Money, Banking & FinanceLecture 1

The Nature of Financial Intermediation

K Matthews

Aims

• Explain the theory and purpose of financial intermediation.

• Describe the structure of financial markets• Show that financial intermediation is welfare

superior to direct transformation of current consumption to future consumption.

• Describe the process of financial intermediation and the markets that enable its efficient functioning.

Financial Intermediation• The mechanism whereby surplus funds from

ultimate savers are matched to deficits incurred by ultimate borrowers

• The process by which ultimate savers are matched to ultimate borrowers.

• Saving = Income – Consumption

• Typically decisions to save are made independently of decisions to invest

Chanelling of Funds

• In a simple economy we have firms and households

• Households are the savers and firms are the investors.

• The mechanism by which households save is by demanding securities from firms

• The mechanism by which firms invest is by supplying securities to households

• These securities are claims to the assets of the firm

Simple model of direct finance

HOUSEHOLDS FIRMS

FUNDS LENT

FINANCIAL CLAIMS

Direct Finance

• Lending and borrowing can occur as a result of direct transacting.

• But there are costs associated with direct finance• Search costs – searching for potential transactors• Verification costs – costs in evaluating investment

proposals• Monitoring costs – costs of monitoring the actions

of borrowing• Enforcement costs – costs of enforcing contracts

Efficient Direct Finance

• Some of these costs can be reduced through the organisation of a market.

• Direct financing requires the existence of an efficient securities market.

• However not all costs are minimised through a securities market.

• An additional issue is that the maturity period of finance for the firm is long term.

• The maturity period of the household is mostly short term.• The maturity mismatch of households and firms provide the

incentive for the development of intermediated finance.

Indirect (Intermediated) Finance

HOUSEHOLDS Financial Intermediary FIRMS

Funds Lent

Financial Claims

Who are the savers and borrowers?

• Savers or lenders are households, firms, governments and foreigners

• Investors or borrowers are households, firms, governments and foreigners.

• Savers can hold corporate securities (shares), government securities (bonds), currency, bank deposits, foreign currency assets

• Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue foreign currency liabilities

General Flow of Funds

Lenders – Savers

1. Households

2. Firms

3. Government

4. Foreigners

FINANCIAL MARKET

Borrowers – Spenders

1. Firms

2. Government

3. Households

Foreigners

Financial Intermediary

Indirect Finance

Direct Finance

A Flow of Funds Analysis

• S = Saving• I = private investment• G = government spending• T = taxes• X = exports• M = imports• Y = C + I + G + X – M• Y = C + S + T• 0 = (I – S) + (G – T) + (X – M)

Financial Assets

• H = high powered money = Currency + bank reserves

• D = Stock of Bank deposits• L = Stock of Bank loans• Q = Stock of Private securities• B = Stock of government bonds• F = Stock of foreign financial assets• A superscript ‘d’ represents demand and a

superscript ‘s’ represents supply.

Stocks and Flows

• A stock is measured at a point in time

• Stock of assets, money, bonds, physical capital measured at 31 December 2007

• Flows are measured over a period of time

• Examples of flows are GDP, Savings, Investment measured quarterly, or annually

Converting stocks into flowsLet Xt be the stock at a point in

time t

1 ttt XXX

Flow of Funds

)()()()(0

)()()(0

)()(

)()(

DHLFFBBQQ

MXTGSI

MXTGIS

FHBLQMXTGI

FQBDS

dsdsds

sss

ddd

Implications of Financial Intermediation

• Assumptions• Two-period analysis• Perfect capital market – (a) can borrow or lend at

the same rate of interest, (b) perfect information, (c) costless access to capital market.

• Investment opportunities are infinitely divisible• PIF – physical investment opportunities frontier• FIL – financial investment opportunities line

Physical Investment Opportunity Frontier

Period 1

Period 0Y0

C1

C0

Cost of investment

Return on investment

E

Financial Investment Opportunity Line

0 A

B

-(1+r)

0B = (1+r)0A

Period 0

Period 1

Borrowing

E

AA’

Lending

E

B

B’

Structure of Financial Markets

• Firm (or individual) obtains funds in the debt market or the equity market

• A debt instrument (bond or mortgage) pays a fixed income stream over a specified period.

• The maturity of the debt instrument is short term if less than a year, long term if more than 10 years and intermediate term if in between,

• Equities (common stock) are claims to shares in the profits and assets of a business.

• Equities pay periodic sums called dividends.• The disadvantage of equity is that the holder is a residual

claimant

Primary and Secondary Markets

• Primary market is the market for new issues of securities, or initial public offerings (IPOs)

• Secondary market is where existing securities are traded (NYSE, NASDAQ, LSE, etc)

• Some IPOs are well known and advertised and attract a lot of attention but many are of unknown enterprises and are underwritten by a known investment bank.

• Brokers are agents of investors who match buyers and sellers of securities. Dealers link buyers and sellers by buying and selling securities at stated prices. A Market Maker buys/sells at the quoted bid-ask spread with the aim of making a profit on the spread.

Money and Capital Markets

• Markets are sometimes distinguished on the basis of maturity of the securities traded.

• The Money Market is a financial market where short term debt instruments are traded (less than a year) – Commercial paper, Bills etc

• The Capital Market is where long term debt (longer than one year such as bonds) and equities are traded.

• The money market is usually more liquid and more traded and so is used by financial institutions to earn income on surplus funds.

International Financial Markets

• Foreign bonds are denominated in the currency of the market in which it is sold.

• Eurobond is bond denominated in in a currency other than the currency of the market in which it is sold.

• Eurocurrencies are foreign currencies deposited in banks outside the home country.

• Eurodollars are dollars deposited in banks outside the USA

Summary

• We have looked at the process and theory of financial intermediation.

• Efficient direct finance is conducted through the mechanism of an efficient capital market

• Indirect finance is through the process of a financial intermediary.

• Financial intermediation is welfare superior to non-market direct financing.