Learning Outcomes

• Define financial intermediation

• Discuss the difference between the old and new financi
al environment
• Differentiate depository financial institutions and non d
epository financial institutions
• Explain the roles of different depository financial institu
tions and non depository institutions
• Discuss the different risks faced by financial intermediar
ies and investors
• Explain the role played by financial intermediaries in th
e socio economic development of a country
• Discuss in detail the economic bases for financial interm
ediation
Financial Intermediary
• A financial intermediary is an entity t
hat acts as the middleman between t
wo parties in a financial transaction, s
uch as a commercial bank, investment
banks, mutual funds and pension fun
ds.
Financial intermediaries co
nt...
• 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 F
inance
• A borrower-lender relationship is the typi
cal direct finance relationship or transacti
on. A bank and a bank depositors are eng
aged in direct finance. A bank and a bank
borrower are engaged in direct finance.
 Direct / Primary Security

Borrowers Investors
( Deficit Units) ( Surplus Units )

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

• When intermediaries pool depos

its and transform them into seco
ndary securities which they sell t
o investors , it is called indirect fi
nance.
 Direct Direct Finance
finance

Depositors Banks Borrowers

Indirect Finance
The Old Financial En
vironment ( OFE )
and The New Financia
l Environment
The Old Financial Environmen
t
( OFE )
• Thomas ( 1997 ) describe the changing natu
re of financial intermediation.
• According to him , the US Congress , after t
he Great Depression of the 1930's , devised
a host of measures to promote a highly spe
cialized financial system.
• Banks were set up to take in deposits and gra
nt only short - term loans. Creation of branch
es was limited and interest rates were duly re
gulated.
• Life insurance companies were allowed only
to issue policies and purchase corporate bon
ds , not stocks.
• In 1993 , the Banking Act of 1933 ( Glass Stea
gall Act ) separated commercial and investm
ent banking.
• Commercial Banks were no longer al
lowed to underwrite corporate stock
s and bonds. On the other hand , inv
estment banks , were not allowed to
accept household deposits or grant c
ommercial loans , which became the
domain of commercial banks.
• Households can no longer go to one finan
cial institution and transact all their busine
sses there. Company who issue stocks and
bonds have to go an investment banks.
• Severe restrictions were placed on the por
tfolios of depository institutions , especiall
y thrifts . This was known as the old financ
ial environment ( OFE ) .
 The New Financial Environment
( NFE )
• OFE began to change in the mid - 1970's when the incre
ase in market rates of interest accompanied by high and
rising rates of inflation clashed with the existing regulat
ory structures.
• The Hadjimichalakises (1995) describe the new financial
environment as being characterized by market-determi
ned or deregulated rates on assets and liabilities of fina
ncial intermediaries and by greater homogeneity amon
g financial institutions , which emerged in 1980s.
• Financial institutions can now perform various fi
nancial functions, which enable households and
companies to go to a single financial institutions
to transact various financial businesses.
• Thereupon emerged the new financial environm
ent ( NFE ) characterized by financial innovations
. New practices and new products emerged. Law
s , regulations , institutional arrangements and t
echnological innovations were introduced.
• In the early 1970s , MMMFs were first introdu
ced and households and small businesses bega
n to have access to a saving tool better than de
posits.
• In 1977 , Merrill Lynch created the Cash Mana
gement Account ( CMA )by combining MMMF
features with securities account and credit line
.
• Private pension funds and state and local gove
rnment retirement funds also grew.
• Credit cards also grew secondary to advances in
computer technology making it profitable for ba
nks to mass market the same.
• In the advent of the new financial environment
, credit cards replaced money in the wallets of i
ndividuals and business executives.
• Even companies opened their own credit card a
ccounts.
• Corporate credit cards are a distinct group wi
thin the greater credit card universe separat
e from both personal and small business cre
dit cards.
• Corporate credit cards categorized into two :
individual payment cards and company pay
ment cards.
Classification of Financial
Intermediaries

1. Depository Institutions
2. Non - Depository Institutions
Depository Institutions
• Refers to financial institutions that accep
t 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
c. Savings and Mortgage Banks
d. Stocks Savings and loan associations
e. Private Development Banks
f. Microfinance Thrift Banks
g. Credit Unions
3. Rural Banks
Commercial Banks
• The biggest of the depository institutions. Th
ey hold the deposits of millions of people, go
vernments and business enterprises.
• Considered as a the heart of our financial sys
tem.
 Ordinary Commercial Banks

• Perform the more simple functions of acce

pting deposits and granting loans. They do
not do investment functions.
Universal Banks or Expanded Commerci
al Banks
• Are a combination of commercial banks and
an investment house. They perform expand
ed commercial banking functions ( domesti
c and international ) and underwriting func
tions of an investment house.
• They offer the widest variety of banking ser
vices among financial institutions.
Thrift Banks
• Is composed of savings and mortgage , stocks s
avings and loan associations , private developm
ent banks , microfinance thrift banks , and credi
t 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 ho
using and diversified.
• Thrift banks are also allowed to grant loans unde
r the Agrarian Reform Credit and supervised cred
it programs of the government.
Savings and Mortgage Banks

• Are banks specializing in granting mortgage loa

ns other than the basic function of accepting d
eposits .

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 th
at a property could be mortgage. If the am
ount of the property is a lot bigger than th
e amount of the first mortgage loan, the p
roperty can br used to secure another loa
n , called second mortgage.
• Mortgage banks , are usually privately ow
ned corporations willing to take risks that
other banks reject.
Stocks Savings and loan associatio
ns
• Accumulate savings of their depositors /st
ockholders and use these accumulated sav
ings, together with their capital for the loa
ns that they grant and for investments in g
overnment and private securities.
• These associations provide personal financ
e and long-term financing for home build
ing and improvement.
Private Development Banks

• Cater to the needs of agriculture and industry

providing them with reasonable rate loans fo
r 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 cert
ain crop, fishermen , teachers , sailors , emp
loyees of one company, etc. and grant loans
to these members and get deposits from th
em.
Rural Banks & Cooperative Banks

• The most popular type of banks in the r

ural communities
• Their role is to promote and expand the
rural economy in an orderly and effectiv
e manner by providing the people in the
rural communities with basic financial s
ervices.
Non - Depository Institutio
ns
• Issue contracts that are not deposits.
• These are pension funds like insurance c
ompanies , mutual funds and financial c
ompanies like depository institutions w
hich perform financial intermediation.
Non-Depository Institutions can be clas
sified 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 lif

e 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 fo
r houses and its contents.
• Auto insurance , covers one's , spouse's
and relative's home and other licensed
drivers to whom the insurer gives permi
ssion to drive his car.
• Flood insurance , is taken if one consider
s flood to be a risk for his business or pro
perty.
• Windstorm insurance, is a separate type
of coverage that protect one's home or b
usiness against wind damage.
• Health insurance , is a type of insurance
that pays for medical expenses in exchan
ge for premiums.
• Professional liability coverage, pro
tects professionals such as doctors
, financial advisors , nursing home
administrators , lawyers, etc. , agai
nst financial losses from lawsuits fil
ed against them by their clients or
patients.
 Fund Managers
• are pension fund companies and mutual fund co
mpanies.
• Pension fund companies sell contracts to provid
e income to policy holders during their retireme
nt years.
• Mutual fund companies are companies that allo
w investors , including individuals to buy into m
utual funds that buy different securities in the s
ecurities market.
Investment Banks / Houses /
Companies
• are financial intermediaries that pool
relatively small amounts of investors
money to finance large portfolios of i
nvestments that justify the cost of pr
ofessional management.
Finance Companies
• profit-oriented financial institutions th
at borrow and lend funds to household
s and businesses. Finance companies a
re sales finance companies, consumer
finance companies and commercial fin
ance companies.They are like banks an
d thrifts.
 Securities Brokers
• are financial intermediaries that look for inve
stors or savings units for the benefit of the b
orrowers or deficit units and compensated by
means of commission.
• Securities dealers, buy securities and resell t
hem and make a profit on the difference bet
ween their purchase price and their selling pr
ice.
Pawnshops
• are the agencies that lend money o
n the security of pledged goods left
in pawn.
• Where people and some businesses
" pawn " their assets as a collateral i
n exchange of an amount much sma
ller than the value of the asset.
Trust companies
• are corporations organized for the p
urpose of accepting and executing tr
usts and acting as trustee under wills
, as executor or as guardian.
Lending investors
• are individuals or companies wh
o loan funds to borrowers gener
ally consumers or household.
Risk of Financial Int
ermediation

