Lecture 1

Introduction to Financial
Institutions
Sherry Zhang
[email protected]
 Overview of lecture topics
• The goals of the financial system and the importance of a well-functioning financial
system.
• Why financial institutions develop and how they help to achieve the goals of the
financial system.
– FIs function as asset transformers
– FIs function as brokers.
• Why FIs' very specialness results in increased regulation and regulatory oversight
that other corporations do not require
• Risks of FIs
• The financial service industry: depository institutions

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An overview of the financial system
• The financial system has five parts, each of which plays a fundamental role in our
economy.
1) Money: Medium of exchange, unit of account, store of value.
2) Financial instruments: legal contracts used to transfer resources and risks between suppliers of
funds and users of funds.
3) Financial markets: places to buy and sell financial instruments.
4) Financial institutions: institutions that provide a myriad of services that facilitate the flow of
funds from savers to investors.
5) Regulators: monitor and stabilize the financial system and economy.

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An overview of the financial system
• The financial system plays two important roles:
– The first is to channel savings to investments.
– The second is to allow economic agents to share risks.
– The two are often closely related.

• Why is the channeling of savings to investments so important to the economy?

– It produces an efficient allocation of capital, which contributes to higher production and
efficiency for the overall economy.

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A simple case
• Suppose you have saved $1,000 this year and you do not have any investment
opportunities yourself. If there is no financial markets, you will just hold on to the
$1,000 and earn no interest.
• However, Carl the carpenter can use your $1,000 to purchase a new tool that will
shorten the time it takes him to build a house, thereby earning an extra $200 per
year.
• If there is a financial market, you can lend him the $1,000 at a fee of
$100 per year.
• Both of you would be better off: You would earn $100 on your $1,000
and Carl would earn $100 more income per year.

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Understanding the Importance of FIs
• A World without FIs and the Issues
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Direct finance: without FIs
• In direct finance, corporations borrow funds directly from households in financial
markets by selling them securities, which are claims on the corporation’s future
income or assets.
– We call these securities the primary securities.

• A balance sheet view of direct finance:

Corporations Households
Assets Liabilities Money Assets Liabilities
Real assets Primary Primary
Securities Securities
Primary Securities

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Issues with direct finance
• Households face the following costs and risks when they directly invest
in primary securities:
– Information/Monitoring costs
– Liquidity costs
– Price risk
– Transaction costs

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Information and monitoring costs
• The problem of asymmetric information
– The issuers of financial instruments know much more about their business prospects and their
willingness to work than potential lenders or investors.

• Lack of information creates problems in the financial system on two fronts: before
the transaction is entered into and after.
– Adverse selection is the problem created by asymmetric information before the transaction
occurs.
– Moral hazard is the problem created by asymmetric information after the transaction occurs.

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Information problems in investing
• Adverse selection (Hidden information problem)
– The lender does not know the exact credit risk of the borrower.
– Without screening, adverse selection makes it more likely that loans might be made to bad
credit risks. Lenders may decide not to make loans even though there are good credit risk in
the marketplace.

• Moral hazard (Hidden action problem)

– After obtaining the money, the borrower can take actions that damage the interest of the
lender. In the extreme case, the borrower can abscond with the money.

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Adverse selection - example
• Suppose there are two firms in the economy, they all need an investment of $1000.
The revenues of the two firms in two different states of the economy are as follow
Economy Probability Safe Firm Risky Firm
Good 0.5 $1051 (5.1%) $2100 (110%)
Bad 0.5 $1051 (5.1%) $0

• Suppose you accept a minimum of 5% expected return on your investment

– But you cannot tell which firm is which
– What happens if you screen investments by interest rate? Consider charging an interest of 5% or
10%.

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Adverse selection - example
• If you charge an interest rate of 5%, both firms are willing to borrow. Your expected return will
be: Economy Probability Safe Firm Risky Firm
Good 0.5 5% 5%
Bad 0.5 5% -100%
Expected return 5% -47.5%

You lend to both firms, which gives you an overall expected return of (5% - 47.5%)/2 = -21.25%

• If you charge an interest rate of 10%, safe firm will not borrow, but risky firm will. Your
expected return will be:
Economy Probability Risky Firm
Good 0.5 10%
Bad 0.5 -100%
Expected return -45%

 Which is even worse! The higher interest rate drives out the safe firm and leaves only the risky firm.
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Moral Hazard - example
• Now suppose you lend $1000 to a firm by charging 5% interest rate. After obtaining your
fund, the firm can choose from two different projects with revenue as the following
Economy Probability Safe Project Risky Project
Good 0.5 $1051 $2100
Bad 0.5 $1051 $0

• The firm’s net profit after paying back the loan amount and interest
Economy Probability Safe Project (a) Risky Project (b)
Good 0.5 $1 $1050
Bad 0.5 $1 $0

• It is of the firm’s interest to take risky project because debt contracts allow owners to keep
all the profits in excess of the loan payments, they encourage risk taking.

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Solutions to adverse selection and moral hazard

• Adverse selection (Hidden information problem)

– The lender does not know the exact credit risk of the borrower.
– The solution to this problem is to sort out borrowers for different credit risks before lending and
charge them the appropriate interest rates.

• Moral hazard (Hidden action problem)

– After obtaining the money, the borrower can take actions that damage the interest of the
lender. In the extreme case, the borrower can abscond with the money.
– The solution is to monitor or check the actions of the borrower.

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Information and monitoring costs
• The solution to adverse selection problem and moral hazard issue is collecting sufficient
information before investment and monitoring after investment.

• Household savers face high information and monitoring costs:

– When household savers invest directly in corporations, they duplicate each other’s effort in
information collection and monitoring.
– These costs can be too high to justify the return on the investment given the usually small stake
each household saver has in the borrower.
– In addition, household savers usually lack the expertise to effectively process information and
monitor the borrower.

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Other costs and risks of direct investment
• Liquidity risk:
– Household savers want to have ready access to their funds whenever they need them. However,
corporate equity and debt are usually long-term in nature and sometimes lack a liquid secondary
market in which households can sell their securities.

• Price risk:
– The price of corporate equity and debt can change significantly over even short period of time,
i.e. they have high price risk. However, household savers are usually more concerned with
preserving the value of their saving and thus dislike high price risk.

• Transaction costs:
– Household investors often face prohibitively high transaction costs when investing directly in
corporations because of the usually small size of their investments.

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Issues with direct finance

• Because of information costs, liquidity risk, and price risk, transaction costs et al. in a
world without FIs, households might find direct investments in corporate securities
unattractive.

• As a result, in a world with only direct finance, many households may prefer either
not to save or to save in the form of cash. As such,
– The flow of funds is likely to be low.
– Little or no monitoring would occur.
– Risk of investments would increase.

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The Functions and Specialness of FIs
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FIs perform two functions
• Brokerage function – assist direct finance
– mainly provide information and transaction services.
– are involved as agents not principals and are usually compensated with a fee for performing
the services.

• Asset transformation function – indirect finance

– borrow from the lender by issuing secondary securities to the lender
– then providing the funds to the borrower by investing in the primary securities issued by the
borrower.

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Intermediated or indirect finance
• An alternative way to channel household savings to investments
• In indirect finance, financial institutions (FIs) serve as intermediaries between the lender
and the borrower

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Asset transformation function
• FIs transform primary securities (e.g., shares of corporations) into the secondary
securities (e.g., deposits) that are more? or less? costly and risky and thus more
appealing to households.

• If this is viable, FIs must be able to deal with those costs/risks in the investment in
primary securities better than households.
• How?

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Specialness of FIs
• How do banks address the costs/risks in the investment in primary securities?
–Information/Monitoring costs
–Liquidity costs
–Price risk
–Transaction costs
FIs to address information/monitoring costs

• FIs have a distinct advantage over individual households to lower the cost of
collecting firm information and monitoring .
• FIs aggregate funds from a large number of households and thus can have a much
larger stake in a firm.
– This results in economies of scale. The costs of information collection and monitoring are
significantly reduced per unit of investment.
– The FI has a much greater incentive to collect information (about fund use and management
effort) and monitor than individual households.

