Chapter 3

Financial Intermediation
by Depositary Institutions
 Financial Intermediation
Financial intermediation is the process performed by
financial institutions like bank of taking funds from a
depositor and then lending them out to a borrower.
It consists of channeling funds between surplus and
deficit sectors.
The banking business thrives on the financial
intermediation abilities of financial institutions that allow
them to lend out money at relatively high rates of interest
while receiving money deposit at relatively low rates of
interest.
Types of Financial Institutions
Financial Intermediaries

Non-
Depository
Depository

Contractual
Commercial Thrift Investment
Type
Banks Institutions Funds
Institutions

Savings and
Insurance
Loan Saving Banks Mutual Funds
Companies
Associations

Pension Money Market

Credit Unions
Funds Mutual Funds

Close-end &
Finance
Open-end
Companies
Funds
 Depository Institutions
A depository institution is a financial institution that accepts
deposits from households and firms and uses the deposits to
make loans to other households and firms.

They are legally allowed to accept monetary deposits from

customers.

Depository institutions are the backbone of economy as they

form capital through collection of scattered money from the
public and mobilize it to the business and other sector of the
economy.

The depository institutions consist of commercial banks,

development banks, finance companies, savings and loan
associations, mutual saving banks, credit unions, cooperative
associations etc.
 Functions of Depository
Institutions
Depository institutions provide service as intermediaries
of the capital and debt markets.

They are responsible for transferring funds from

investors to companies, in need of those funds.

The presence of financial institutions facilitate the flow of

money through the economy.

To do so, savings are pooled to mitigate the risk brought

to provide funds for loans.

Such is the primary means for depository institutions to

develop revenue.
 Functions of Depository
Institutions (cont.)
There are other varied functions that are
performed by depository institutions.
Some of them are mentioned below:
1. Accepts deposits
2. Provides loan
3. Provides agency functions
4. General utility functions
5. Provides information
6. Acts as securities underwriter or brokerage
7. others
 Role of Financial Intermediaries
1. Create linkage between savers (depositors)
and users (borrowers)
2. Enhance efficient delivery of financial services
3. Help in project financing
4. Provide satisfactory return
5. Match risk and return
6. Sharing of risk
 Deposit and Loan
Deposit:
– Demand deposit
– Saving deposit
– Time deposit
Loan
– Business Loan
– Consumer loan
– Mortgage loan
– Auto loan
Factors affecting Deposit and
Loan
Competition
– Competition from banks
– Competition from non bank institutions
– Competition from unorganized sector
Asymmetric information
– Different information between parties (information gap)
– Bank’s customers know more about their business than banks
– Normally affect loan proposals
– Some of best loans may be termed as bad and vice versa
– Banks lose better customers and customers with high possibility
of default remain in the bank.
– The actual rate of return will decrease though loan deposit ratio
is high
Factors affecting Deposit and
Loan (contd.)
Default risk
Transaction costs
Business environment
Occasions/festivals
Per capita income/general economic
situation
Regulation
Risk in Financial Institutions
Liquidity Risk
– Liquidity risk refers to a quick unexpected use of
credit or withdrawal of deposits.
– Shortage of cash or near cash assets in a bank
– Typically, the use of credit and withdrawals can
be accurately forecasted.
– However, big and unexpected changes cause
the liquidity risk.
– There are two sides of this risk:
(a) asset side (unexpected use of short-term credit) and
(b) liability side (unexpected withdrawals of funds).
 Managing Liquidity Risk
Financial institutions running liquidity risk first sell some
reserves such as highly liquid government bills.

Second, there are some liquidity management

techniques that FIs can seek for. Such as:
1. Repurchase agreements with the central bank
Central bank typically try to forecast short-term liquidity in the system and
intervene into the system using repurchase agreements with banks.
2. Interbank market, banks buy and sell assets over the day to
keep their target/required reserve
3. Issue short-term fixed income securities such as certificates of
deposits (CDs).
4. Central banks as lender of last resorts
5. Deposit insurance
 Interest Rate Risk
The performance of a bank is highly influenced by
the interest payments earned on its assets relative
to the interest paid on its liabilities (deposits).
The difference between interest payments
received versus interest paid is measured by the
net interest margin (spread).
Because the rate sensitivity of a bank’s liabilities
normally does not perfectly match that of the
assets, the net interest margin changes over time.
 Interest Rate Risk (cont.)
The change in Net Interest Margin basically
depends on:
1. Interest Rate Sensitivity
Whether bank assets are more or less rate
sensitive than bank liabilities.

