FINANCIAL INSTITUTIONS AND INTERMEDIARIES

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 Contents

• 2.1 Financial institutions

a. “credit Institutions”
b. Institutions supplying venture capital
c. Investment firms
d. Institutional investors
e. Shadow banking
f. Some numbers
• 2.2 Financial intermediaries
a. Definition
b. Explaining their existence
c. “Banks”
• Products liability side
• Products asset side
• Off balance
• Risks
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2.1 Financial institutions

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Introduction
Insitutions are endogenous.

So can institutions be grouped on the basis of the need they alleviate?

Tentatively yes, but differences between categories can fade :

– Institutions that offer a service (sell a product/ act as go-between)

– Credit institutions

– Investment companies

– Collective investment undertakings

– Institutions that use financial assets as a resource

– Pension funds

– Insurance companies

– Institutions that act for their own account

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– Venture capitalists
2.1.a “Credit Institutions”

Bank law March 22 1993 -> law in Belgium whether a company is a credit
institution

any company whose operations consist in receiving money deposits or other

redeemable “monies” from the public and in granting credits for their own
account.

= The “typical” bank.

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2.1.b Institutions supplying venture capital

1/ investment bank = merchant bank = “banque d’affair”

does not exists as such in België (no legal definition)

2/ venture capitalists (see part by Prof. Vandorpe)

venture capital

private equity

3/ holdings

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2.1.c Investment companies

Law of April 6 1995 -> Belgian law that describes what an investment company is

Companies whose professional activity consists in providing investment

services for third parties.

• Brokerage firms (stockbroker)

• Portfolio management and investment advice companies

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2.1.d Institutional investors

Financial institutions that reinvest the money that they acquire from the
public for a long time in the capital markets.

• Insurance companies
– Non life
– life (llife insurance)

• Collective Investment Undertakings

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2.1.e shadow banking

• No clear definition!
1. “activitities in which the short term funds do not stem from deposits.”
2. “Traditional banking transforms risks on a single balance sheet. It uses
the law of large numbers, monitoring, and capital cushions to
“convert” risky loans into safe assets – bank deposits. Shadow banking
transforms risks using different mechanisms, many more akin to those
used in capital markets.”
3. “The shadow banking system can broadly be described as credit
intermediation involving entities and activities outside of the regular
banking system.” (FSB)

Examples (of shadow banking in the narrow sense): Hedge funds, Money
market funds, Special Purpose Vehicles,…

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2.1.f Some numbers: shadow banking

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Source: FSB
2.1.f Some numbers: shadow banking

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Source: FSB
2.2 Financial intermediaries

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2.2.a Definition

Company with the following features

1. Borrows money from a group of economic agents and

lends it to another group of agents
2. Both groups are large
3. the pay outs to both groups are different (“other state
contingent pay out”).

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2.2.b Existence: reasons

1. External financing

2. Reduction of market imperfections

3. Asset transformation

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2.2.b Reasons : External financing

money money
Financial intermediation
Indirect financing

Surplus
Fin.need Families
Families money money
Financial market Government
Government
Direct financing companies
companies
Domestic &
Domestic &
abroad
abroad

Source: De Becker et
al. 19
2.2.b Reasons: reduction of market imperfections

Value added from reducing information problems.

Information asymmetry

precontract & postcontract

Adverse “Duplicated Moral hazard

selection screening”

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2.2.b Reasons: reduction of market imperfections

Adverse selection
An erroneous interpretation of the risk profile of clients
leads to higher interest rates. Borrowers with a low risk
profile will hence abstain from taking loans. In the end the
bank will end up with only high risk borrowers.

Doing your homework pays off: credit analysis is necessary.

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2.2.b Reasons: reduction of market imperfections

Duplicated screening
As information is not destroyed after being used, it can be
re-used. This permits an intermediary to work in a cost
efficient way and this gives a cost advantage.

This cost advantage increases to some extent with

– the size of the economy &
– the efficiency of the information processing system of the go-
between.

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2.2.b reasons: reduction of market imperfections
low search costs

Search costs decentralised Search costs centralised

Tania Mari 3 4 … Central
e party

Carl c c c c … Tani Mari 3 4 …

a e

Igor c Carl …

3 c Central Igor
party
4 c 3
4
…

…
Search costs: Search costs:
 2.2.b Reasons: reduction of market imperfections:
low search costs

The cost advantage

500
Cost efficiency is one of the prime
450
reasons of existence of a financial
400
intermediary.
350

300

250
Technological evolutions (public
peer to peer availability of information, low cost
200 tinder like
computer power and artificial
150
intelligence) risk to undermine this
100
advantage and threaten this reason
50
of existence.
0
2 3 4 5 6 7 8 9 10 11 12 13 14 15
size of the market
2.2.b Reasons: Reduction of marktimperfections

Moral hazard
The behaviour of the borrower while the contract is running
should not go against the interests of the lender (or
investor)

Finan. Institutions are perfectly aware of moral hazard risks

and provide countermeasures. Their experience gives them
also a cost advantage (= information advantage)
– which countermeasures work
– avoidance of losses thanks to these measures

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2.2.b Reasons: Asset transformation

Value added due to

– creation of products with
– transfer of risk
= change of the qualitative features of assets by transferring
risk for their own account.
– maturity
– credit risk
– size
– Liquidity (=ease of transforming into cash without
costs)

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2.2.b reasons: transparency
Intermediation
costs
Capital
market

Banks

Decreasing
transparency

Bron: De Becker et al.

