supervision and regulation will be explained.

Financial Intermediaries: Definition

Financial intermediaries are financial institutions that act as the bridge between investors or savers (surplus units or SUs)
and borrowers or security issuers (deficit units or DUs), which issue their own financial instruments called secondary instruments.
The original issuers or borrowers who borrow funds issue what is termed as primary securities.

A bank gets deposits from the depositors. In this case, the depositor is the lender and the bank is the borrower. Original
borrowers issue primary securities. The buyer of the primary security is the lender. In this case, the primary security is the deposit
account, say, the checking account. The check represents the checking account, an asset that the buyer of the security can use to
pay his/her account. In the same manner, the buyer of marketable securities can sell the marketable securities or use them to pay
for his/her account if the lender to the owner of the securities is willing to accept them as payment.

The bank, as a financial intermediary, can create secondary securities that it can sel. It can pool deposits to have a bigger
amount available to be sold as a secondary security, say commercial papers or negotiable certificates of deposits, that it can now
sell to interested investors, or it can simply lend accumulated deposits to borrowers as a loan. The commercial papers or
negotiable certificate of deposits that the bank issue, as a financial intermediary are now secondary securities. The loan is a
secondary security. The primary security is not transformed into a secondary security. This is the asset transformation role of the
financial intermediary. Borrowers do not need to contact the savers directly. In the process, the bank cams through the interest
spread between what these banks pay to depositors as interest and the interest that these banks charged the borrowers. For
example, a bank gives 6% interest to depositors but charges the borrowers 12%. The spread is the difference between the two
rates (12% -6% = 6%, the interest spread).

The relationship or transaction between the bank and the depositor is direct finance, with the depositor as the lender and
the bank as the borrower, even if the transaction is not directly called a loan, but a deposit. It is, however, in essence a loan by the
depositor to the bank because the bank will use the deposit and relend it to other borrowers. The depositors are actually the surplus
units and the bank is the deficit unit.

When the bank pools the deposits and relends the same to borrowers, it acts as an intermediary. The depositors
are the savers or surplus units, the borrowers are the deficit units, and the bank is the intermediary. The borrowers from the
bank now have an indirect relationship to the depositors; hence, such relationship is termed indirect finance. However. like the
relationship between the depositors and the bank, the relationship between the bank and borrowers is also direct finance and the
IOU of the borrower issued to the bank is a primary security being a product of direct finance. In this kind of transaction, the
borrower is spared the cost of finding the source of funds.

Financial intermediaries usually issue their own securities or instruments as we have seen in our first example; hence,
these instruments or securities are called secondary securities. Other financial institutions that channel funds to deficit units from
the surplus units but do not issue their own market or financial instruments or securities are called market specialists. Direct
securities or primary securities such as stocks and bonds sold in the open market through market specialists are also termed open
market securities. Market specialists are a special type of financial intermediary, in the sense that they provide the connection
between surplus and deficit units without issuing their own securities. Securities dealers are market specialists. They sell
securities issued by other firms.

Financial intermediaries have brought into existence several of the financial products or securities now available in the financial
markets. Financial intermediaries are generally large and have economies of scale in terms of operation and specifically in
analyzing creditworthiness of borrowers to ensure that securities issued by these borrowers are worth investing into or purchasing
for the buyers/investors. Weston and Brigham (1993) stated:

A system of specialized intermediaries can enable savings to do more than just draw interest. For example,
individuals can put money in banks and get both interest income and a convenient way of making payments (checking),
or put money into life insurance companies and get both interest income and protection for their beneficiaries.

Financial intermediaries are differentiated from other businesses in that their assets and liabilities are overwhelmingly
financial. They have very small amounts of tangible assets. This is because intermediaries simply move funds from one sector to
another (Bodie et al. 199S). As stated above, financial intermediaries do not only sell securities issued by other companies; but,
also issue their own securities to raise funds to purchase securities of other corporations they wish to buv either as their own
investment or for resale in cases where selling them will bring them better profit. These secondary securities issued by financial
intermediaries include life insurance policies. money market mutual funds, and pensions and pre-need plans. Financial
intermediaries use these secondary securities to attract funds from the surplus units, the same funds they use to buy the primary
securities issued by deficit units.

Classification of Financial Intermediaries

Financial intermediaries are varied but they all have one characteristic in common. All of them (except market specialists) issue
secondary securities to be able to purchase primary securities issued by deficit units. They can, however, be grouped into two
basic categories:

1. Depository institution
2. Non-depository institution

Depository Institutions

Depository institution, as the name implies, refers to financial institution that accepts deposits from surplus units. It issues
checking or current account, savings, and time deposit and help depositors with money market placement. Current or checking
account can be withdrawn by issuing a check. Most current accounts do not earn interest, although due to competition. there are
now banks offering interest on these checking or current accounts. These are called NOW accounts. Savings accounts can be
withdrawn by using the passbook given by the bank to the depositors when they initially make their deposit. All the deposits and
withdrawals are recorded in (he same passbook. It also details the interest earned and any tax or charge deducted from the
account.

Time deposit refers to deposit that has maturity period, say 30 days, 60 days, 90 days, 180 days, or 360 days. This deposit
cannot be withdrawn without penalty prior to maturity, but it earns more interest than the savings account. Time deposit is
evidenced 205 by certificate of deposits; however, these are not the negotiable certificates of deposits that are bought and sold in
the open market. In addition, banks or depository institutions help the depositors do the more risky money market placements if
they want to earn more than what time deposit pays.

Compared with non-financial firm, the deposit that depository institution accepts from both financial and non-financial
firms is its liabilities, while this deposit is the asset of the hon-financial and financial firms doing the deposit. The loans the
depository institution gran lo non-financial and financial firms are the assets of the depository institution, which are the liabilities
of the borrower non-financial and financial firm. This is explained further by the following illustration:
 To reiterate, the deposit made by the non-financial and other financial institutions are their assets and these deposits they
place with the depository institutions become the liabilities of the depository institution. On the other hand, the loans that the
depository institution grants the non-financial and other financial institutions are the assets of the depository institution and the
liabilities of the non-financial and other financial institutions.

This depository institution pools the deposits of the depositors and lends the pooled funds to deficit units or uses such deposits to
purchase securities. The deposits that depository institution issue are free of risk as the amount of deposit, or principal does not
fluctuate like stocks and bonds. Deposits are only reduced if the depositor makes withdrawal and are subjected to taxes and bank
charges. The deposits placed in depository institution generally can be withdrawn on demand, or in certain cases, only within a
short notice (if amount to be withdrawn is too large). Individuals and business companies are depositors and they are also
borrowers. Depository institutions include:

1. Commercial banks
a. Ordinary commercial banks
b. Expanded commercial or universal banks
2. Thrift banks
a. Savings and mortgage banks
b. Private development banks
c. Savings and loan associations
d. Microfinance thrift banks
e. Credit unions
3. Rural banks
4. Cooperative Banks

////// Commercial Banks

Traditionally, commercial banks grant only short term loans. These loans were originally extended to merchants for the
transport of their goods in both the domestic and international markets, as well as to finance the holding of inventories during the
brief period required for their sale. As industry developed and grew, producers became the clients of commercial banks. Today,
commercial banks are the largest lenders in commercial and industrial loans. They supply funds to traders, manufacturers,
industries, governments, and other financial institutions. Liabilities of commercial banks and commercial banks alone (except
smaller savings and depository institutions), circulate as money. Commercial banks have the power to create and destroy money
through their savings and loan operations (Fajardo et al. 1994).

