The Significant Role of Financial Intermediaries - Essay Example

A Paper on Introduction to Financial Services THE SIGNIFICANT ROLE OF FINANCIAL INTERMEDIARIES. Financial intermediaries are middlemen that smooththe flow of funds between savings surplus units (SSUs) and deficit spending units (DFUs), and includes commercial banks, mutual savings banks, savings and loans associations, mutual funds, pensions funds, credit unions and insurance companies (Downes & Goodman 1987). An SSU (normally the household sector) is one where income exceeds consumption, and a DFU, consisting normally of businesses and government, is one where current expenditure exceeds current income and external sources of funds must be found to make up for or supply the difference In the process of redistributing savings into productive uses, financial intermediaries combine small savings into substantial pools of capital which are re-lent to a wide number and variety of borrowers, or invested in various forms of securities, thus providing risk diversification and liquidity. Intermediation is defined as the placement of money with a financial intermediary which invests in bonds, stocks, mortgages, loans, money market securities and government obligations to achieve targeted returns. Essential to understanding the intermediation market is the existence of a direct credit market where borrowers or investors meet and transact financial business directly with the providers of funds. An example is a cash-rich business which purchases a commercial paper directly from a finance company. Another would be a household that buys a new share of stock of an industrial company from a stockbroker which underwrote the issue. No financial intermediary was involved here because it was not necessary. A financial intermediary plays a significant role only when hindrances or inefficiencies can occur, such as when the denomination, maturity, and other security characteristics do not match exactly the desires and requirements of the SSU. When a household has available funds of only ₤500, it would not be able to participate in buying a bond issue denominated at ₤5000 each. Financial intermediaries come into the picture when it buys direct claims from the DSUs with specific security characteristics (maturity, denomination, and liquidity) and sells indirect claims to SSUs packaged to conform to the specific requirements of the market. The indirect claims upon the financial intermediaries consist of savings deposits, time certificates of deposit, checking accounts, negotiable orders of withdrawal (NOW) or money market funds, which are liabilities from the viewpoint of financial intermediaries. The direct claims bought from DSUs consist of home mortgage loans to other households, corporate bonds, equities, and loans. From the accounting viewpoint, the direct claims are assets (uses of funds) of the financial intermediaries, and the indirect claims are liabilities (application of funds). The DSUs receive the funds (assets) and have a liability in the form of direct claims of the financial intermediary (Kidwell, Peterson, & Blackwell 1997) It is clear that financial intermediaries serve both the SSUs and DSUs in a way that results in advantages to both sides, otherwise financial intermediaries would not exist. They produce and sell financial products that both sides accept because the funds are pooled and packaged so that the SSUs are able to participate in the financial and investment markets, while the DSUs are able to obtain the funds with the denomination, maturity and liquidity characteristics they specifically require. Financial intermediaries enjoy some competitive advantages in their operations. Firstly, because of the volume of business that they can muster and their specialization, it is possible for them to achieve economies of scale. Such economies, like those possessed by large corporations, enable a firm to reduce its costs per unit of financial product because fixed costs are widely spread out over a large number of units. Secondly, while a company engaged in direct credit can gather good information, the financial intermediaries can obtain such information more cheaply and with more facility, particularly with regard to sensitive information. They can also generate better quality and more reliable information because of their usual thoroughness in processing them. The following are the advantages that financial intermediaries provide for all parties involved in financial transactions they handle. 1. A wide range and variety of denominations. Financial intermediaries gather and pool small amounts of funds and invest them in obligations or securities of a wide variety of denominations. Without such services, small investors would not be able to participate in investments whose minimum denominations are large, such as those of bonds and mutual funds. 2. A wide range of maturities. Financial intermediaries can buy direct claims with long maturities while they can sell indirect claims which are short term in nature or payable on demand such as time deposits and checking accounts. Such matching of maturities would be nearly unachievable in large volumes in the direct credit market. 3. Diversification of risk. A small saver or investor would only be able to invest in one or two types of investments, whereas if his funds were pooled with those of others, his small investment can participate in a portfolio of many securities, such as those of mutual funds. Consequently, his risk of loss is minimized as his investment is spread out over a larger number of securities. Finally, 4. Liquidity. Indirect claims issued or sold by financial intermediaries to SSUs to small investors are highly liquid, withdrawable on demand or on short notice. At the same time, the level of direct claims bought from DSUs are maintained because even when loans or investments are held over a period of time, the amount of savings account are maintained at a certain stable levels because deposits and withdrawals even out. THE THREE KEY FUNCTIONS OF THE CENTRAL BANK The three key functions of the central bank as part of its management of monetary policy are 1) open market operations, 2) the reserve requirements, and 3) the discount or base rates. These functions are described below: 1. Open Market Operations. In order to manage the economy’s money supply, the central bank buys and sells Treasury securities – consisting of: a) Treasury bills with maturity of up to one year, b) Treasury notes with maturities of from 2 years to 10 years, and c) Treasury bonds, with maturities from 11 to 30 years. When it sells securities, the central bank attempts to reduce the money supply by the volume of funds that investors pay for them. By buying them back at a subsequent future time, it releases the funds back to the economy thus stimulating spending and investing activities. In a period of deflation, such repurchasing of Treasury securities can help stimulate economic activity and employment. When the central bank (the Bank of England in the UK) sells Treasury securities, it seeks to contract money supply particularly during times of inflation and when the economy is overheating. 