•Risk is the possibility tha

t actual returns will devi
ate or differ form what is
expected.
 Risk of Financial Int
ermediation
1.Interest Rate / Market Value/
Price Risk
2.Reinvestment Risk
3.Refinancing Risk
4.Default/Credit Risk
5.Inflation/Purchasing Power Ri
6. Political Risk
7. Off-Balance-Sheet Risk
8. Technology and Operation
Risk
9. liquidity Risk
10. Currency or Foreign Excha
nge Risk
11. Country or Sovereign Risk
1. Interest Rate / Mark
et Value/Price Risk
•Is the risk that the market
value ( price ) of an asset
will decline ( when interes
te rate rises ) resulting in a
capital loss when sold .
2. Reinvestment Risk
•The risk that earnings fro
m a financial asset need to
be reinvested in lower yiel
ding assets or investment
because interest rates hav
e fallen or decreased.
3. Refinancing Ris
k
•Risk that the cost of rol
ling over or reborrowin
g funds could be more t
han the return earned
on asset investments.
4.Default/Credit R
isk
•Risk that the borro
wer will be unable t
o pay interest on a l
oan or principal of a
loan or both.
5. Inflation/Purchasing
Power Risk
•Risk of increase in value
of goods and services re
ducing the purchasing p
ower of money to purch
ase goods or services.
6. Political Risk
•Risk that government la
ws or regulations will a
ffect the investors expe
cted return on investme
nt and recovery of inves
tment adversely or neg
7.Off-Balance-Sheet
Risk
• Off - balance - sheet transactions
are usually engaged in by financi
al institutions. Transactions that
do not appear in the financial ins
titutions balance sheet but repre
sent transactions that pose conti
ngent assets or contingent liabili
ties on the financial institutions.
8. Technology and Oper
ation Risk
•Are related because
technological innova
tions generally invol
ve and affect operati
ons.
9. liquidity Risk
•Results from withdraw
al of funds by investors
or exercise of loan right
s or credit lines of clien
ts.
10. Currency or Foreign
Exchange Risk
•Is the possible loss r
esulting from an unfa
vorable change in th
e value of foreign cur
rencies.
11. Country or Sover
eign Risk
• In general, while investing in s
ecurities denominated on oth
er foreign currencies is advant
ageous for a financial interme
diary , it is likewise posing a co
untry or sovereign risk in inves
ting in securities denominated
Role of Financi
al Intermediari
es in Socio-Eco
nomic Developme
nt
• In a developing country like the Ph
ilippines, financial intermediaries
play an important role in its socio-
economic development. While Fin
ancial intermediaries play an impo
rtant role in the urban areas, wher
e a lot of businesses are located a
nd where the financial market are
very active, they are also very inst
rumental in the rural areas for the
development of these less develo
•In addition to rural banks, c
ooperative banks, and micro
finance thrift banks the gro
wth of commercial banks in
the rural areas has helped t
he areas tremendously by m
aking credit available to the
rural residents so they can u
se the same to advance the
•The objective of rich countries
helping the poor countries is t
he same objective of financial
intermediaries in the govern
ment-to help the poor sector
to alleviate poverty; encourag
e individual or personal indust
ry; promote entrepreneurship
; ang motivate self sufficiency
( Thomas 1997.)