While deposits form a major part of commercial banks’ liabilities or source of funding. Commercial banks also have
other non-deposit sources of funds such as subordinated notes and debentures. Their loans, on the other hand, are also a mixture of
consumer loans, commercial loans, real estate loans, and even international loans. Traditionally, commercial banks were the only
depository institutions allowed by law to offer transactions services by providing a financial instrument-demand deposits (better
known as checking accounts)that serves as a medium of exchange. Historically, commercial banks served the financial needs of
commerce by providing the substantial portion of short-term credit to non-financial businesses providing the bulk of money in the
form of checking accounts (Hadjimichalakises 1995).

Commercial banks, like some other smaller depository institutions, have several branches in the different parts of the
country. These enable them to reach a broader base and help the country, at large, in its economic development. Nationwide
branching is common among commercial banks and it has helped, not only the country in general, but also the communities where
these branches are located, in particular.

Ordinary commercial banks perform the more simple functions of accepting deposits and granting loans. They do not do
investment functions. Expanded commercial banks or universal banks (also called unibanks) perform investment services. They
are "expanded" because they function as an investment house and investing in stocks and bonds of non-allied businesses. In
addition, they render financial services, payment processing, securities transactions, underwriting, and financial analysis.

Universal and commercial banks represent the largest single group, resource-wise, of financial institutions in the country.
They could have been the pioneers in financial intermediation. They offer the widest variety of banking services among financial
institutions. In addition to the function of an ordinary commercial bank, universal banks are also authorized to engage in
underwriting and other functions of investment houses, and to invest in equities of non-allied undertakings.

In 1980. the financial reforms in the Philippines saw the creation of what is now known as universal banks (Fajardo et al.
1994). Universal banks are a combination of commercial banks and an investment house. They perform expanded commercial
banking functions (domestic and international) and underwriting functions of an investment house.
The functions of an investment house may be done by the commercial bank:

(a) ) in-house by establishing a department for the purpose; or by

(b) the establishment of a subsidiary which will do the investment function.

As an investment house, however, they cannot go into other finance companies business, such as leasing. As an
investment house, they can only do underwriting of securities, securities dealership, and equity investment. The minimum paid-in
capital of a universal bank is ₱1.5 billion Some commercial and universal banks have become global.

In this website, thismatter.com expounded on commercial banks citing the following:

The primary business of commercial banks is to serve businesses, although with banking deregulation, they have entered
into the consumer business as well. Commercial banks provide the widest variety of banking services. In addition to
savings accounts, checking Services, consumer loans, commercial and industrial (C&l) loans, and credit cards,
commercial banks may also offer trust services, trade financing, investment banking and management for corporations,
governments and their agencies, and treasury services. Community banks, however, are smaller commercial banks with
assets of less than $1 billion that generally serve their immediate community of consumers and small businesses.
Community banks are often called regional and super-regional banks which cover a much wider geographic area, and
usually have assets in the hundreds of billions of dollars. They have many branches that extend into several states and
many ATM machines at convenient locations throughout their area. Global banks also offer international services, such
as letters of credit, and currency exchange. These larger banks use short term borrowing, also the most numerous by a
large margin. Some commercial banks, borrow in the money markets to supplement their deposits and often require
loans from the smaller community banks. These correspondent banks have accounts at the larger banks which facilitate
the frequent transfer of funds with the big banks. Some banks money— center banks—borrow for their funding instead
of relying on deposits. However, the recent credit crisis has forced money center banks to become depository institutions
because they could not sell their commercial paper or bonds in financial markets that have been greatly diminished by
investors' fear of defaults.

According to investorwords.com, universal banking is a system of banking where banks are allowed to provide a variety
of services to their customers. In universal banking, banks are not limited to loans, checking and savings accounts, and other
similar activities, but are allowed to offer investment services as well. Also, financial-dictionary.thefreedictionary.com defined
universal banking as banking services that include savings, loans, and investments. Universal banking combines both commercial
banking and investment banking. The term universal banking is more common in Europe than in the US because of stricter
regulation of American banks.///////////

Deposits are a significant part of the money supply of a country, and commercial banks play a key role in using these
deposits, as do other depository institutions in the economic development of the country. Also, being in direct contact with the
central bank of the country. they receive all regulations and monetary policies of the central bank which govern the financial
system in the country. As such, they disseminate these regulations and policies to their depositors. Like other financial
intermediaries, they mismatch maturities creating new instruments/securities in the process making available to even small
depositors a variety of securities/ instruments as saving tools. But because they form a significant part of the financial system of
any country, they are regulated by the central bank and the government to protect against any disruption in the provision of their
services and to protect the cost that will be imposed on the economy. They are regulated Separately from savings institutions and
credit unions.

Bank supervision and bank regulation are essential for the maintenance of a balanced financial system. Bank supervision
deals with ensuring the soundness and safety of banks. Bank regulation consists of the administration of laws in the form of rules
and regulations that govern the conduct of banking and the structure of the banking industry. There are bank regulations that
govern the establishment of a certain bank in a certain location. There are also bank regulations that govern mergers or
acquisitions affecting banks. Banks, and other financial institutions, are supervised and regulated to ensure that they engage in
healthful practices to maintain a healthy financial system. They are supervised and regulated to ensure they perform their
functions to benefit, not only their own organizations, but also the people they serve In particular and the economy and the
country in general.

The Philippine Deposit Insurance Corporation insures the deposits in the depository institutions including commercial
banks to help depositors have peace of mind knowing that their deposits are insured and, therefore, safe in the banks, thereby
maintaining a healthy financial system in the Philippines.

Regulatory agencies in the Philippines include the Bangko Sentral ng Pilipinas, the Securities and Exchange
Commission, the Bureau of Internal Revenue, and the provincial, city, or local governments. On-site reviews are, at times,
made to ensure the healthy operations of these depository institutions.

An older measure of the soundness of a bank evaluated a bank’s management, asset quality. Capital adequacy, risk
management, and operating results (MACRO). This was superseded by CAMELS rating in 1994.
Prior to 1994, the MACRO rating was used by regulatory agencies to gauge credit standing of banks:

M - Management

A - Asset quality

C - Capital adequacy

R - Risk management

O - Operating results

In |994,CAMELS rating was used:

C - Capital adequacy

A - Asset quality

M - Management

E - Earnings

L - Liquidity

S - Sensitivity to risk

The purpose of CAMELS ratings is to determine a bank’s overall condition and to identify its strengths and weaknesses
financially, operationally, and managerially. Each element is assigned a numerical rating based on five key components.
“CAMELS is a comprehensive rating on a scale of one to five, with one signifying the best and five as the lowest. It provides an
early warning signal to prevent a collapse. A rating of one means most stable, two or three is average. Suggesting supervisory
attention, and a rating of four or five means below average, signaling a problem bank.”