2. Degree of difference in rate sensitivity

3. Direction of interest rate movement
Impact of changes in Interest Rate
on bank’s NIM
Interest Rate on Loans & Securities

Cost of Fund

Spread 
Time

Impact of Increasing Interest Rates on a Bank’s NIM (If the Bank’s

liabilities are more rate sensitive than its asset
Impact of changes in Interest Rate
on bank’s NIM


Interest Rate on Loans &
Securities
Spread

Cost of Fund

Time

Impact of Decreasing Interest Rates on a Bank’s NIM (If the Bank’s

liabilities are more rate sensitive than its asset
Methods Used to Reduce Interest
Rate Risk
Interest rate risk can be reduced by:
– Maturity Matching
– Using floating-rate loans
– Using interest rate futures contract
a contract between the buyer and seller agreeing to the future delivery
of any interest-bearing asset.
– Using interest rate swaps
Exchanging the interest obligation with differing nature of debt
– Using interest rate caps
derivative in which the buyer receives payments at the end of each
period in which the interest rate exceeds the agreed strike price
For example: LIBOR plus 1%
 Credit Risk
One of the major risk of financial institutions like
depository institution is the credit risk.
It is the risk of loss due to a debtor’s non-payment
of either interest or principal on a loan or other line
of credit.
Indeed, the most common reason by far for the
failure of financial intermediaries is loan losses.
Credit risk is unavoidable, however, businesses can
limit such risk by establishing sound lending
principles, policies, credit analysis and control.
 Managing Credit Risk
A financial intermediary has three lines of
protection against credit risk.
1. Care: Careful assessment of the risks and
realistic pricing are essential.
2. Diversification: Don’t put all eggs in one
basket.
3. Capital: If loans do go bad, adequate capital
protects the intermediary from insolvency.
 Managing Credit Risk
Accurate loan pricing
Credit rationing
Use of collateral
Loan diversification
Credit derivatives and assets securitization
 1. Pricing the loan
Any bank will wish to ensure the “price” of a loan
(loan rate) exceeds a risk-adjusted rate, and
includes any loan administration costs.
The loan rate should include a market rate, risk
premium, and administration costs.
RL = i + ip + fees
Thus, the higher the market interest rate, the
higher the interest rate (i).
Similarly, the riskier the borrower, the higher the
premium.
2. Credit Rationing (Limits)
Most banks do not rely only on loan rates when
taking a lending decision.
The availability of a certain type of loan may be
restricted to a selected class of borrowers,
especially in retail market.
In retail market, banks normally quote one loan
rate (or a very narrow range of rates) and then
restrict the amount individuals or small firms can
borrow according to the criteria such as wealth
and collateral.
2. Credit Rationing (Limits)
Branch managers are given well-defined credit
constraints that limit credit to the borrowers.
By contrast, in whole sale markets, credit limits are
of secondary importance.
Banks give importance to loan rate, value of a
firm, independent auditor reports on a company’s
financial performance.
 3. Collateral or Security
Banks also use collateral (e.g. house, stocks) to
reduce credit risk exposure.
However, if the price of such collateral becomes
more volatile, then for an unchanged loan rate,
banks have to demand more collateral to offset the
increased probability of loss on the credit.
 4. Diversification
Additional volatility created from an increase in the
number of risky loans can be offset either by
injections of capital into the bank or by
diversification.
Diversification reduces the overall riskiness of the
loan portfolio, provided bank seeks out assets which
yield returns that are negatively correlated.
In this way, banks are able to diversify away all non-
systematic risk.
Banks should use correlation analysis to decide how
a portfolio should be diversified.
 5. Credit Derivatives and
Asset Securitization
Credit derivatives are privately held negotiable
bilateral contracts like forward, futures, swap, option
etc. that allow users to manage their exposure to
credit risk.
For example, a bank concerned that one of its