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FIs to address liquidity costs

• FIs offer highly liquid contracts, such as demand deposits, to savers while investing
in relatively illiquid securities issued by corporation. How?

• FIs are better able to deal with liquidity costs because of their ability to diversify the
source of their funds.
• For example, by diversifying its source of funds, the FI can predict more accurately
its expected daily withdrawals and set aside cash to meet these withdrawals
without liquidating its entire long-term investments at loss.

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FIs to address liquidity costs: Practice

Suppose the probability that one household withdraws the deposit over the next year
is 20%. Assume household withdrawal needs are independent. What is the probability
that the FI will have at least 1000 AUD deposits for each of the following cases? Which
one is higher?
1. 2 households, each deposits 1000 AUD
2. 4 households, each deposits 500 AUD

(Please share your answer in Moodle Lecture 1 Discussion Forum)

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FIs to address price risk

• The key to reduce price risk is diversification: investing in many different firms at the
same time.
• Many household savers hold relatively undiversified portfolios due to their limited
wealth.
• By pooling funds from individual households, the FIs can invest in many different
firms at the same time.
– As long as the returns on different investments are not perfectly positively correlated, FIs can
diversify away significant amount of firm-specific risk.
– This allows FIs to predict more accurately its expected return on its asset portfolio.
– Recall portfolio management/asset pricing courses you may took before.

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FIs to address transaction costs

• Due to their large size, FIs are able to do transactions much more efficiently and
lower the average cost of transaction
• FIs collect small investors funds and invest in bulk
– Economies of scale effect

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FI’s Specialness - Summary

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Regulations of FIs

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Regulation of FIs
• FIs are heavily regulated! Why?
– Much more than commercial firms

• Specialness of FIs
– Services provided by FIs are crucial to the economy
– Distressed FIs create negative externalities for the entire economy
– Failure of an FI affects not only the private claimants on its assets, but also many other parties in
the society.

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GFC and Bailouts

http://www.globalissues.org/article/768/global-financial-crisis#Thescaleofthecrisistrillionsintaxpayerbailouts
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Bailout Programs
• United States
– Emergency Economic Stabilization Act and Troubled Asset Relief Program
– Big institutions bailed: Bear Stearns (sold to JP Morgan Chase), Merrill Lynch (sold to Bank of
America), Fannie Mae and Freddie Mac, American International Group, Washington Mutual (sold
to JP Morgan Chase), Citigroup
• United Kingdom
– 2008 United Kingdom bank rescue package
– Big institutions bailed: Lloyds and Royal Bank of Scotland

• Why the governments need to bail out their big financial institutions?
– Related to their roles and functions in the economy.

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Forms of protection and regulation
• Safety and Soundness Regulation
− FIs are required to diversify their assets
− capital adequacy requirement to protect against unexpected losses
− guaranty funds are set up by regulators, e.g. DIF for commercial banks
− periodic monitoring and surveillance
• Investor Protection Regulation
– prevents insider trading
– requires disclosure
• Consumer Protection Regulation
– prevents discrimination in lending
• Monetary Policy Regulation
– requires minimum level of cash reserves
– requires FIs to serve as an intermediation of monetary policy
• Credit Allocation Regulation
– supports FIs to provide lending to socially important sectors such as farming and housing
– impose price and quantity restrictions in such lending
• Entry Regulation
– sets high direct costs, eg. Equity/capital requirements
– sets high indirect costs, eg. Restrictions on who can establish FIs 33
Financial regulators in Australia
• APRA = Australian Prudential Regulation Authority.
– Responsible for the prudential regulation and supervision of the finance services industry.

• ASIC = Australia Securities and Investments Commission

– Responsible for market integrity and consumer protection across the financial systems.
– Set standards for financial market behavior with aim to protect investor and consumer
confidence.
– Administers the Corporate Law to promote honesty and fairness in companies and markets.

• RBA = Reserve Bank of Australia

– The central bank of Australia
– Responsible for the development and implementation of monetary policy and for overall
financial stability.