// Thrift Banks

The thrift banking system is composed of savings and mortgage banks, private development banks, stock savings and loan
associations, and microfinance thrift banks. Credit unions, although not classified as banks, can be considered as a thrift institution
in the sense that they encourage people to save. These different thrift institutions cater to the needs of households, agriculture, and
industry. They encourage the habit of thrift and savings and provide loans at reasonable rates. Thrift banks are engaged in
accumulating savings of depositors and investing them. They also provide short-term working capital and medium-and long-term
financing to businesses engaged in agriculture, services, industry and housing, and diversified financial and allied services, and to
their chosen markets and constituencies, especially small and medium enterprises and individuals.”

Thrift banks may, at the approval of the Monetary Board, establish banking offices (branches and extension offices) nationwide
just like commercial banks. A branch is an independent unit of the head office performing all the functions and offers the service
facilities of the head office. An extension office operates like a branch, but is under the supervision and administrative control of
the nearest branch of the head office or the head office if the head office is the one nearest to it.

Thrift banks are also allowed to grant loans under the Agrarian Reform Credit and Supervised Credit Programs of the government.
They may invest in the equity of allied undertakings as leasing companies, banks, investment houses, financing companies, credit
card companies, and other financial institutions serving small-and medium-scale industries. These investments, however, are
regulated. A thrift bank may own up to 100% of the equity of an allied undertaking company.

Savings and mortgage banks are banks specializing in granting mortgage loans other than the basic function of accepting deposits.
They are organized for the purpose of accumulating savings of depositors and investing the same, together with its capital in
highly liquid marketable bonds and other debt securities, commercial papers, drafts, bills of exchange, acceptances, or notes
arising out of commercial transactions or in loans secured by bonds, mortgages, and other forms of security or in loans for
personal or household finance, secured or unsecured, and financing for home building and improvement. In addition, they may
invest in other investments and loans with the approval of the Monetary Board of the Bangko Sentral ng Pilipinas. The portfolio of
savings banks consists mainly of mortgages.

Private development banks cater to the needs of agriculture and industry providing them with reasonable rate loans for medium-
and long-term purposes. The Philippine government has asked the assistance of government agencies like the Development Bank
of the Philippines (DBP), the Philippine National Bank (PNB), the Government Service Insurance System (GSIS), the Social
Security System (SSS), and other governmental departments to help the private development banks in their effort to uplift the
economic status of the private development banks’ clients. They are authorized to grant real estate mortgage loans with maturities
of not more than twenty years for the purposes of the establishment, rehabilitation, and expansion of, and for investment in
agricultural, industrial, manufacturing, commercial, and other economic enterprises (Fajardo et al. 1994).
Savings and loan associations (SLAs, S&Ls) accumulate savings of their depositors/ stockholders and use these accumulated
savings, together with their capital, for the loans that they grant and for investments in government and private securities. These
associations provide personal finance and long-term financing for home building and improvement.

Savings and loan associations first appeared in the 1800s so that factory workers could save money to buy a home. They were
loosely regulated until the Great Depression, when the US Congress passed several major laws to shore up the banking industry
and to restore the public’s trust in them. Before 1980, SLAs were restricted to mortgages and savings and time deposits, but the
Monetary Control Act extended their permitted activities to commercial loans, non-mortgage consumer lending, and trust services.
Many S&Ls have been owned by depositors, which was their main source of funding thus they were called Mutual Savings and
Loans Associations or Mutual Associations. Mutual S&Ls, like credit unions, used their earnings to lower future loan rates, raise
deposit rates, or reinvest, while corporate S&Ls either reinvested profits or returned profits to their owners by paying dividends.
Nowadays, most S&Ls are corporations, giving them access to additional capital funding to compete more successfully and to
facilitate mergers and acquisitions.

Microfinance thrift banks are small thrift banks that cater to small, micro, and cottage industries. Hence, the term micro”. They
grant small loans to small businesses, like sari-sari stores, small bakeries, cottage industries, among others. They help uplift the
standard of living In most rural areas.

Another institution that is a form of a thrift institution (though not a bank) is the credit union. Credit unions are cooperatives
organized by people from the same organization (whether formally or informally organized) like farmers, fishermen, teachers,
sailors, employees of one company, among others. Credit unions grant loans to these people who become members of the credit
union and get deposits from them. Usually, the members avail of loans as a multiple (two times or three times) of their deposits.
Cooperatives are under the supervision of the Cooperative Development Authority under the Office of the President.

Today, membership in credit unions is no longer restricted to a certain group. Non teachers can become members of a teachers’
credit union, just like in other credit unions. The loans granted to their members are no longer restricted to short-and medium-term
loans. They also grant long-term loans for home buying or financing new business. Credit unions of today even sell life insurance
and offer investment advice. Because they only cater to members, they are classified as non-profit organization enjoying certain
tax benefits.

Rural Banks and Cooperative Banks

Rural banks and cooperative banks are the more popular type of bank in the rural communities. Their role is to promote and
expand the rural economy in an orderly and effective manner by providing the people in the rural communities with basic
financial services. Rural and cooperative banks help farmers through the stages of production from buying seedlings to marketing
of their produce. Rural banks and cooperative banks are differentiated from each other by ownership. While rural banks are
privately owned and managed, cooperative banks are organized/owned by cooperatives or federation of cooperatives.

Dictionary.com equated cooperative banks with savings and loan associations and are termed as building societies in Britain.
International Co-operative Banking Association defined a cooperative bank as a financial entity which belongs to its members,
who, at the same time, are the owners and the customers of their bank. Cooperative banks are often created by persons belonging
to the same local or professional community or sharing a common interest. Cooperative banks generally provide their members
with a wide range of banking and financial services (loans, deposits, banking accounts, among others). In most countries, they are
supervised and controlled by banking authorities and have to respect prudential banking regulations, which put them at a level
playing field with stockholder banks. Depending on countries, this control and supervision can be implemented directly by state
entities or delegated to a cooperative federation or central body.

Generally, rural banks and cooperative banks are geared toward the development of the countryside, i.e., non-urban areas and
cities. However, in today’s world, we can see rural banks even in cities in the provinces. Today, a lot of cities in the provinces are
already developed just like the cities in the urban areas. In the Philippines, Valenzuela City, Meycauayan City, Marilao City,
Malolos City, and a lot more in Cebu and Davao are already developed, yet still have rural and cooperative banks in them.

II. Non-Depository Institutions

Non-depository institutions, unlike depository institutions, which obtain funds by issuing deposits issue contracts that are
not deposits. Non-depository institutions such as pension funds, life insurance companies, mutual funds, and finance companies
like depository institutions also perform financial intermediation. Pension funds and insurance companies issue contracts for
future payments under certain specified conditions. Mutual funds issue shares in a portfolio of securities or basket" securities.
Mutual funds differ in accordance with the types of securities they buy for their portfolios. Money market mutual funds issue
accounts like checking accounts (but are called money market mutual fund and not checking account) that can be withdrawn by
checks. Finance companies raise funds that they lend to households and firms by selling marketable securities and by borrowing
from banks.