customers may not be able to repay a loan can
protect itself against loss by transferring the credit
risk to another party while keeping the loan on its
books.
Another form of credit risk management is through
securitization.
 5. Credit Derivatives and
Asset Securitization (cont.)
Securitization is the process through which an issuer
creates financial instrument by combining other
financial assets and then marketing different tiers of
the repackaged instrument to investors.
An example would be a financing company that has
issued a large number of auto loans and wants to
raise cash so it can issue more loans.
One solution would be to sell off its existing loans,
but there isn ’ t a liquid secondary market for
individual auto loans.
 5. Credit Derivatives and
Asset Securitization (cont.)
Instead, the firm pools a large number of its loans and
sells interests in the pool to investors.
For financing company, this raises capital and gets the
loans off its balance sheet, so it can issue new loans.
For investors, it creates a liquid investment in a
diversified pool of auto loans, which may be attractive
alternative to a corporate bond or other fixed income
investment.
The ultimate debtors – the car owners- need not be
aware of the transaction and continue making payment
on their loans, but now those payments flow to the new
investors as opposed to financing company.
 Operational Risk
Operational risk is defined as the risk of loss
resulting from poor or failed internal processes,
people and systems, or from external events.
It can also include other class of risk like fraud, legal
risk, environmental risk etc.
It can be summarized as human risk i.e. it is the risk
of business operations failing due to human error.
The risk will change from industry to industry and is
an important consideration to make when looking at
potential investment decisions.
Industries with lower human interaction are likely to
have lower operational risk.
Managing Operational Risk
The operational risk management is the continual cyclic
process which includes risk assessment, risk decision
making, and implementation of risk controls which
results in acceptance, mitigation or avoidance of risk.
It includes:
 Exchange Rate Risk
Possibility of change in exchange rate of
related currencies.
Change in exchange rate can affect the market
value of its assets and liabilities differently,
causing a change in value of equity.
Normally, exchange rate risk arises because of
borrowing and lending by financial institutions
denominated in a foreign currency .
Another major source of exchange rate risk is
bank’s foreign exchange trading.
Managing exchange rate risk
Running a matched book
– Practice of matching the amounts of assets
and liabilities in a given currency
Hedging exchange rate risk
– Using different derivative instruments to
reduce risk
– Forward trading, futures, options, and swaps
are used to hedge exchange rate risk.
– Currency swap is powerful tool normally used
by commercial banks
 Agency Problem in Financial
Institutions
In financial markets, financial intermediaries act as
agents of issuers and investors, and
“gatekeepers.” This multiplicity of functions can
lead to conflicts of interest.
By performing its gatekeeping role well, for
instance, a financial intermediary may have to
forgo profitable investment banking assignments
The large proportion of funds in financial
institutions come from the public.
This means the promoters share is very less
compared to that of public.
Hence, there is conflict of interest between two
parties giving rise to agency problem.
 Moral Hazard &
Adverse Selection
 Information Asymmetry
Situation when one party has more or better information
than other counter party.
Asymmetric information in transaction appears when
there are the differences in the information available to
buyers and the information available to sellers.
It leads to two types of problems:
– Moral Hazard
– Adverse Selection
These two problems exist especially in banking and
insurance industry.
 Moral Hazard
This is the tendency of an insured to take greater risks
because he is insured.

It is the prospect that a party insulated from risk may

behave differently from the way it would behave if it were
fully exposed to the risk.