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Australian Regulation System (Cont.)

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The regulation of DIs: overview
The Financial Service Industry: Depository Institutions
Types of FIs

• There are many different types of FIs, each plays one or more functions we just
discussed. They also perform certain institution-specific functions.
– Depository Institutions
– Finance Companies
– Securities Firms and Investment Banks
– Superannuation funds, managed funds and unit trusts
– Insurance Companies

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Depository institutions (DIs)
• DIs accept deposits from individuals and institutions and make loans. They make up the
largest group of FIs by size of balance sheet.
• In Australia, these institutions are called authorized depository institutions (ADIs), including
– Banks – the largest Dis in terms of size, more varied assets and liabilities
– building societies – operate on a cooperative basis
– credit unions - mutual cooperative organisations formed by common bond
• DIs provide important payment services to the economy.
• Because the liabilities of DIs are a significant component of the money supply that impacts
the rate of inflation, DIs play a key role in the transmission of monetary policy from the
central bank to the rest of the economy.

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Depository institutions (DIs)
• DIs accept deposits from individuals and institutions and make loans. They make up the
largest group of FIs by size of balance sheet.
• In Australia, these institutions are called authorized depository institutions (ADIs), including
– Banks – the largest Dis in terms of size, more varied assets and liabilities
– building societies – operate on a cooperative basis
– credit unions - mutual cooperative organisations formed by common bond
• DIs provide important payment services to the economy.
• Because the liabilities of DIs are a significant component of the money supply that impacts
the rate of inflation, DIs play a key role in the transmission of monetary policy from the
central bank to the rest of the economy.

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Banks: recent trends

• In 2014, Australia had 70 banks, compared to 13 banks in 1985.

• Overall increase in number of banks driven by:
– relaxation of entry requirements
– changes in the regulatory requirements of non-bank depository institutions.

• In 2014, the “Big 4” banks held 54.77% of the assets of all Australian banks, which
points towards a highly concentrated industry
Banks: balance sheet and recent trends

• Shift from commercial lending to lending for residential housing over the last 20 years:
– changes in the structure of the banking industry
– implementation of capital adequacy regulations in 1989.
• Growth of foreign currency assets and liabilities:
– relaxation of regulations with respect to banks’ holdings of foreign currency deposits
– banks enabled to access funding in Eurodollar markets.
• Large drop of liabilities raised through Australian dollar deposits due to retail savings
growth in superannuation accounts.
• Increased importance of off-balance-sheet (OBS) activities:
– OBS activities = items that move onto the balance sheet when a contingent event occurs
– used to generate additional income
CBA’s 2022 Balance Sheet

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CBA’s 2022 Balance Sheet – Continued

What are CBA’s lliabilities?

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Major Risks Of FIs

This Photo by Unknown Author is licensed under CC BY-NC-ND

Risks of FIs

• Interest Rate Risk – Week 2 & 3

– In mismatching the maturities of assets and liabilities as part of the asset transformation
function, FIs potentially expose themselves to interest rate risk.
• Market Risk – Week 9
– The values of assets in the trading portfolio of an FI is affected by changes in market variables,
which expose FIs to market risk.
• Credit Risk – Week 4 & 5
– The risk that promised cash flows from loans and securities are not paid in full.
• Liquidity Risk – Week 7
– The risk that a sudden surge in liability withdrawals may leave an FI in a position of having to
liquidate assets in a very short period of time and at low prices.

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Risks of FIs
• Foreign Exchange Risk – Week 5
– The risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in
foreign currencies.
• Sovereign Risk
– Sovereign risk is a different type of credit risk when an FI purchases assets of foreign governments or
corporations.
– A foreign borrower may be unable to repay the loan even if it would like to when the foreign
government prohibits or limits such payments.
• Off-balance-sheet Risk
– The risk incurred by FIs due to off-balance-sheet activities.
• Technology and Operational Risk – Week 10 briefly
– Technology risk: technological investments may not produce the cost savings anticipated, e.g.
diseconomies of scale.
– Operational risk: existing technology or support systems may malfunction or break down. Also include
fraud and errors.
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