Non-depository institutions can be classified into the following:

1. Insurance companies
 a. Life insurance companies
b. Property casualty insurance companies
2. Fund managers
3. Investment banks/houses/companies
4. Finance companies
5. Securities dealers and brokers
6. Pawnshops
7. Trust companies and departments
8. Lending investors

Life Insurance Companies

Life insurance companies are financial intermediaries that sell life insurance policies. Policyholders pay regular
insurance premiums. These premiums are used to purchase investments so that the company can pay cash as needed (e.g., when an
insured dies). Life insurance companies provide protection over a contracted period or term, which may be a yea, five years, or for
life. If the insured person dies during the term of the policy, the insurance company pays the beneficiaries the agreed-upon sum,
called the face value of the insurance policy. If the insured person outlives the term of the policy, the insurance company pays
nothing. That is the reason why these policies have what is termed as loan value and cash surrender value. Loan value of a policy
is the amount that can be borrowed against the policy during the term of the policy. The cash surrender value is the amount that
will be given to the insured or beneficiary if the insured or the beneficiary decides to surrender the policy before the term ends,
which means the policy is discontinued.

A special type of life insurance is the accident insurance that insures against death or disability caused by accidents. Like
the ordinary life insurance, it has a term and a face value and works in exactly the same way as any life insurance. The only
difference is the cause—accident.

Other than life, some life insurance companies, the biggest one like Lloyds Bank of London, insure body parts like throat for
singers and hands for pianists and sculptors. Lloyd’s Of London has provided some of the most famous celebrity body-part
policies like those for Jimmy Durante’s $50,000 nose, Bette Davis’ $28,000 waistline, and Michael Flatley’s $39 million legs. In
general, one has to pay higher premiums for surplus lines insurance than he Would tor insurance on the regular market. The
oddball body-part policies can then become a means of adding extra coverage for an especially valuable star. An entertainment
company Will typically max out on standard life and disability insurance for a given celebrity before turning to specialty policies.
In the United Kingdom, the members of the Derbyshire Whiskers Club insured their beards against “fire and theft,” and a soccer
fan insured himself against psychic trauma if England loses this year’s World’s Cup.” Anyone can order up some specialty
insurance if he thinks he needs it. As long as he is willing to pay the premium, he can get insurance for the body part of his choice.
Premiums for these types of insurance are higher than the regular life insurance.

Property/Casualty Insurance Companies

Property/casualty insurance companies offer protection against pure risk. They insure against injury or property loss resulting
from accidents, work-related injuries, malpractice, natural calamities, and, at the extreme, exotic adventures as trips to the wild
like in the African safaris. The events requiring payment from property/casualty insurance companies are less predictable than that
of life insurance companies; hence, they invest in more liquid, more marketable, lower-yielding securities so that they will have
the cash available when needed.

Casualty insurance does not only cover property but also individuals. It provides help if a person meets an accident. At times, it is
referred to as disability insurance. When it comes to one’s personal finances, long-term disability can have a devastating effect if
he is not prepared. Disability insurance can replace a portion of the salary one is making before he becomes disabled and unable to
work after a serious injury or illness. But before one seeks coverage, he should first understand the different types of disability
definitions used by insurers.

Property and casualty insurance is insurance that protects against property losses to one’s business, home or car, and/or against
legal liability that may result from injury or damage to the property of others. This type of insurance can protect a person or a
business with an interest in the insured physical property against losses.

The AXA Group (an insurance group of companies) stated that property-casualty business includes the insurance of personal
property (cars, homes) and liability (personal or professional). It covers a broad range of products and services designed for
individual and business clients. Allstate Corporation, another insurance company, discussed property casualty insurance, in
insurance terms, as one that can also be called property liability insurance. It helps protect against financial losses that come as a
result of being held legally liable for an accident that causes damage to another person or another person’s belongings or property.
It may help pay for a person’s injuries or any legal costs incurred as a result of the person being injured on a property due to
negligence. This kind of insurance comes mostly into play with auto, homeowners, and even renters insurance. It pays for the
repair or replacement of the other person’s car, in addition to any medical bills if that person suffers physical injury. It also
generally extends to any additional damage done to the other person’s personal belongings that he has with him at the time of the
accident. It can also cover damages when one suffers from an accident while on his property at home.
Allstate.com cited the following examples of the sort of damages that property casualty insurance may cover:

 Medical bills. Whether the injured person has medical insurance is beside the point. If you are found to be at fault, you
could be held responsible for the payment of those medical bills.
 Pain and suffering is another type of damage people typically claim when in an accident. Medical bills aside, if someone
is seriously injured, he could also seek to hold you financially responsible for the monetary equivalent of the pain and
suffering they have experienced as a result of the accident.
 Loss of wages. If someone gets injured severely enough, he may not be able to work for quite a while. If this were to
happen, you could be held liable for those lost earnings.
 Legal fees. If you are sued, it can cost you to hire an attorney to defend you. Casualty insurance typically covers your
attorney fees if someone injured in your home sues you for damages.

Homeowners insurance is insurance for house and its contents. Homes and their contents are assets, that is why it is imperative to
protect their values.

Auto or vehicle insurance covers a person, his spouse, and his relatives who live in one home and other licensed drivers to whom
the insurer gives permission to drive his car. The policy is "package protection" which provides coverage for both bodily injury
and property damage liability, as well as physical damage to the vehicle. This damage can include that which is caused by
collision and damage and others that are not caused by collision such as flood, fire, wind, hail, among others.

If your car gets into an accident and it is your fault, you can claim damages from your insurance company. Based on the author's
experience, a damaged car that is insured can be declared as “total loss" so the maximum amount that can be claimed is obtained
by the owner. This does not mean that you can no longer use your car. In the United States, you can still have the damaged car
repaired at owner's cost (despite being paid by the insurance company, i.e., the insurance company does not get the damaged car)
and can still be driven and used. This is, however, reported to the Department of Motor Vehicles (DMV). Flood insurance is
becoming more and more popular nowadays as places that normally do not experience floods become flooded due to extreme
weather. Many regular homeowners insurance policies do not cover against flood. This is a separate type of coverage that one has
to purchase if he considers flood to be a risk for his business or property.

Windstorm insurance is a separate type of coverage that protects one’s home or business against wind damage. Wind damage may
result from items flying and destroying one’s property as a result of a hurricane, hail, snow, sand, or dust. Strong storms bring not
only rain and flood. But also strong wind. This is, however, more common in the US where certain states are beset by hurricanes.

Umbrella liability policy refers to an additional policy that starts when other’s insurance policy has reached its limit. Home
insurance, auto insurance, and flood insurance have limits, which is the value of the policy purchased. To protect one’s self against
damage for more than the insurance values for the house, auto, and flood, the umbrella liability policy is bought.

Health insurance is a type of insurance that pays for medical expenses in exchange for premiums. The insurance policy contracts
healthcare providers and hospitals to provide benefits to its members at a discounted rate. These costs include medical
examinations, drugs, and treatments referred to as covered services” in the insurance policy.