Moral hazard arises because an individual or institution

does not bear the full consequences of its actions, and
therefore has a tendency to act less carefully than it
otherwise would, leaving another party to bear some
responsibility for the consequences of those actions.
Contd.
Moral hazard in financial institutions arises after the
transaction between two parties.
– In the lending, borrowers engage in activities that are not
desired by lenders and loan investments expose to risk.
– The insurance companies also bear moral hazard when
insured party takes greater risks because of insurance
purchase.
For examples:
– An individual with insurance against automobile theft may
be less vigilant about locking his or her car, because the
negative consequences of automobile theft are (partially)
borne by the insurance company.
– A ship owner may face the choice between two routes –
one safe but slow, the other fast but risky. Without
insurance, the ship owner chooses the safe route; with
insurance, he chooses the fast route.
Moral Hazard in Lending
Moral hazard in lending is the problem created by
asymmetric information after the transaction occurs.
Moral hazard in the financial markets is the risk (hazard)
that the borrower might engage in activities that are
undesirable from the lender’s point of view because they
make it less likely that the loan will be paid back.
Because moral hazard lowers the probability that the
loan will be repaid, lenders may decide that they would
rather not make a loan.
Another way of describing the moral hazard problem is
that it leads to conflict of interest, in which one party in a
financial contract has incentives to act in its own interest
rather than in the interests of the other party.
Contd.
Moral hazard in insurance refers to the undesired
incentives a contract gives to a contracting person or
firm.
Moral hazard is a typical feature of insurance contracts
because the contract alters the incentives faced by the
insured.
– For example, with a ship-insurance, the ship owner may choose
the fast and risky root and ship owner without insurance choose
the safe and slow root.
Moral hazard also appears in deposit insurance because
the insured depositors can afford to be careless in
placing their deposits.
Contd.
If the insurance guarantees the deposits, the depositor
give lesser incentive to investigate the soundness of the
bank where depositor plans to place his/her deposits.
However, the investors, in general, are very concerned
about the viability of the firm in which they plan to invest.
Deposit insurance also creates moral hazard for
managers at insured depository institutions.
Solution to Moral Hazard Problem
Collateral and Net Worth
– Demanding sufficient collateral from counter party is one of the
solutions to lessen problem of moral hazard.
– The collateral acts the security to compensate for possible
losses that can cause to the party who suffers in transaction.
Monitoring and enforcement of restrictive covenants
– Frequent monitoring of compliance of terms and conditions
mentioned in the contract also help to minimize the problem of
moral hazard arise in transaction.
Financial Intermediation
– Banks and other intermediaries have advantages on monitoring
Adverse Selection
This is the tendency of worse risks to buy insurance and
better risks not to.
In other words, it is the tendency of those in dangerous
jobs and high risk lifestyles to get life insurance.
It can also be defined as the situation where one party
has information that the other don’t (or vice versa) about
some aspect.
The insurance industry can also face problems of
signaling and screening. People who buy insurance
often have a better idea of the risks they face than do the
sellers of insurance.

People who know that they face large risks are more
likely to buy insurance than people who face small risks.
Adverse Selection in Lending
If the borrower knows more than lender in trading debt
and the lenders realize all the loans in a certain risk
class look much the same.
Then the lenders fail to identify which one of the loans
turn to be the bad.
– For example, a financial institution has loans outstanding to two
borrowers A and B.
– From lender’s view, both the borrowers are look like good risks,
so the lender charges them same rate of 8 percent interest rate.
– However in reality, lender is unknown that A is good borrower
who does not default loan and B is bad borrower and is in
serious problem.
Adverse Selection in Insurance
Adverse selection in insurance is the tendency of buying the worse
risks instead to buying better risks by insurance company.
– In other words, it is the problem that customers apply for insurance policies are
more likely to be the most in need of insurance.

Adverse selection problems appear almost in all kind of insurance

policies such as property insurance, life insurance, deposit
insurance, etc.

Insurance companies try to minimize the problem that only the

people with big risks will buy their product, which is the problem of
adverse selection, by trying to measure risk and to adjust prices they
charge for this risk.
– Thus, life insurance companies require medical examinations and will refuse
policies to people who have terminal illnesses, and automobile insurance
companies charge much more to people with a conviction for drunk driving.
Contd.
For example:
– Suppose the price of insurance is same for all cars. In
the given situation, the owners of cars that are in poor
shape will find insurance more attractive, and will be
more likely to purchase it, than owners of sound cars.
– The common adverse selection problem in life
insurance policies such as someone with chronic
health problems is more likely to purchase a life
insurance policy than someone in perfect health.
Solution to Adverse Selection Problem

1. Private production and sale of information

2. Government regulation to increase information
3. Collateral and net worth
4. Financial intermediation
end of the chapter