Chapter 3

Financial Intermediation by Depository

Institutions

By
Birendra Bista
BBA-VII

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 Contents
• Deposit and Loan and factors affecting them:
Competition, asymmetric information, default risk,
transaction cost.
• Adverse selection, moral hazard and credit rationing.
• Agency problems in financial institutions.
• Liquidity risk, interest rate and exchange rate risk,
credit risk, and operation risk inherent in financial
institutions, and management of those risks.
• Lessons learnt from the national and international
experiences.

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 Financial Intermediary
• A financial intermediary is a financial
institution that acquires funds from one group
of investors and make available to another
economic unit.
• Thus, financial intermediaries play a very
pertinent role in the economy by channeling
funds from surplus saving units to deficit
saving units.

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Depository Institutions include commercial
banks( or simply banks), saving and loan
associations (S&L), saving banks and credit
unions.
S & Ls, saving banks and credit unions are
commonly called Thrifts, which are specialized
types of depository institutes.
– These financial intermediaries accept deposits
(liabilities) and make direct loans and invest in
securities.
• DI are highly regulated.

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 Deposit and Loan Functions
• Depository financial intermediaries are
economic units whose principal function is
obtaining funds from depositors and other,
and then lending those funds to borrower
Depository Financial Intermediary
Balance Sheet
Assets Liabilities and Equity
Loans Deposits
Other assets Equity
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• Deposit Function
– A financial intermediaries collect money from
those who have excess money ( i.e. savers;
depositors) and provides those who need money (
i.e., borrowers).
– They obtain deposit from saver by offering deposit
instruments that
• Have a wide variety of denominations, interest rates,
and maturities.
• Are risk free( insured deposits)
• Have a high degree of liquidity
– These characteristics meet the needs of most
savers better than bonds and stocks that may
have higher denomination, high risk, less liquidity,
and high transaction costs.

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• Loan Function
– Financial institutions make every types of loan
that is legally permissible and for periods up to
thirty years ( i.e. home mortgage). By doing so,
they gained expertise in evaluating and
monitoring the risks associated with lending. Thus
intermediation allows for banks that specialize in
risk management.
• Financial intermediation between depositors
and borrowers is crucial to the growth and
stability of the economy.
• Economic growth depends on a large volume
of savings and the effective allocation of
saving to productive and profitable users.

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Factors Affecting Deposits and Lending
• Asymmetric information
• Competition
• Default risk
• Transaction cost

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 The Role of Asymmetric Information in Lending

• Asymmetric information plays crucial role in the

lending; the relationship between bank and
customer s who borrow from them.
• Asymmetric Information and Adverse Selection
– Bank requires the information about the prospective
borrowers to determine if they are creditworthy for
granting loan.
– Borrowers have more and accurate information about
themselves ( project or other loans) than bank.
– This inequality of information between the bank and the
borrower is called asymmetric information.

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• Because of asymmetric information, banks
tend to charge an interest rate that reflects
the average rate of all borrowers. The average
rate is too high for borrowers with low risk
investment projects, and too low borrowers
with high risk investment projects: (Adverse
Selection).
– Adverse Selection: it means that high-risk borrowers try to
get loans from banks because they are willing to pay the
average rate of interest, which is less than they would
have to pay if their true condition were known to the
bank. It also follows that low-risk creditworthy borrowers
may be able to borrow directly from the money and
capital markets at rate lower than those offered by banks.

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• The adverse selection occurs before the loan
is made.
• Moral Hazard: It is the risk that the borrower,
who now has the loan, might use the funds to
engage in higher-risk activities in the
expectation of earning higher return which
further causes the increase in the probability
of default on loan.
• The asymmetric information also gives rise to a moral hazard
problem after the loan is made.
• This problem is most likely to occur when the lender is unable
to monitor the borrower’s activities.

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 The Competition
• If there is only one bank for lending and deposit, it is
very common that the bank will pay less on the
deposit and charge more on the loans.
• However, if there are many banks, then paying less
on deposits or charging more for loans than
competitors will lose a lot of business.
• If there are a few banks, the bank may able to
arrange things for mutual benefits but this explicit
collusion is illegal.
• If there is only a bank or if there are few banks ,
competition from non bank substitute may be the
problem.

