The Nature of Financial

Intermediation

International Banking
Key Concepts
 Pivotal role of banks and other deposit-taking FIs
 Rapid pace of change in markets, technologies and
non-bank competition
 Information costs are responsible for emergence of
financial intermediaries
 Financial intermediaries deal with:
 Search
 Verification
 Monitoring
 Enforcement costs.
Important Terms – Defined …
 Liquidity and funding risk
 The threat of insufficient liquidity on the part of the bank for normal operating requirements
 Settlement/payment risk
 Is created when one party to a deal pays money or delivers assets before receiving its own cash
or assets, hence exposing itself to a potential loss and interest rate risk.
 Interest rate risk
 The risk that arises from mismatches in both the volume and maturity of interest-sensitive
assets, liabilities and off-balance sheet items
 Market or price risk
 The exposure of banks to losses due to market or price fluctuations in well-defined markets
 Foreign exchange or currency risk
 The exposure of banks to fluctuations in foreign exchange rates that affect positions held in a
particular currency for a customer or the bank.
 Sovereign risk
 In which the political or economic conditions in a particular country threaten to interrupt
repayment of loans or other debt obligations
 Operating risk
 Arising from losses caused by fraud, failure of internal control, or unexpected expenses, as in
the case of lawsuits.
Financial Intermediation

 Information is the underlying, core reason for

the existence of financial intermediaries.
 Borrowers do not have the means to search out
and contract with lenders. Even if they do, it is an
expensive and time consuming and unsystematic
process that can be prohibitively expensive.
 This situation does exist…for example in the case of
angel capital.
Financial Intermediaries
 There are many types of financial intermediaries
that have evolved over time:
 Deposit-taking financial intermediaries
 Banks /Trust companies
 Credit unions
 Non-depositor
 Life and P&C insurance companies
 Investment dealers
 Finance Companies
 Other
 Mutual funds
Uniqueness Recognized
 One of the themes dominating FI organization in Canada is the degree to
which the specialness of Fis should be enshrined in law and regulatory
practice.
 The end result is that financial institutions are among the most heavily
regulated and heavily taxed organizations in our society.
 You are encouraged to follow the current debates on this topic in the financial
press. Look for:
 deposit taking FI regulation
 insurance company regulation
 securities industry regulation
 Bank of Canada policy concerning FIs
 CDIC policy concerning FIs
 Regulatory activities of liability insurers
 international coordination of FI regulation
 Role of OSFI in supervision
Intermediation Services of FIs
 risk transfer, reduction, and monitoring
services
 liquidity services
 maturity intermediation services
 transaction services
 financial information services
 denomination intermediation (mutual funds)
 Deficit-Saving Surplus-Saving
Economic Unit Economic Unit

Borrowers:
Savers:
• borrow large sums
(mortgages/commercial/ Deposit-taking • many of them saving small
amounts individually, but
personal loans) Financial large amounts in aggregate
• for long periods of time Intermediary • for short periods of time (ie.
• complex legal transactions Need liquidity)
because of the long-term
• are generally risk averse
nature of the debt contracts
and the need to contractually • don’t have the capacity, time
ensure that the interests of the or sophistication to analyze
lender are protected. risk or to monitor borrowers
 Deficit-Saving Surplus-Saving
Economic Unit Economic Unit

Deposit-taking
Financial
Deposit-taking FIs: Intermediary
• pool deposits, provide liquidity for depositors, collect/analyze/monitor the financial
positions/activities of borrowers, make credit allocation decisions among opportunities to
lend/invest, negotiate/monitor/enforce loan agreements.
• In this manner the need of both savers and borrowers are met with efficiency. In the absence
of FIs failure, confidence in the system is built and this encourages full participation, thereby
reducing monetary leakage….currency in circulation is made available for the best
competing uses in our society.
Price Risk
 the risk that the sale price of an asset will be
lower than its purchase price.
Secondary Claims
 example: demand deposit in a deposit-taking
FI
 it is a financial asset that has characteristics
far different than primary securities (bonds,
stocks, commercial loans) => often improved
liquidity/safety of principal, etc.
Maturity Intermediation
 a service performed by deposit-taking FIs for
secondary asset holders
(depositors)....because of ‘pooling’ and
‘diversification’....
 mismatching the maturities of assets and
liabilities of the FI.
Securitization