Long-term care (LTC) is defined as a need for assistance with some of the activities of daily living (often called ADLs). ADLs
include functions that most of us perform each day, like eating, bathing, using the bathroom, dressing, transferring and
maintaining continence. The need for assistance may be due to physical inability or mental impairment, such as memory loss,
Alzheimer’s, or dementia. The reason to buy long-term care insurance is to protect one’s assets in case he needs to pay for assisted
living, home care, or a nursing home stay. Long-term care insurance helps one to pay for these services which can be very
expensive and, over time, can be financially devastating. The policy also ensures that one can make his own choices about what
long-term care services he receives and where he receives them in advance. A great number of people over 65 will spend some
time in a nursing home, assisted living, or extended care facility. The cost of such care can quickly erode the assets of even the
most well-prepared savers. The risk of outliving one’s money in this situation can be great, and one of the best ways to transfer
this risk is to purchase long-term care insurance.

Professional liability insurance is a specialty coverage not covered under any property or homeowners endorsements. Professional
liability coverage protects professionals, such as doctors, financial advisors, nursing home administrators, lawyers, among others,
against financial losses from lawsuits filed against them by their clients or patients. While practitioners from different professions
are expected to have extensive technical knowledge and experience, mistake might happen and they can be held responsible in a
court of law for any harm they cause to another person or business. This type of policy is often called errors and omissions or
malpractice policies.

Credit insurance is an optional protection purchased from lenders and is often associated with mortgages, loans, or credit cards. It
protects the lender and the borrower on the chance that he is unable to repay the debt due to death, disability, or involuntary
unemployment.

Fund Managers
Included among the fund managers are pension fund companies and mutual fund companies.

Pension fund companies sell contracts to provide income to policyholders during their retirement years. Pension funds are set up
to accumulate funds to provide for retirement, disability, and/or lump-sum death benefit payments to the employees of companies
or labor union members. Pension funds can be funded by employees only or by both employees and their employers during the
policy-holders’ income-earning years. Contributions to the fund are made while the policyholders are still employed, and the
disbursements from the fund are made in a series of payments over the retirement years of the policyholders or in lump-sum upon
retirement. This ensures that even if retired, the policyholders will be receiving income from their fund. Contributions are not
taxed but disbursements are. For employers, contributions to the pension fund of their employees are tax-deductible as employee
benefits. Social Security is a form of pension plan. A pension plan places member contributions in a portfolio of stocks, bonds,
and other assets in the expectation of building an even larger pool of funds as the need arises. It also helps employees to balance
planned consumption upon retirement with the amount of savings set aside today.

Pension plans may be defined-contribution plans or defined-benefit plans. Defined contribution plans are the ones where the
employees only or both the employees and the company make payments to the fund as a fixed percentage of salaries making the
size of the retiree’s benefit dependent upon the investment success of the fund manager. Under the defined-benefit plans, a fixed
benefit payment to the employee is calculated, which is usually related to the size of the employee’s salary and the number of
years of service; actuaries estimate the interest that the portfolio will earn and the expected life span of the employee; then, they
calculate the sizes of the periodic contribution that the employee or the employee and the company will make to the fund to ensure
that the retiree will receive the benefit that has been predetermined. In short, it is a plan that either pays a retired employee so
many dollars/pesos per month or it pays the individual a percentage of his average final salaries (Van Horne 1995).

Mutual fund companies are companies engaged in the mutual funds market. They allow investors, including individuals, to buy
into mutual funds that buy different securities in the securities market, like stocks, long-term bonds, or short-term debt instruments
issued by businesses or government units. Moreover, individuals can invest in mutual funds.

Open-end investment companies belong to this group. They are financial intermediaries that pool relatively small amounts of
investors' money to finance large portfolios of investments that justify the cost of professional management. By pooling funds,
these organizations reduce risks by diversification. They also achieve economies of scale, which lower the costs of analyzing
securities, managing portfolios, and buying and selling securities (Weston and Brigham 1993). Open-end investment companies
are called mutual funds. They issue new shares whenever one wants to buy them and repurchase shares whenever an investor
wants to sell them. The price of a mutual fund share equals the net value of the portfolio divided by the number of shares
outstanding at that time. This value is calculated twice a day-at noon and at the close of the market for the day (Shetty et al. 1994).
The shareholders become the owners of the portfolio of the fund. These portfolios of securities could be made up of equity
securities or debt securities or even other mutual funds.

Mutual funds could be:

a. growth funds, which invest in assets that are expected to reap large capital gains (generally equity securities);
b. income funds, which invest in stocks that regularly pay dividends and in notes and bonds that regularly pay interest;
c. balanced funds, which combine the features of both the growth funds and the income funds;
d. sector funds, which invest in specific industries as health care, financial services, utilities, extractive industries;
e. index funds, which invest in a basket of securities that make up some market index as the S&P 500 index of stocks; and
f. global funds, which invest in securities issued in many countries providing diversification.

Money market mutual funds invest in high-quality short-term securities. They have check-writing privileges, combining the
features of current account and mutual funds. Like the mutual funds, traditional financial institutions establish their own divisions
or buy or establish a subsidiary that specializes in money market mutual funds. These divisions or subsidiaries conduct their
business mostly by mail or electronic transfer of funds.

Investment Banks/Houses/Companies

Investment companies are financial intermediaries that pool relatively small amounts of investors’ money to finance large
portfolios of investments that justify the cost of professional management. Closed-end investment companies issue a fixed number
of shares which they sell to the public to raise money to purchase investments. These shares trade in the open market like the
shares of any corporation and their price varies with the demand. Open-end investment companies are also called mutual funds as
discussed in the previous section.

Investment banks underwrite new issues of equity and debt securities. In an underwriting transaction, the investment bank, also
known as merchant bank, guarantees the sale of the issues at an agreed price. The investment bank will try to resell all the issues
to investors and any remaining unsold issues will have to be bought by the investment bank for its own account. Aside from
providing the funds in advance, the investment bank also gives advice to the issuing company as to the price and number of
securities to issue. The issuer is spared the risk and cost of creating a market for its securities on its own. An investment house or
investment bank works primarily for corporations and governments. These banks help raise money for their clients through debt
and stock offerings. They also advise companies on mergers and acquisitions and help bring prospective buyers together with
sellers. They provide advisory services to investors, primarily to large institutional customers as insurance companies and pension
and mutual funds. Investment banks provide advisory services to investors, but primarily to larger institutional customers such as
pension and mutual funds.

Finance Companies

Finance companies are profit-oriented financial institutions that borrow and lend funds to households and businesses. They are
like banks and thrifts. However, finance companies do not issue checking or savings accounts and time deposits. They raise funds
in the open markets and borrow from banks. They act as financial intermediaries by issuing securities in the open markets and
borrowing from banks and then relend these funds to households and businesses.

Finance companies are traditionally grouped into three:

1. Sales finance companies

2. Consumer finance companies
3. Commercial finance companies

Sales finance companies provide installment credit to buyers of big-ticket items like cars and household appliances. Most sales
finance companies are subsidiaries of major manufacturers of these cars and household appliances. They serve as outlets for the
manufacturers; hence, they are captive finance companies because they cannot sell any other item except those manufactured by
the manufacturers.

