Learning Outcomes

• Define financial intermediation

• Discuss the difference between the old and new
financial environment
• Differentiate depository financial institutions and non
depository financial institutions
• Explain the roles of different depository financial
institutions and non depository institutions
• Discuss the different risks faced by financial
intermediaries and investors
• Explain the role played by financial intermediaries in
the socio economic development of a country
• Discuss in detail the economic bases for financial
intermediation
Financial Intermediary
• A financial intermediary is an entity
that acts as the middleman between
two parties in a financial transaction,
such as a commercial bank,
investment banks, mutual funds and
pension funds.
Financial intermediaries cont...
• Are the financial institutions that act as
a bridge between investors or savers (
surplus units or SUs ) and borrowers or
security issuers ( deficit unit or DUs ) .
Direct Finance & Indirect Finance
• A borrower-lender relationship is the
typical direct finance relationship or
transaction. A bank and a bank
depositors are engaged in direct finance.
A bank and a bank borrower are engaged
in direct finance.
 Direct / Primary Security

Investors
Borrowers ( Surplus Units )
( Deficit Units)

Banks,
Banks , Borrowers
, Issuing Corps. Depositors ,
Corporation
Indirect Finance

•When intermediaries pool

deposits and transform them
into secondary securities which
they sell to investors , it is called
indirect finance.
 Direct Direct Finance
finance

Depositors Banks Borrowers

Indirect Finance
The Old Financial
Environment ( OFE )
and The New Financial
Environment
The Old Financial Environment
( OFE )
• Thomas ( 1997 ) describe the changing
nature of financial intermediation.
• According to him , the US Congress , after
the Great Depression of the 1930's ,
devised a host of measures to promote a
highly specialized 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.
• Life insurance companies were allowed only
to issue policies and purchase corporate
bonds , not stocks.
• In 1993 , the Banking Act of 1933 ( Glass
Steagall Act ) separated commercial and
investment banking.
• Commercial Banks were no longer
allowed to underwrite corporate
stocks and bonds. On the other hand
, investment banks , were not
allowed to accept household
deposits or grant commercial loans ,
which became the domain of
commercial banks.
• Households can no longer go to one
financial institution and transact all their
businesses there. Company who issue
stocks and bonds have to go an
investment banks.
• Severe restrictions were placed on the
portfolios of depository institutions ,
especially thrifts . This was known as the
old financial environment ( OFE ) .
 The New Financial Environment
( NFE )
• OFE began to change in the mid - 1970's when the
increase in market rates of interest accompanied by
high and rising rates of inflation clashed with the
existing regulatory structures.
• The Hadjimichalakises (1995) describe the new financial
environment as being characterized by market-
determined or deregulated rates on assets and liabilities
of financial intermediaries and by greater homogeneity
among financial institutions , which emerged in 1980s.
• Financial institutions can now perform various
financial functions, which enable households
and companies to go to a single financial
institutions to transact various financial
businesses.
• Thereupon emerged the new financial
environment ( NFE ) characterized by financial
innovations. New practices and new products
emerged. Laws , regulations , institutional
arrangements and technological innovations
were introduced.
• In the early 1970s , 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.
• Private pension funds and state and local
government retirement funds also grew.
• Credit cards also grew secondary to advances in
computer technology making it profitable for
banks to mass market the same.
• In the advent of the new financial environment
, credit cards replaced money in the wallets of
individuals and business executives.
• Even companies opened their own credit card
accounts.
• Corporate credit cards are a distinct group
within the greater credit card universe
separate from both personal and small
business credit cards.
• Corporate credit cards categorized into two :
individual payment cards and company
payment cards.
Classification of Financial
Intermediaries

1. Depository Institutions
2. Non - Depository Institutions
Depository Institutions
• Refers to financial institutions that
accept deposits from surplus units .
• They issue checking or current accounts /
demand deposits , savings , time deposit
and help depositors with money market
placement.
Depository Institutions
1. Commercials Banks
a. Ordinary Commercial Banks
b. Expanded Commercial or Universal Bank
2. Thirft Banks
a. Savings and Mortgage Banks
b. Stocks Savings and loan associations
c. Private Development Banks
d. Microfinance Thrift Banks
e. Credit Unions
3. Rural Banks
Commercial Banks
• The biggest of the depository institutions.
They hold the deposits of millions of people,
governments and business enterprises.
• Considered as a the heart of our financial
system.
 Ordinary Commercial Banks

• Perform the more simple functions of

accepting deposits and granting loans.
They do not do investment functions.
Universal Banks or Expanded Commercial
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.
• They offer the widest variety of banking
services among financial institutions.
Thrift Banks
• Is composed of savings and mortgage , stocks
savings and loan associations , private
development banks , microfinance thrift banks ,
and credit unions.
• Credit unions , although not classified as banks
can be considered as a thrift institutions in the
sense that they encourage people to save.
• 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.
• Thrift banks are also allowed to grant loans
under the Agrarian Reform Credit and supervised
credit programs of the government.
Savings and Mortgage Banks

• Are banks specializing in granting mortgage

loans other than the basic function of
accepting deposits .

Mortgage Banks
• Do not accept deposits but extend loans.
They offer first and second mortgages on
commercial property, residential houses
and residential apartments.
• First mortgage represents the first time
that a property could be mortgage. If the
amount of the property is a lot bigger than
the amount of the first mortgage loan, the
property can br used to secure another
loan , called second mortgage.
• Mortgage banks , are usually privately
owned corporations willing to take risks
that other banks reject.
Stocks Savings and loan associations

• 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.
Private Development Banks

• Cater to the needs of agriculture and industry

providing them with reasonable rate loans
for medium - and long - term purposes.