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• Non bank substitutes may be Thrift, mutual fund,
saving bonds, consumer or business loan from
finance companies.
• Trade credit is another source of the
competition.
• Trade credit is the largest source of short term
business credit in the United States.
• Online services www.bankrate.com ( for deposit
rate) and www.lendingtree.com( for lending).
• Therefore, the growth of non bank lenders has
resulted in highly competitive terms of lending on
loan and standard used to make those loans.

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 Default Risk
• Lending involves the default risk. It is the
risk of repayment, i.e., the possibility
that n obligor will fail to perform as
agreed, causing loss to the lender.
 By evaluating level of default risk, a bank my charge
high interest rate on high default risky lending and
low for lower risky lending.
• Credit scoring is used to determine the likelihood
that prospective borrower will default on a loan.

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• Approaches to reduce default risk
– Avoid making high risk loan
– Threat of loss of the Collateral
– Diversify the loan portfolio
– Limit the amount of credit extended to any single
borrower, or group of borrower.
– Monitor the behavior of the borrower
– Transfer the risk to other parties. Hedging

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 Transaction Costs
• It is the time and money spent in lending.
– Cost of hiring the lawyer to write up the
loan contract.
• Financial intermediary should be able to
achieve the economies of scale, reduction in
the transaction cost per transaction as the size
of transaction increases.

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• Credit Risk
– Risk related to the earnings and capital that an obligor
may fail to meet the terms of any contract with the bank.
– Credit risk is associated with loan and investment, but it
also arise in the connection with derivatives, foreign
exchange, and other extensions of bank credit.
– The single most important reason of bank failure is bad
loans.
– Causes of loan losses: Unforeseen change in the economic
condition, change in the interest rate, exchange rate, tax
laws and so on.

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• Interest Rate Risk
– It is risk to earnings and capital that market rtes of
interest may change unfavorably.
– Sources- Differences in timing of rate changes,
timing of cash flow, changes in the shape of yield
curve.
– Market value of banks assets, earnings, fees and
costs of borrowed fund are affected with the
change in the interest rates.
– Bank can reduce their interest rte risk by hedging
with derivative securities and using assets and
liabilities management techniques.

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• Operational Risk
– It is the risk to earnings or capital arising from
problem associated with the delivery or service of
product.
– Electric power blackout, September 11 attack.
– It encompasses the efficiency and effectiveness of
all back-office operations including MIS, personnel
compliance, external and internal frauds, lawsuits

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• Liquidity Risk
– It is the risk to earnings or capital related to a
bank’s ability to meet its obligations to depositors
and the needs of borrowers by turning assets into
cash quickly with minimal loss.
– Bank should able to borrow funds when needed
and having funds available to execute profitable
security trading activities.
– Large deposits- importance of liquidity.

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• Exchange Rate Risk
– It is risk associated with the fluctuation in the
exchange rates.
– Suppose, Interest rate in Japan is much higher
than Nepal, so you decide to invest Rs. 10 million
in a one year Japanese T-bill with a market yield of
10 percent. Your HPR is ?
– To buy the Japanese T-bill, you must pay in Yen.
To acquire the Yen you need, you must sell your
Rs in exchange forYen. The price you receive for
your Rs in marks is called the Yen-Rs exchange
rate.

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 Loan Commitments

• Institutionalizing long term relationships

• Bank makes the commitment to provide firm
with loans up to a given mount at a fixed
interest rate (or market interest rate).
• Major benefits to the firm is that it has a source of
credit when it needs it.
• Major benefit for the bank is that it promotes the long
term relationship and reduce the cost of collection and
monitoring of information.

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 Collateral
• Loan with collateral ( Secured loan) lessens the
consequences of adverse selection.
Compensating Balance
• Minimum balance required in checking account at
bank for getting loan.
• Beside serving as collateral, compensating balance
help increase the likelihood that loan will be paid up.
• It gives the signal of inquiring the borrower’s
activities.( Declining the balance in checking a/c)

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 Credit Rationing
• Rationing is the controlled distribution of resources
and scarce goods or services: it restricts how much
people are allowed to buy or consume.
• Credit rationing describes the situation when a bank
limits the supply of loans, although it has enough
funds to loan out, and the supply of loans has not yet
equalled the demand of prospective borrowers.
• Credit rationing is a way to deal with the adverse
selection and morale hazard problem.

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 Agency Problems in Financial Institutions

• Agency Theory: The analysis of principal-agent

relationships, in which one person, an agent,
acts on behalf of another person, a principal.
• Agency Problem: Conflicts of interest among
stockholders, bondholders, and managers.

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