Financial Intermediation

The Flow of Funds and Financial Intermediation

  • Society comprises 'savers' and 'borrowers':

    • Primary Investors: Savers, generally households

    • Ultimate Borrowers: Business sector

  • There exists a conflict of preferences between both parties.

The Conflict of Preferences

Primary Investors

  • Interested in exchanging surplus cash for:

    • Financial Assets

      • Characteristics: High liquidity and low risk

Ultimate Borrowers

  • Desire to maximize shareholder wealth through:

    • Investments in Real Assets

      • Characteristics: Long-term horizons, uncertain outcomes, low liquidity, and high risk

Savings into Investment Without Financial Intermediaries

  • Savings

    • Preferences: High liquidity

    • Costs: High search costs

  • Investment

    • Preferences: Low liquidity

    • Costs:

      • High agreement costs

      • High risk for households (Primary Investors)

      • High monitoring costs for large amounts

Introduction of Financial Intermediaries

  • Roles of Financial Intermediaries:

    • Brokers

    • Asset Transformers:

      • Risk transformation

      • Maturity (liquidity) transformation

      • Volume transformation

    • Economies of Scale:

      • Efficiencies in gathering information

      • Risk spreading

      • Reduced transaction costs

Savings into Investment With Financial Intermediaries

  • Savings

    • Preferences: High liquidity

    • Costs: Reduced search costs

  • Investment

    • Ultimate borrowers (businesses) attract savers by:

      • Selling securities with low risk and high liquidity (e.g., shares, bonds)

    • Costs: Reduced agreement and monitoring costs

  • Financial Markets: Enhance liquidity and reduce risks of searching and monitoring.

The Financial System: The Banking Sector

  • Types of Banks:

    • Retail Banks

    • Wholesale Banks:

      • Raising external finance for companies

      • Broking and dealing

      • Fund management (asset management)

      • Assistance in corporate restructuring

      • Risk management using derivatives

    • International Banks:

      • Foreign banking

      • Eurocurrency banking

    • Other Institutions:

      • Building societies

      • Finance houses

The Financial System: Long-Term Savings Institutions

  • Pension Funds:

    • Large sums built up for investment (over £1100bn)

  • Insurance Funds:

    • General insurance

    • Life assurance: Term assurance, whole-of-life policies, endowment policies, annuities

    • Life assurance companies managing over £900bn

The Financial System: The Risk Spreaders

  • Types of Investment Vehicles:

    • Unit trusts

    • Investment trusts

    • Open-ended investment companies (OEICs)

The Financial System: The Markets

  • Financial Markets:

    • Platforms where finance seekers meet investors.

    • Primary Markets: Raising new finance through issue of shares

    • Secondary Markets: Allow trading of existing shares, aiding:

      • Diversification

      • Risk shifting

      • Hedging

      • Arbitrage

Specific Types of Financial Markets

  • Money Markets:

    • Short-term (< 1 year) borrowing and depositing, usually large amounts (£500k+)

  • Bond Markets:

    • Longer-term funding

  • Foreign Exchange Markets (Forex):

    • Trading foreign currencies

  • Share Markets:

    • Primary and secondary markets for equities

  • Derivative Markets:

    • Buy and sell financial instruments