Micro Finance Thrift Banks

• Small thrift banks that cater to a small ,
micro , and cottage industries .
Credit Unions

• are cooperatives organized by people from

the same organization like farmers of a
certain crop, fishermen , teachers , sailors ,
employees of one company, etc. and grant
loans to these members and get deposits
from them.
Rural Banks & Cooperative Banks
• The most popular type of banks 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.
Non - Depository Institutions
• Issue contracts that are not deposits.
• These are pension funds like insurance
companies , mutual funds and financial
companies like depository institutions
which perform financial intermediation.
Non-Depository Institutions can be classified into
the following :
1. Insurance companies
a. Life insurance companies
b. Property/Casual 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
Life Insurance Companies

• are financial intermediaries that sell

life insurance policies.

Property/ Casualty Insurance companies

• offers protection against pure risk.

Does not only cover property but
also individuals
Property/ Casualty Insurance companies
includes ;
• Home owners insurance, is insurance
for houses and its contents.
• Auto insurance , covers one's , spouse's
and relative's home and other licensed
drivers to whom the insurer gives
permission to drive his car.
• Flood insurance , is taken if one
considers flood to be a risk for his
business or property.
• Windstorm insurance, is a separate type
of coverage that protect one's home or
business against wind damage.
• Health insurance , is a type of insurance
that pays for medical expenses in
exchange for premiums.
•Professional liability coverage,
protects professionals such as
doctors , financial advisors ,
nursing home administrators ,
lawyers, etc. , against financial
losses from lawsuits filed against
them by their clients or patients.
 Fund Managers
• are pension fund companies and mutual fund
companies.
• Pension fund companies sell contracts to
provide income to policy holders during their
retirement years.
• Mutual fund companies are companies that
allow investors , including individuals to buy into
mutual funds that buy different securities in the
securities market.
Investment Banks / Houses /
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.
Finance Companies
• profit-oriented financial institutions
that borrow and lend funds to
households and businesses. Finance
companies are sales finance
companies, consumer finance
companies and commercial finance
companies.They are like banks and
thrifts.
 Securities Brokers
• are financial intermediaries that look for
investors or savings units for the benefit of
the borrowers or deficit units and
compensated by means of commission.
• Securities dealers, buy securities and resell
them and make a profit on the difference
between their purchase price and their
selling price.
Pawnshops

•are the agencies that lend money

on the security of pledged goods
left in pawn.
•Where people and some
businesses " pawn " their assets as
a collateral in exchange of an
amount much smaller than the
value of the asset.
Trust companies
• are corporations organized for the
purpose of accepting and executing
trusts and acting as trustee under
wills , as executor or as guardian.
Lending investors
•are individuals or companies
who loan funds to borrowers
generally consumers or
household.
Risk of Financial
Intermediation

•Risk is the possibility

that actual returns will
deviate or differ form
what is expected.
 Risk of Financial
Intermediation
1.Interest Rate / Market
Value/Price Risk
2.Reinvestment Risk
3.Refinancing Risk
4.Default/Credit Risk
5.Inflation/Purchasing Power
6. Political Risk
7. Off-Balance-Sheet Risk
8. Technology and Operation
Risk
9. liquidity Risk
10. Currency or Foreign
Exchange Risk
11. Country or Sovereign Risk
1. Interest Rate / Market
Value/Price Risk
•Is the risk that the market
value ( price ) of an asset
will decline ( when
intereste rate rises )
resulting in a capital loss
when sold .
2. Reinvestment Risk
•The risk that earnings
from a financial asset
need to be reinvested in
lower yielding assets or
investment because
interest rates have fallen
3. Refinancing Risk
•Risk that the cost of
rolling over or
reborrowing funds
could be more than
the return earned on
asset investments.
4.Default/Credit Risk
•Risk that the
borrower will be
unable to pay
interest on a loan
or principal of a
5. Inflation/Purchasing Power
Risk
•Risk of increase in
value of goods and
services reducing the
purchasing power of
money to purchase
goods or services.
6. Political Risk
•Risk that government
laws or regulations will
affect the investors
expected return on
investment and
recovery of investment
7.Off-Balance-Sheet Risk
•Off - balance - sheet
transactions are usually engaged
in by financial institutions.
Transactions that do not appear
in the financial institutions
balance sheet but represent
transactions that pose
contingent assets or contingent
8. Technology and
Operation Risk
•Are related because
technological
innovations
generally involve
and affect
9. liquidity Risk
•Results from
withdrawal of funds
by investors or
exercise of loan
rights or credit lines
of clients.
10. Currency or Foreign
Exchange Risk
•Is the possible loss
resulting from an
unfavorable change
in the value of
foreign currencies.
11. Country or Sovereign
Risk
•In general, while investing in
securities denominated on
other foreign currencies is
advantageous for a financial
intermediary , it is likewise
posing a country or sovereign
risk in investing in securities
Role of Financial
Intermediaries in
Socio-Economic
Development
•In a developing country like the
Philippines, financial
intermediaries play an important
role in its socio-economic
development. While Financial
intermediaries play an important
role in the urban areas, where a
lot of businesses are located and
where the financial market are
very active, they are also very
instrumental in the rural areas for
•In addition to rural banks,
cooperative banks, and
microfinance thrift banks
the growth of commercial
banks in the rural areas has
helped the areas
tremendously by making
credit available to the rural
residents so they can use
•The objective of rich
countries helping the poor
countries is the same
objective of financial
intermediaries in the
government-to help the poor
sector to alleviate poverty;
encourage individual or
personal industry; promote
entrepreneurship; ang