Consumer finance companies grant credit to consumers. They grant small loans to individuals, generally those with low credit
ratings and are unable to borrow from the regular lending institutions like banks and thrifts. Because of the high credit or default
risk, the interests charged on these loans are higher.

Commercial finance companies, also known as business finance companies, grant credit to businesses. While consumer finance
companies grant loans to consumers, commercial finance companies grant loans to commercial enterprises or businesses. Like
consumer finance companies, they grant loans to businesses with difficulty in obtaining loans from the regular source of these
loans because of their low credit rating. Interests on these loans are, therefore, higher. These loans are usually secured by the
businesses assets like accounts receivables, inventories, or equipment and other fixed assets that the businesses may have.

Securities Brokers and Dealers

Securities brokers and dealers can be counted among the other finance companies. Securities brokers are only compensated by
means of commission. They act as financial intermediaries in that they look for investors or savings units for the benefit of the
borrowers or deficit units. They help in the meeting of these units. They only earn commission on any sale they make. They do not
buy the securities directly. Securities dealers, on the other hand, buy securities and resell them and make a profit on the difference
between their purchase price and their selling price.

Pawnshops

Pawnshops are agencies where people and some small businesses “pawn their assets in exchange of an amount much smaller than
the value of the asset or use their assets as collateral for a loan. They are in the business of lending money on the security of
pledged goods left in pawn, or in the business of purchasing tangible personal property to be left in pawn on the condition that it
may be redeemed or repurchased by the seller for a fixed price within a fixed period of time. A “pawn transaction” does not
include the pledge to, or the purchase by, a pawnbroker of real or personal property from a customer followed by the sale or the
lease of that property back to the customer in the same or a related transaction.

Pawnshops have been in business for many years and have provided loans to people who use their assets as collateral. In the
Philippines, pawnshop has the highest rate of return, almost 60%, earned annually and earns return of investment in 3.5 years
(payback period). These are the reasons for pawnshops to flourish like mushrooms across the country, even in the cutthroat
competition in the lending business. Cebuana Lhuillier has over 1,500 branches all over the Philippines.

The Chamber of Pawnbrokers of the Philippines, Inc. (CPPI) is the first and only organization to serve and to represent the best
interest of the pawnshops. CPPI claims that it is the first and only organization to serve and to represent the best interests of the
firms and individuals involved in the aspects of the pawnbroking industry.”” CPPI offers a wide range of services and programs
which can make a real difference in the success and growth of the pawnshop business. Membership to the CPPI definitely has its
advantages.

In a study (part of a larger study on the informal credit markets supported by the Asian Development Bank) made by Mario
Lamberto of the Philippine Institute for Development Studies, Mr. Lamberto stated that pawnshops constitute the smallest group
among financial institutions. According to the study in 1985, pawnshops’ total combined assets was 808 million pesos, which was
less than one percent of the total assets of the entire financial system. Mr. Lamberto concluded that pawnshops have carved out
their own niche in the financial market, servicing small borrowers who could not be accommodated by the banking system. Like
the informal moneylenders, pawnshops have provided a safety net to small firms and households who suffered liquidity problems.
The strong demand for the services of pawnshops made them an attractive business venture. Pawnshops have sprouted In every
corner of the country. In fact, pawnshops stood side by side in almost every commercial place. Pawnshops have, indeed, become a
permanent fixture in the lives of ordinary Filipinos.

Trust Companies/Departments

Barron’s Banking Dictionary defined trust companies as corporations organized for the purpose of accepting and executing trusts
and acting as trustee under wills, as executor, or as guardian. Some trust companies, mostly banks, perform banking services with
a special trust department. They can perform trust functions for companies issuing bonds to ensure that bondholders are paid as
needed. They can act as fiscal agents or paying agents for the government.

Lending Investors

Lending investors are individuals or companies who loan funds to borrowers, generally consumers or households. They perform
granting loans, but they are not as big as the regular financial intermediaries. No matter how small they are, they still bridge the
gap between lenders and borrowers or the deficit units or the saving units. They also charge a higher rate of interest on the loans
they grant. Individuals that grant loans under the so-called “5/6” terms are, in effect, lending investors. Companies that grant loans
to SSS pensioners are also lending investors.

Role of Financial Intermediaries in Socio-Economic Development

In a developing country or a less developed country like the Philippines, financial intermediaries play an important role in its
socio-economic development. It is the financial intermediaries that bring the available funds from the urban areas to the rural
areas, which are mostly in need of such funds. Rural and cooperative banks and microfinance thrift banks have been a great help
in these less fortunate areas. They are the ones doing the lending to farmers and other rural residents that need to improve their
status in life. They can borrow from the rural and cooperative banks and/or from the microfinance thrift banks and start their own
small business or send their children to school.

In addition to rural and cooperative banks and the microfinance thrift banks, the growth of commercial banks in the rural areas
have greatly helped the areas by making credit available to the rural residents so they can use such credit to advance.
Entrepreneurship and micro and cottage industries had been pushed in these areas to help these areas develop and improve, not
only the economic aspects of the residents’ lives but also their social life. Financial intermediaries had been influential and helpful
in the establishment of schools and businesses in these areas aiding in their socio-economic development. They had helped the
government in securing funds for infrastructure development of these areas. They had helped individuals pursue education or
businesses and livelihood projects to attain economic independence.

The objective of rich countries helping the poor countries is the same objective of financial intermediaries and the government—
to help the poor sector to alleviate poverty, encourage individual or personal industry, promote entrepreneurship, and motivate
self-sufficiency (Thomas 1997). These efforts are done by making available the necessary and much-needed resources from the
savings units to the deficit units. These efforts push toward agricultural development, especially for countries like the Philippines,
which is predominantly agricultural. It promotes the growth of micro and cottage industries and encourages growth of small
businesses. Farmers usually borrow money to buy fertilizers and other products they need for their farm. Fishermen borrow
money to buy banca or boat and net for their fishing. Banks, as financial intermediaries, help a great deal in these regards. These
financial intermediaries are also, at times, instrumental in buying the produce from the agricultural and rural areas to help farmers
get the immediate price for their product. Because of their vast networking, they are able to find farmers a market or a buyer.
Farmers do not have to wait for their produce to reach the market. The financial intermediaries provide financing while they wait
for the realization of their sale. They simply pay interest on the loan they get, generally using their produce as collateral for their
loan. Such interest is generally covered by the sales price of their product, still allowing them to earn, even a little profit. Helping
them ultimately results in their socio economic welfare and development.

Moreover, these financial intermediaries have helped a lot of the rural folks escape usurers. Financial intermediaries had partnered
with the government in its effort to develop these rural areas and uplift the economic and social standing of the rural communities
and, at the same time, get rid of usurers. The usurers will flourish if rural areas do not have the bank to help them in their fight
against poverty. Fajardo et al. (1994) maintained that a financial system mobilizes the financial resources of society, and utilizes
these for social and economic development.

