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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 21
ROLE OF FINANCIAL INTERMEDIARIES
Role of Financial Intermediaries:
Pool Savings
Safekeeping, accounting services and access to the payments system
Liquidity
Risk diversification
Information Services
Role of Financial Intermediaries
As a general rule, indirect finance through financial intermediaries is much more important than
direct finance through the stock and bond markets
In virtually every country for which we have comprehensive data, credit extended by financial
intermediaries is larger as a percentage of GDP than stocks and bonds combined
Around the world, firms and individuals draw their financing primarily from banks and other
financial intermediaries
The reason for this is information;
Financial intermediaries exist so that individual lenders don't have to worry about getting
answers to all of the important questions concerning a loan and a borrower
Lending and borrowing involve transactions costs and information costs, and financial
intermediaries exist to reduce these costs
Financial intermediaries perform five functions:
They pool the resources of small savers;
They provide safekeeping and accounting services as well as access to the payments system;
They supply liquidity;
They provide ways to diversify risk; and
They collect and process information in ways that reduce information costs
International banks handle transactions that cross borders, which may mean converting
currencies
Taking deposits from savers in one country and providing them to investors in another country
Converting currencies to facilitate transactions for customers who do business or travel
Pooling Savings
The most straightforward economic function of a financial intermediary is to pool the resources
of many small savers
To succeed in this endeavor the intermediary must attract substantial numbers of savers
This is the essence of indirect finance, and it means convincing potential depositors of the
soundness of the institution
Banks rely on their reputations and government guarantees like deposit insurance to make sure
customers feel that their funds will be safe
Safekeeping, Payments System Access, and Accounting
Goldsmiths were the original bankers;
People asked the goldsmiths to store gold in their vaults in return for a receipt to prove it was
there
People soon realized that trading the receipts was easier than trading the gold itself.
Eventually the goldsmiths noticed that there was gold left in the vaults at the end of the day, so
it could safely be lent to others
Today, banks are the places where we put things for safekeeping;
We deposit our paychecks and entrust our savings to a bank or other financial institution
because we believe it will keep our resources safe until we need them
Banks also provide other services, like ATMs, checkbooks, and monthly statements, giving
people access to the payments system
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Money & Banking ­ MGT411
VU
Financial intermediaries also reduce the cost of transactions and so promote specialization and
trade, helping the economy to function more efficiently.
According to the principle of comparative advantage, people and companies concentrate on the
activities
At which they are the best and
For which their opportunity cost is lower
This leads to specialization in a particular activity
More specialization => more trading => more financial transaction => calls for low cost of
transaction
The bookkeeping and accounting services that financial intermediaries provide help us to
manage our finances
Pay-Cheques
House-rents
Utility bills
Loan payments
Food clothing and other expenses
Savings and retirement plans
Providing safekeeping and accounting services as well as access to the payments system forces
financial intermediaries to write legal contracts, which are standardized
Much of what financial intermediaries do takes advantage of economies of scale,
The average cost of producing a good or service falls as the quantity produced increases
Information is also subject to economies of scale
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY