1.1 Financial institutions

So far, we have treated all nancial institutions as essentially similar. For example,

we said that nancial institutions were much like any other sort of rm; we said that

they act as ‘intermediaries’ whose function is to deal separately with borrowers and

lenders, creating for each group liabilities and assets which are more attractive than

would be the case if the two groups dealt directly with each other.

Liquidity:The speed and convenience with which an asset can be converted into money

for a certain value.

Creating assets which are attractive to lenders involves creating assets which are

‘liquid’. A liquid asset is one which can be turned into money quickly, cheaply and

for a known monetary value. Thus the achievement of a nancial intermediary must

be that lenders can recall their loan either more quickly or with a greater certainty

of its capital value than would otherwise be the case. Notice that ‘liquidity’ has three

dimensions: ‘time’ – the speed with which an asset can be exchanged for money;

‘risk’ – the possibility that the asset may have depreciated in value or that the issuer

may have defaulted in some way on its terms (see Box 1.4); and ‘cost’ – the pecuniary

and other sacrices that have to be made in carrying out that exchange. However,

intermediaries also have to supply the needs of borrowers in an attractive way. This

includes making the loan available to the borrower for a certain period of time. How

do intermediaries satisfy these apparently conicting needs of lenders and borrowers?

Box 1.4

A selection of risks

Default risk– the risk that a borrower fails to pay interest or to repay the principal at the

date originally specied

Capital risk– the risk that an asset has a different value from what was expected when

it is sold or matures

Income risk– the risk that the income from an asset is different from what was expected

Reinvestment risk– the risk that the rate of return available when funds from a matur-

ing asset are reinvested in future is different from what was expected

Part of the answer is that intermediaries do it by maturity transformation. By this

we mean that they accept deposits of a given maturity, i.e. deposits which are liable

for repayment to lenders at a given date, and ‘transform’ them into loans of a quite

different maturity. A good example is provided by building societies which accept

deposits of a very short maturity. Indeed, some of these deposits are repayable on

demand or ‘at sight’. These deposits are then lent to house buyers who have the

guaranteed use of the loan for up to twenty-ve years.

The deposits that building societies hold, and the loans or ‘advances’ they have

made, appear in the societies’ balance sheet as liabilities and assets respectively. Of

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Chapter 1 • Introduction: the nancial system

course, the societies have other assets and liabilities, but the balance sheet is dominated

by deposits on the liabilities side and mortgage advances on the assets side.

Let us repeat: what we have just said in the case of building societies is typical of

all nancial intermediaries. Their services are attractive to lenders and borrowers alike,

because they engage in maturity transformation. The degree of that transforma-

tion and of course the precise nature of the liabilities and assets involved will differ

between institutions. Notice that we have used banks and building societies (i.e.

deposit-taking institutions) to illustrate the process. This is because the process of

intermediation is central to their activities. This is principally what they do. When

we turn to NDTIs, however, intermediation itself becomes less central and more a

by-product of their other activities. in the case of unit and investment trusts, for

example, we shall see in sections 4.3 and 4.4 that we have to look quite hard to nd

the intermediation activity. But some degree of intermediation is always involved

which is why the terms nancial institution and nancial intermediary are some-

time used interchangeably.

We said a moment ago that maturity transformation is part of the answer to the

question of how intermediaries reconcile the desires of lenders and borrowers. Since

lenders want liquidity and borrowers want a loan for a certain, minimum period, then

clearly what lenders are willing to lend has to be ‘transformed’ into something that

borrowers want. This raises an interesting (and important) question: ‘How are inter-

mediaries able to carry out this transformation?’ In particular, how are they able to do

it in safety, avoiding the risk that lenders may want repayment at short notice when

their funds have been lent-on by the intermediary for a long period? This question

is obviously most pressing for DTIs where depositors are entitled to repayment on

demand, i.e. without notice, while borrowers may have borrowed for long periods.

The ability of nancial institutions to engage in maturity transformation and to

supply the other characteristics of liquidity depends fundamentally uponsize. The

advantages of size come in a number of forms.

Maturity transformation:The conversion of funds lent for a short period into loans of

longer duration.

Firstly, with a large number of depositors rms will expect a steady inow of deposits

and a steady outow of deposits each day. To a large extent the ows will cancel each

other out and intermediaries will be subject only to small netinows and outows.

What is more, it is a statistical fact that the behaviour of these ows will be more

stable the larger the number of depositors, and the greater will be the condence that

rms can place upon the net ow. Of course, the magnitude of these net ows will

change as circumstances change. For example, if competing institutions raise their

interest rates, a rm will experience a deterioration in its net ow. But once again, the

larger the number of depositors, the more stable and predictable will be the relation-

ship between net ows and other variables. Large size therefore reduces the risk to the

intermediary of unforeseen outows and enables it to operate with relatively few very

liquid reserve assets. The rest can be made up of illiquid, interest-earning loans.

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