Economic Bases for Financial Intermediation

Imagining a world without financial intermediaries will explain the important roles financial intermediaries play in the economic,
if not social, development of a country. If they did not exist, there would be no place to put our money where it will earn interest.
Putting our money in a piggy bank or a house post will not earn us anything. Without them, we would have no help to resort to
when we could not afford to send our children to school to improve their lives. Similarly, we would have no help to start our own
business. All of these are possibilities that may happen without financial intermediaries.

Other than helping in the socio-economic development of the nation, financial intermediaries bear a large part of the cost that
individuals and small borrowers would have shouldered if they themselves had done what the financial intermediaries are doing. It
is costly to do market research and analysis, including determining the most profitable and the safest means of investing our hard-
earned savings. The big network and economies of scale available to these financial intermediaries allow them to shoulder all the
costs, including transaction costs, which the individual and small borrowers would have shouldered. This makes the existence of
financial intermediaries indispensable.

Financial intermediaries help both the surplus units and the deficit units. They help surplus units by pooling funds of thousands of
individuals and entities overcoming obstacles that stop them from purchasing primary claims directly. Such obstacles include lack
of financial expertise, lack of information, limited access to financial markets, absence of many financial instruments in small
denominations, among others. The spread of risk is made possible only by the pooling funds. This is generally termed as
diversification (Thomas 1997). The pooling of resources spreads risk. If borrowers default, several lenders suffer the loss, instead
of just one lender shouldering the loss.

Financial intermediaries also help deficit units by broadening the range of instruments, denominations, and maturities of financial
instruments, enabling even small savers or surplus units to take advantage of the safer and more profitable investment alternatives.
Even governments are helped most of the time by these institutions in disposing of government securities to a broader base.
Thomas (1997) stated that financial intermediaries increase economic efficiency, boost economic activity, and elevate living
standards.

Changing Nature of Financial Intermediaries

Thomas (1997) aptly described the changing nature of financial intermediation. According to him, the US Congress, after the
Great Depression of the 1930s, devised a host of measures to promote a highly specialized (each type of financial institution has to
perform certain functions peculiar only to it) financial system. Banks were set up to take in deposits and grant only short term
loans. Creation of branches was limited and interest rates were duly regulated. Thrift institutions, to protect banks, were prohibited
to grant consumer and commercial loans and issue checking accounts (which were prohibited to grant interest) and were forced to
specialize in long-term fixed-rate mortgages. Life insurance companies were allowed only to issue policies and purchase corporate
bonds, not stocks. In 1933, the Banking Act of 1933 or Glass Steagall Act separated commercial and investment banking.
Commercial banks were no longer allowed to underwrite corporate stocks and bonds, which function became the dominion of
investment banks, and they were not allowed to hold common stocks in their investment portfolios. On the other hand, investment
banks were not allowed to accept household deposits or grant commercial loans, which became the domain of commercial banks.
Financial institutions, therefore, became highly specialized. Households could no longer go to one financial institution and
transact all their businesses there. They had to go to banks to open checking accounts, go to an insurance company to purchase
insurance policies, go to a thrift institution to mortgage their house and lot, among others. Companies who issue stocks and bonds
had to go to an investment bank for underwriting of their issues and go to a commercial bank for a loan. Severe restrictions were
placed on the portfolios of depository institutions, especially thrifts. This was known as the old financial environment (OFE).

OFE began to change in the mid-1970s when the increase in market rates of interest, accompanied by high and rising rates of
inflation clashed with the existing regulatory structures. Hadjimichalakises (1995) described the new financial environment (NFE)
as a market-determined or deregulated rates on assets and liabilities of financial intermediaries and by greater homogeneity among
financial institutions (no longer specialization) which emerged in the 1980s. Financial institutions can now perform various
financial functions and households and companies can now go to a single financial institution to transact various financial
business. Thereupon emerged NFE characterized by financial innovations. New practices and new products emerged. Laws,
regulations, institutional arrangements and technological innovations were introduced. These innovations sprung from attempts by
households, firms, and banks to circumvent existing regulations to maximize profit/wealth. The governments were left with no
other choice but to simply protect the health of their respective economic and financial systems. Hadjimichalakises (1995) opined
that the proximate cause for the demise of the regulated deposit rates in the 1930s till the early 1970s was the high and rising rate
of inflation in the late 1960s, the 1970s, and the early 1980s. According to them, inflation rate rose from 4.7% in 1972 to 9.7% (an
increase of 5%) in 1981 in the span of 9 years. This inflation rate embedded in the double-digit rate of interest pushed interest
rates up. As the spread between deposit rates and interest rates widened, wealthy households and firms withdrew their funds from
the regular-rate deposit accounts and placed them in higher-earning financial instruments like T-bills, which pay market-
determined rates. Small savers were unable to take advantage of these financial instruments because of denominations they could
not afford. The outflow of funds from financial intermediaries is termed disintermediation, which plagued the depository
institutions, especially thrifts. Moreover, financial technology has developed and paved the way for those who can afford the said
technology to circumvent existing regulatory structures. As such, the old structures became less effective and less useful and
ultimately became obsolete.

In the early 1970s, Money Market Mutual Funds (MMMFs) were first introduced and households and small businesses began to
have access to a saving tool better than deposits. In 1977, Merrill Lynch created the cash management account (CMA) by
combining MMMF features with securities account and credit line (Hadjimichalakises 1995). CMA is an MMMF in which
deposited funds can be used to purchase securities or can be withdrawn by check or credit card. It has no limit on the number of
checks that can be issued against the account or the size of the check. Credit card also grew secondary to advances in computer
technology making it profitable for banks to mass market the same. It replaced money in wallets of individuals and business
executives. Even businesses have their own credit cards to be used for official business. Private pension funds and state and local
government retirement funds also grew. This dramatic increase in pension funds and mutual funds hurt commercial banks, thrift
institutions, and investment banks, benefiting life insurance companies, which moved into management of pension fund assets. It
also raised interest rates on deposit to prevent withdrawal of deposits, boosted the commercial paper market, and allowed small
businesses to borrow from finance companies (which, in turn, issue commercial papers to obtain loanable funds). It also increased
the demand for high-yielding mortgage-backed securities that led to the securitization of consumer loans in the mid-1980s
(Thomas 1997). Securitization means loans made by banks and finance companies were transformed into securities sold in large
blocks.

Risks of Financial Intermediation

Risk is the possibility that actual returns will deviate or differ from what is expected. If one expects prices to go up and he
buys securities, he is taking a risk because prices could go up or down. If prices go up, he gains; if prices go down, he loses.
Financial intermediation is highly market sensitive, i.e., it changes with changes in the market environment. As such, financial
intermediaries face several risks.

A. Interest Rate/Market Value (Price) Risk

Financial intermediaries perform what is known as asset transformation in their buying primary securities and selling secondary
securities, They buy one asset and transform this asset into another asset that they sell. Short-term assets are pooled and converted
to long term securities. This mismatching of maturities of assets and liabilities exposes them to what is termed as interest rate or
market price risk. Interest rate or market value/price risk is the risk that the market value (price) of an asset will decline (when
interest rate rises), resulting in a capital loss when sold. The market value of an asset or liability is theoretically equal to its
discounted future cash flows. Therefore, when interest rates increase, the discount rate on those cash flows increases and reduces
the market value of the asset or liability. On the other hand, when interest rates fall, the market values of the assets and liabilities
increase. In short. Securities decline in price when interest rates rise. Interest rate risk and market price risk go in opposite
direction. When prices rise, interest rates fall; when prices fall, interest rates rise.

