Financial Intermediation 2

Page 4: The Flow of Funds and Financial Intermediation

• Society is composed of ‘savers’ and ‘borrowers’, specifically:

  • Primary Investors: The savers, typically households.

  • Ultimate Borrowers: The business sector.

  • A conflict of preferences exists between savers and borrowers.

Page 5: The Conflict of Preferences

• Primary Investors: Prefer high liquidity and low risk financial assets in exchange for surplus cash.

• Ultimate Borrowers: Aim to maximize shareholder wealth by investing in real assets, which often involves:

  • Low liquidity

  • High risk

  • Long-term investments with uncertain outcomes.

Page 6: Savings Into Investment Without Financial Intermediaries

• Conceptual Model:

  • Savings and Investment Preferences:

    • High liquidity and low risk for savers (households).

    • Low liquidity and high risk for borrowers (businesses).

  • Costs faced: Search, agreement, and monitoring costs are significant between savers and borrowers.

Page 7: The Introduction of Financial Intermediaries

• Types of Financial Intermediaries:

  • Brokers

  • Asset Transformers:

    • Risk transformation

    • Maturity (liquidity) transformation

    • Volume transformation

• Economies of Scale for Intermediaries:

  • Efficiencies in gathering information

  • Risk spreading

  • Reduced transaction costs

• Overview of Financial Markets

Page 8: Savings Into Investment With Financial Intermediaries

• Impact of Financial Intermediaries and Markets:

  • Reduced search costs for liquidity.

  • Reduced agreement costs between ultimate asset borrowers (businesses) and primary investors (households).

  • Attracting savers by selling securities with desired characteristics (liquidity and risk).

  • Financial markets enhance liquidity and reduce risk, search, and monitoring costs.

Page 9: The Financial System: The Banking Sector

• Types of Banks:

  • Retail Banks

  • Wholesale Banks:

    • Raise external finance for companies

    • Engage in broking and dealing

    • Fund management (asset management)

    • Assistance in corporate restructuring

    • Risk management using derivatives

  • International Banks:

    • Foreign banking

    • Eurocurrency banking

  • Building Societies

  • Finance Houses

Page 10: The Financial System: Long-Term Savings Institutions

• Key Institutions:

  • Pension Funds: Over £1100bn available for investment due to long time horizon.

  • Insurance Funds:

    • General insurance

    • Life assurance (including term assurance, whole-of-life policies, endowment policies, annuities)

    • Life assurance companies manage over £900bn.

Page 11: The Financial System: The Risk Spreaders

• Types of Risk Spreaders:

  • Unit trusts

  • Investment trusts

  • Open-ended investment companies (OEICs)

Page 12: The Financial System: The Markets

• Function: Connects those requiring finance with those having funds to invest.

• Types of Markets:

  • Primary Markets: Raising new finance (issue of shares).

  • Secondary Markets: Allow subsequent trading, contributing to:

    • Diversification

    • Risk shifting

    • Hedging

    • Arbitrage

Page 13: The Financial System: The Markets

• Market Types:

  • Money Markets: Short-term (< 1 year) for borrowing and depositing (commonly £500k+).

  • Bond Markets: Longer-term funding sources.

  • Foreign Exchange Markets (Forex or FX): Buy and sell foreign currencies.

  • Share Markets: Primary and secondary markets for equities.

  • Derivative Markets: Buy and sell financial instruments.