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2.2.c Banks

Assets Liabilities
Liquid 266,8 197 Interbank debt
Resources
Claims 510,3 617 Debt to clients of which
Mortages 170,7 607 Deposits of which
Fixed loans 292,0 241 Sight dep
Other 47,6 266 Reg. depo
Transfer. sec. 174,8 84,5 Debt rep. by sec.
Fixed assets& 83,1 63 Other
others
71,7 Own resources
Total 1035 1035 Total

Bron: NBB
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2.2.c Banks: products liability/funding

• Overnight deposits
• Savings accounts
• Term accounts
• “Cash bonds” & “Capitalisation bonds”
• Insurance bonds
• Bonds/securities
• Commercial paper/deposits

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2.2.c Banks: products liability/funding

maturity Rate resettable type tradeable Money demand type clients

Overnight
account No Daily account No Transaction retail/corporate

Savings deposit No Daily account No Transaction retail

Term account Yes Fixed for term account No investment retail/corporate

Cash bond Yes Fixed for term security No investment retail

Insurance bond Yes Fixed for term security yes investment retail

CP Yes Fixed for term security yes investment professional

Bond Yes Fixed for term security yes investment professional/retail

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2.2.c Banks: products liability/funding

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2.2.c Banks: products asset side: corporations

• Overdraft
• Straight loans
• Investment loans
• Roll over credits
• Bank guarantees
• Leasing
• Factoring

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2.2.c Banks: products asset side: retail

• Consumer credits
• Mortgages

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2.2.c Banks: products asset side: retail
?
0,2008% 0,1986% 2,3828%
rate 2,409%
capital
rate Monthly
time reimburs
payment payment
150000 ement
150000 1 297,8505 488,4677 786,3182
149511,5 2 296,8806 489,4377 786,3182
149022,1 3 295,9087 490,4095 786,3182
148531,7 4 294,9349 491,3833 786,3182
148040,3 5 293,9592 492,359 786,3182
147547,9 6 292,9815 493,3367 786,3182
147054,6 7 292,0019 494,3163 786,3182
146560,3 8 291,0204 495,2978 786,3182
146065 9 290,0369 496,2813 786,3182
145568,7 10 289,0514 497,2668 786,3182
. . . . .
. . . . .
. . . . .
4685,257 235 9,303375 777,0148 786,3182
3908,242 236 7,76048 778,5577 786,3182
3129,685 237 6,214521 780,1037 786,3182
2349,581 238 4,665492 781,6527 786,3182
1567,928 239 3,113388 783,2048 786,3182
784,7235 240 1,558202 784,76 786,3182
0

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2.2.c Banks: products asset side: retail

• Some useful formulas

Ot= outstanding amount at time t (left to be paid off)
MP= monthly payment (constant by definition)
Rt interest payment at time t
CRt: capital reimbursement at time t (left to be paid
off)
n = max number of payment periods
i = interest rate for the frequency
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2.2.c Banks: products asset side: retail

New loan 15Y

life @2,5%
Loan amount: Use the new loan to reimburse
150,000 the old + pay 3 months of “old
Rate = 5% pa rate “as indemnity to bank

T=0 T=5 T=20 Y

Rate 15 Y drops
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to 2,5%
2.2.c Banks: products asset side: retail

Using the numbers of the above example, determine the nominal at t = 60, ie
after 5Y, using

This gives O61 = 124,933.5923

We need a new loan of with this nominal to pay back the old loan. With the
penalty (=2.942) we wipe out the old loan’s obligation.

With
 and where “i” is the new interest rate.

we determine the new monthly payments (=831,38695).

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2.2.c Banks: products asset side: retail

Suppose a variable 5 – 5 – 5 cap 2 (-> interest rate can go up

by 2% from the previous one) loan. Total maturity is 20 Y.
The Initial interest rate is 2,5%. Hence the maximum rate
one can ever pay equals 4,5%.
What is the maximum monthly payment you will ever have
to make?

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2.2.c Banks: Off balance

• Those items on which the bank may (or not) in the future
have a right (asset off-balance) or on which the banks
creditor may have a claim (liability off-balance).
• typically:
– derivatives (contingent pay offs)
– securitisations
– guarantees
– Letters of credit
– Liquidity lines

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2.2.c Banks: Off balance
Spot transactions in course of settlement
in mio euro
lendings and lendings and
spot FX borrwings ( am to borrwings (am to
be received) be delivered)
38.794 39.288 33.226

forward transactions
Interest rate
currencies interest rate swaps
options
344.105 3.475.421 200 +

confirmed credit
guarantees
lines (granted to
obtained
clients)
293.642 2.961.306
Bron: NBB, Juni 2016 40
2.2.c Banks: Off balance

Working example

– Situation 1 – Situation 2
2.2.c Banks: risks

• Based on the balance sheet of the banks

– A lot of liquidity
– Deposits > loans, but deposits < (loans + portfolio)
– term assets << term liabilities (funding)
– Investment portfolio reasonably large
– A lot of leverage (own funds << claims on clients + portfolio)
– Amounts are important
– Net interest margin is the most important source of P&L (QA
Transformer)
– Fee business becomes more important (broker)

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3 Quiz

1. According to the Miller-Modigliani theorem it is not important how a firm is funded. Is this
true for the financial system?
2. Indicate whether the statements below are true, false or undetermined. Explain your
answer. (exam June/September 2018)
1. The information on the balance sheet of a bank permits to get a perfect view on the risk born by that bank.
2. Financial intermediaries and capital markets are perfect substitutes. One can replace the other at no cost.
3. Collective investment undertakings are substitutes for banks..

3. You take a constant annuity mortgage for 250 000 euro. The term is 20 years. The interest
rate is set at 1,8%. What is the monthly payment? How much has been reimbursed after 5
years ?

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