 The creation of a marketable financial asset

through financial innovation…of otherwise
illiquid financial assets

 Eg. MBSs
Economies of Scale
 FIs provide potential economies of scale in
transactions costs...information collection and
risk management.
Institutional Aspects of Special-ness

 money supply transmission (banks)

 credit allocation (banks, trusts, credit unions, and finance
companies)
 risk offlay (insurance companies)
 intergenerational transfer (pensions, life insurance companies,
and deposit-taking FIs)
 payment services (banks, trusts, and credit unions)
 denomination intermediation (mutual funds, pension funds)
Rationale for Regulation
 Relevance of Negative Externalities
 Failure to provide essential intermediation services, or the

breakdown in provision of these services can be costly to both

surplus savings economic units and deficit-spending economic
units
 Such failures can have negative implications for the government,

social stability and for the standard of living in an economy

 Financial crisis in one country can have contagion effects in other

countries
 The foregoing negative externalities are the underlying reason for
the extra regulatory attention paid to financial institutions.
 This extra attention gives rise to net regulatory burden (the
difference between the private costs of regulations and the
private benefits for the producers of financial services)
Types of FI Regulation

1. Safety and soundness regulation

2. Monetary policy regulation
3. Credit allocation regulation
4. Consumer protection regulation
5. Investor protection regulation
6. Entry and chartering regulation
Safety and Soundness Regulation
Purpose:
To protect depositors and borrowers against the risk of FI
failure.

Layers of Protection:
1. Diversification regulation (no more than 10% of a portfolio
can be invested in one security/asset) – banks cannot
have loans exceeding 25% of total equity capital to any
one company or borrower.
2. Minimum capital requirements
3. Guaranty funds (CDIC, CIPF) to meet insolvency losses
to small claimholders
4. Monitoring and surveillance (OSFI for example)
Monetary Policy Regulation
 In classical central bank theory, the central bank
can control the quantity of bank deposits (D)
using changing reserve requirements (R).
 Where:
 (r) = desired ratio of cash reserves
 (R) = quantity of bank reserves outstanding 1
 Today, banks in Canada are not subject to
reserve requirements – however, they are all D  R
highly cognizant of the need for liquidity
reserves – reserves are costly – and required
r
reserves are seen as a ‘tax’
 However, the Bank of Canada does stand ready
to inject liquidity if necessary to prevent
technical insolvency.
 The Bank of Canada does use moral suasion
and through changes in the overnight lending
rate, affect the level of short-term interest rates
in the country – thereby taking preemptive
action to try to control inflation.
Credit Allocation Regulation
 Lending to socially important sectors of society such as:
 Small business
 Farming
 Poor - Housing
 Consists of price (maximum rates that can be charged) and quantity restrictions (amount
of foreign assets)
 Canada does not use this type of regulation however, because of the imposition of private
costs on our FIs.
 Canada does take other actions to encourage/support/subsidize lending to important
sectors of the economy by creating programs that lower the risk to the FI or by providing
the service itself:
Government providing the service
 Business Development Bank of Canada
 Export Development Canada
 FedNor
 Northern Ontario Heritage Fund
Government programs to lower the cost to private FIs
 All of the foregoing government crown corporations and departments work jointly on projects and
programs that also involve some private sector involvement either in financing or administration
 CMHC
 Student loan programs
 Government (both federal and provincial programs) guarantees for loans to farming, forestry
Consumer Protection Regulation
 2001 – Bill C-8 – created the
Financial Consumer Agency of Canada
 Provides consumer information on bank accounts and
investment products
 Examines and imposes fines on FIs that violate consumer
protection laws
 Privacy laws at the provincial levels
 Pressure on FIs to:
 Provide lending to small business
 Provide banking services to low-income Canadians
Investor Protection Regulation
 Provincial securities acts govern:
 Insider trading
 Information disclosure requirements through
prospectus and continuous reporting
requirements for seasoned issues
 SROs indirectly provide protection, and if
they didn’t government would step in to
impose regulation:
 Know-your client rules and enforcement of other
types of compliance
Trends in Canada
 Gradual movement to universal banking through increasingly permissive
regulations and competitive/strategy moves over time by FIs
 More frequent review and renewal of governing legislation including
deregulation and an increasingly welcoming environment for foreign FIs
 Leveling of the playing field through uniform requirements for banks and
insurance companies
 Access to the payment system extended beyond banks to life insurance and
underwriting firms
 Incentives for credit union merger and growth
 Continuing limits on chartered banks to sell insurance through branches (except
for credit insurance) and retail consumer leasing
 Completion of the demutualization process for life insurers – giving these key
FIs (SunLife, Canada Life, Mutual Life (Clarica)) access to capital
 Extension of products lines by Investment Dealers and Insurance Companies
into savings products, chequing products, wrap accounts, etc.
 Continued develop of fee-based income (off-the-balance sheet) sources of
income for banks
 Continued pursuit of international presence by Canadian banks
 Consolidation (merger) in the life insurance sector
 Takeover of other pillars by banks (TD took over Central Guaranty Trust in 1992
and Canada Trust in 2000) and all banks have a brokerage arm since the 1980s
(RBC, CIBC Wood Gundy, etc)
Entry Regulation

 Chartering/federally-licensing for business,

banks – Bank Act
 Minimum requirements to create FIs.