1.1 Financial institutions

Box 1.5

The gains from diversication

Imagine an investor faced with the opportunity to invest in either or both of two shares,

Aand B, the returns on which behave independently. Suppose that both are expected to

yield a return of 20 per cent in ‘good’ times and 10 per cent in ‘bad’ times. Assume further-

more that there is a 50 per cent probability of each share striking good and bad conditions.

Then it follows that investing wholly in Aor wholly in Bproduces the expected return:

K 0.5(20%) + 0.5(10%) 15%

Notice that although the expected return averaged over a period of time will be 15 per

cent per year, in any one year there is a 50 per cent chance of getting a high return and

a 50 per cent chance of getting a low return. Savers can be sure that whatever they get

it will not be the expected return!

Now consider the possible outcomes if one half of the investor’s funds are allocated

to each of Aand B. Since good and bad conditions can arise independently for each of

Aand B, it follows that four outcomes are possible, each of course with an equal prob-

ability of 0.25. The outcomes and the returns associated with each are:

Outcome	ABReturn
1	GoodGood20%
2	GoodBad15%
3	BadGood15%
4	BadBad10%

Over the years, the expected return will be:

K 0.25(20%) 0.25(15%) 0.25(15%) 0.25(10%) 15%

The expected return is still 15 per cent, but notice that instead of a zero chance of

getting that return in any one year, there is now a 50 per cent chance of getting it. It is

now the most likely outcome!

transaction costs are involved until the sale of the equities, the costs will be very high,

unit costs rising dramatically with the decreasing size of the purchase. Such costs will

be much higher than the 5 per cent initial and 1 per cent per annum management

charge that a unit trust management can charge because of the low unit transaction

costs it incurs by purchasing large blocks of securities.

The same process is at work with deposit-taking institutions. One standard con-

tract covers each class of deposit. Similarly one standard contract will sufce for

a very large number of loans. The institutions’ search costs are driven almost to

zero for large institutions because their high street presence means that lenders

and borrowers bear most of the cost of search by coming to them. For most routine

lending and borrowing the cost is limited to the effort of walking in off the street.

The cost or ‘price’ of intermediation by deposit-taking institutions is represented

by the ‘spread’ or differential between the interest rate paid to depositors and the

rate charged to lenders.

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Chapter 1 • Introduction: the nancial system

Suppose, for example, that a borrower were to set out with the intention of bor-

rowing directly from a lender and that somewhere in the economy a lender sets out

with the intention of lending directly to a borrower. Suppose further that they each

have in mind the same acceptable rate of interest, i. On top of this, however, the

borrower has to pay substantial additional costs (of search, contract, etc.) and from

this rate of interest the lender has to deduct similar costs. In both cases these can be

expressed as a percentage of the sum lent. Let us call these costs cand c, respectively.

bl

Then it follows that the net return to the lender and the gross cost to the borrower

can be written as follows:

iic

ll

iic

bb

Suppose now that an intermediary is able to bring the two parties together and

provide an agreement and carry out all the other administrative work for a cost,

c, which is less than the total costs of the borrower and lender dealing directly.

i

That is:

C(C+ C)

i1b

Then it follows that the borrower and lender would be better off dealing through

an intermediary, provided that the intermediary’s charge for its services, the price

of intermediation p, were less than the saving in transaction costs. That is, provided

i

that:

p(c+ c) c

i1bi

Typically, deposit intermediaries engage in some element of price discrimination

so that for large customers, where the economies of scale are most evident in low

unit costs, pmay be as low as 1 per cent.

i

In this section we have seen how nancial intermediaries can (a) create additional

assets and liabilities in an economy by taking funds from lenders and transferring them

to borrowers, and (b) make those additional assets and liabilities more attractive to

borrowers and lenders than the original assets and liabilities would have been. This

describes accurately the fundamental activity of most types of nancial intermediary.

However, in Chapter 3 we shall see that there is one group of intermediaries who

can go one step further than creating just liquid assets. Banks can create money.

This is possible because the liabilities which they create for themselves (assets to the

general public, remember) are deposits and in most nancial systems these make

up the bulk of the money supply. At the moment, it is necessary only to understand

whythe monetary nature of bank liabilities enables banks to create deposits. The

‘moneyness’ of deposits is important in two ways.

Firstly, it ensures that a decision to lend (an asset decision) leads automatically to

the creation of additional liabilities and thus an expansion of the balance sheet. This

happens because when a bank makes a loan to a customer and the customer uses

that loan to make payment, someone else mustreceive a corresponding addition to

his/her bank deposit. Even if the payment was unexpected and the recipient turns

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