B. Reinvestment Risk/Refinancing Risk

Reinvestment risk arises as a result of interest rate/market price risk. Reinvestment risk means the risk that earnings from a
financial asset need to be reinvested in lower-yielding assets or investment because interest rates have fallen. Uncertainty about
interest rate at which a company could reinvest funds borrowed for a longer period is reinvestment risk. If the cost of borrowing
is, say 10%, the financial intermediary should be able to earn more than 10% when it reinvests the borrowed funds. Refinancing
risk is the risk that the cost of rolling over or re-borrowing funds could be more than the return earned on asset investments. If the
cost of rolling over borrowed funds is, say 10%, and the return that will be earned on investing the borrowed funds will only result
in a rate of return of, say, 9%, the financial intermediary loses 1%.

C. Default/Credit Risk

Default risk or credit risk is the risk that the borrower will be unable to pay interest on a loan or principal of a loan. If one borrows
from a bank and fails to pay any interest payment on the loan or the principal upon maturity, he is said to be in default. If a
company issues bonds and is unable to pay interest on interest payment dates or fail to pay the principal on bond redemption date,
the company is said to be in default. This is the reason there are credit investigators who investigate background of borrowers
before companies or banks are able to grant loans requested by borrowers. Suppliers investigate background of buyers before
granting credit to these buyers because of the risk of default.

D. Inflation/Purchasing Power Risk

Inflation risk or purchasing power risk is the risk of increase in value of goods and services reducing the purchasing power of the
currency. Families struggle when the prices of staple commodities like rice, fish, meat, and vegetables rise. Their earnings can
only buy less of these commodities, making survival difficult. When gas price increases, drivers complain because they can only
buy less gas with their money. As prices or inflation rises, purchasing power decreases. Prices and purchasing power go in
opposite direction, just like market prices and interest rates do.

E. Political Risk

Political risk is the risk that government laws or regulations bring to the investor’s expected return on investment adversely or
negatively. Even in extreme cases, this could lead to the total loss of invested capital. Increased taxes on petroleum products will
reduce returns on stockholders of petroleum companies. Regulated interest rates on deposits discourage depositors and motivate
them to move their funds to other higher-earning investments as money market mutual funds or Treasury bills.

F. Off-Balance Sheet Risk

OT-balance sheet transactions are usually engaged in by financial institutions. These are transactions that do not appear in the
financial institution’s balance sheet but represent transactions that pose contingent assets or liabilities on the financial institution.
Happening of Contingent assets is favorable, but the happening of a contingent liability becomes unfavorable and disadvantageous
to a financial intermediary. A financial institution that grants a letter of credit to the company for its issuance of bonds would
create a liability on the part of the financial institution should the company fail to meet its interest and principal payment on its
bonds. The financial institution would be the one forced to pay such interests and principal on the bonds issued by the company.
The happening of such event would only be the time that such liability will be shown in the balance sheet of the financial
institution.

Technology/Operation Risk Technology and operation risks are related because technological innovations generally involve
operations. Advancement in technology poses an operational risk to all businesses, including financial institutions. These
businesses need to update their own operations by investing in software and hardware as computer knowledge advances and
international networking and communications become prevalent. Banks have to put up automated teller machines (ATMs) for the
convenience of depositors and improvement of their own operations. Credit cards need networking facilities so that users of credit
cards and businesses can transact business. Businesses without the credit card terminals necessary for credit card transactions lose
sales and, consequently, profits. Companies with international operations need to be able to communicate directly with all their
branches and outlets scattered throughout the world. They even, at times, need to put up their own satellite system to keep up with
the needs of the times. These technological innovations all aim to widen customer base, take advantage of economies of scale,
reduce operating costs, increase operating efficiency, and ultimately increase profits and improve the owners’ wealth.
Technological/operational risk arises when these investments in technology do not produce the desired results, i.e., fail to get
more customers, unable to produce economies of scale, fail to increase profit, or reduce costs. These result when technological
innovations produce excess capacity and bureaucratic inefficiencies, among others. Benefits from technological innovations,
however, could result in operating efficiency better than competition, advancing the company ahead in the race for superiority in
its field. It can also help develop new products that will help in the firm’s survival and earning potential.

G. Liquidity Risk

Financial intermediaries also face liquidity risks. Liquidity risk results from withdrawal of funds by investors or exercise of loan
rights or credit lines of clients. Financial intermediaries, especially banks with a lot of deposit accounts that are supposed to be
met daily and immediately cause the financial intermediary a problem on how these withdrawals would be met. They hold very
little cash on hand as most of their assets are in investments, most of which are long-term versus their short-term liabilities. It is
this mismatching of assets and liabilities that poses or causes the liquidity risk faced by financial intermediaries. The first sign of a
liquidity problem faced by a financial intermediary can cause what is termed as a “run”. When bank depositors all demand
withdrawals of their funds deposit with a certain bank at the same time, it will cause a bank run,” which could ultimately result in
bank insolvency and bankruptcy. Deposit insurance and discount windows were designed to help with such liquidity problems.

H. Currency or Foreign Exchange Risk

Currency or foreign exchange risk is the possible loss resulting from an unfavorable change in the value of foreign currencies. If a
Philippine investor buys US securities in the hope that the US$ will increase in value, he will lose if the US$ falls because his
dollar investment will fall in value. A US investor who buys Euro securities will lose if the Euro falls in value relative to the US
dollar. Financial intermediaries usually do not only own domestic securities. They also own securities denominated in foreign
currencies. Diversification reduces their foreign exchange risk because holding only securities denominated in one currency will
make the financial intermediary at a losing end should the currency of the securities they are holding fall in value without any
security to offset the loss. If it holds securities in various foreign currency denominations, a loss in one can be offset by a gain in
another.

I. Country or Sovereign Risk

While investing in securities denominated in other foreign currencies is advantageous, in general, for a financial
intermediary, it is, likewise, posing a country or sovereign risk in investing in securities denominated in foreign currency. This is
because unlike investing in domestic-currency denominated securities, which provides recourse to the country’s domestic
bankruptcy courts in case of default, any default in a foreign country is difficult to pursue as the government of the foreign
country may prohibit payment or limit payment secondary to foreign currency shortage and some other political reasons. Country
or sovereign risk overrides the credit risk from a foreign borrower because even if the borrower is in good credit standing, the
government of that foreign country could set up regulations that prohibit debt repayments to outside or foreign creditors. Even if
willing to pay, the foreign borrower cannot pay its obligation because its own government prohibits the repayment. There are no
international bankruptcy court lenders to resort to. Therefore, lending to a foreign borrower needs an evaluation of the credit or
default risk of the borrower and an evaluation of the country or sovereign risk of the country where the borrower is located.