2. The Reserve Requirements. A certain reserve ratio relative to all deposits is imposed by the central bank on commercial banks to answer for normal withdrawals of such deposits. However, such reserves can be raised or reduced for purposes beyond such ordinary requirements, as a tool to manage the money supply although such changes are infrequently used because of the instability it can cause on bank operations. A reserve ratio, say, of 10 percent means that banks must hold in their vaults or as deposits with the central bank ₤10 for each ₤100 of customers’ savings, checking and time deposits. However, if such reserve requirement is increased to 20 percent, for example, banks will be able to lend less money to borrowers or to other banks, and they would then have to use the loan repayments to replenish such reserves, or they may have to run to the central bank to borrow reserves. Less money is available for lending, and less economic activity can result, all other things being held equal. When the reserve is reduced, however, more borrowings are made available, stimulating consumer spending and investing. For economists, in particular, the reserve requirement is interesting for one special reason: It determines the money multiplier that causes the creation of money in the economy. The multiplier effect, as it is termed, of a 10 percent reserve requirement is 10 times the amount of the deposits, and the increase of the reserve requirement to, say, 20 percent, can cause the multiplier effect to be reduced to 5 times. It is evident that the multiplier effect is derived by calculating the reciprocal of the reserve requirement (1/.10 and l/.20 respectively in the above examples). 3. The Base Rate. The central bank has a discount window that enables commercial banks to borrow in order to replenish their reserves as well as to increase their loan availabilities. When banks are lending excessively, their reserves can fall significantly or get depleted, so they march to the central bank to borrow. The discount rate is raised when the central bank believes that the economy is overheating (growing too fast with high inflationary tendencies) or when there is too much money seeking goods (inflation caused by excessive money in circulation). Commercial banks will then borrow less from the discount window because of high base rates, and will be able to lend less money because their spreads (difference between base rates and lending rates) get narrower and they will be forced to raise their lending rates accordingly, thus reducing demand for loans by borrowers. During times of sluggish economic activity the central bank may decide to reduce the base rates in order that banks can borrow from it and can lend to their customers at lower rates. Central banks are also known to use their discount windows to support the commercial banking system during a credit or financial crisis, as the US Federal Reserve Bank did during the recent mortgage default crisis and as the Bank of England intends to do by infusing some ₤50 billion to the UK economy through the banks to stimulate re-lending as a consequence of the credit crisis caused by the collapse in the values of mortgage securities purchased by UK financial institutions from the United States. During the 1987 stock market crash, the US central bank, the Fed, supported distressed stock brokerages, and when the Continental Illinois Bank experienced a bank run, the Fed infused some $5 billion to save it from complete collapse.(Mankiw 1998) B. THE EFFECT OF REDUCTION OF BASE RATES. A base rate reduction can have varying effects on loans and securities 1. Effect on Mortgages. When the central bank reduces the base rate, the mortgagors (the borrowers) would be encouraged to refinance their mortgages at the current lower rates, if such rate reduction is significant enough, in order to reduce their future levels of amortization or periodic repayments (Rosefsky 1996) This is particularly true in the case of fixed rate loans. In the case of adjustable rate mortgages, the financing can be attractive because the base rate is used in calculating the lifetime cap on the rate applied to the amortization. The investors of mortgage securities stand to lose as a consequence of a base rate reduction for the reason that while they receive repayments for the loan, the refinancing will cause them to receive less amortization payments in the future. It is best for such investors for the base rate to hold steady, rather than drop or rise. An increased base rate will also be disadvantageous because of the higher risk of repayment defaults. 2. Effect on Bonds. Bond prices generally move inversely with base rates. If base rates fall, bond prices will rise. Long-term bonds, which yield higher than intermediate term and short-term bonds, are most sensitive to interest rate changes. According to Ellis (1997) each rise or fall of 1 percentage point in interest rates for 20-year treasury bonds will trigger a change of 9 percent. Three-year Treasury notes, on the other hand, would cause a change of 2 percent to 3 per cent. How does a fall in the base rate actually affect the bond prices? Consider an existing bond paying 8 percent (₤80 per ₤1000) annually. If the base rate drops to 6 percent, the effect will be an increase in the price of the existing bond. The price of the 8 percent bond will have to rise to ₤1333 in order to equate it with the bond paying 6 percent. Because interest rate trends are not easily predictable, actual trades do not always adhere precisely to this calculation, as demonstrated by the estimates made by Ellis above. This calculation applies, however, only to the most common class of bonds traded in the securities markets. Floating rate bonds are not affected because the rates are allowed to move up or down, while the principal value will not fluctuate (Rosefsky 1996). Banks are the common users of this type of bonds, and Citicorp is considered a prominent issuer. BIBLIOGRAPHY Brealey, RA, Myers, SC & Marcus AJ 1999, Fundamentals of corporate finance, 2nd edn., McGraw Hill, New York. Downes, J & Goodman, JE 1987, Dictionary of finance and investment terms, 2nd edn., Barrons Educational Series, Hauppage, NY Ellis, J 1997, Your top investing moves for retirement, Times Inc., New York. Hirt, GA & Block SB 1986, Fundamentals of investment management, 2nd edn., McGraw Hill, New York. Kidwell, DS, Peterson RL, & Blackwell, DN 1997, Financial institutions, markets, and money, The Dryden Press, Orlando, FL Mankiw, NG 1998, Principles of economics, The Dryden Press, Orlando, FL. Rosefsky, RS 1996, Personal finance, 6th edn., John Wiley & Sons, New York. Morris, KM, & Siegel, AM 1993, The Wall Street Journal Guide to understanding money and investing, The Lightbulb Press, New York. Read More