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AND MARKET
Asit Mohanty
Financial Intermediaries
INDIRECT FINANCE
Financial
Intermediaries
BORROWERS
Government
SAVERS Business
Households
Households
Business
Objective : To intermediate funds from savers to Borrowers in the most risk free manner
Financial Institutions…. Intermediaries
Direct Finance :
borrowers borrow gets fund directly from the lenders
in the financial markets, by selling them securities
( also called financial instruments). These are assets
who buys them and liabilities to those who
sell( issue) them.
INDIRECT FINANCE & DIRECT FINANCE
INDIRECT FINANCE
Financial
Intermediaries
BORROWERS
Government
SAVERS Business
Households
Households
DIRECT FINANCE
Business
Financial Markets
Direct and Indirect Finance
INDIRECT FINANCE
Financial
Intermediaries
Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply
Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply
Demand
Loanable Funds
The Market For Loanable Funds
Interest
Rate
Supply
5%
Demand
Movement to
equilibrium is
5% consistent with
principles of supply
and demand.
Demand
5%
Demand
Decrease in Taxes
5% on savings increases
the incentive to save
affecting the supply
of loanable funds
Demand
5%
4%
Demand
5%
Demand
Tax Break on
investment would
increase the
incentive to borrow
5% altering the demand
for loanable funds.
Demand
6%
5%
Demand
Government Deficit:
When the government spends more than it
receives in tax revenues
The budget deficit:
Altersthe supply curve, reducing supply.
Causes the supply to shift to the left.
Results in Crowding Out.
Government Policy That Affects The Economy’s
Saving and Investment
5%
Demand
Government
borrowing to finance
its budget deficit,
5% reduces the supply of
loanable funds.
Demand
6%
5%
Demand
where
ir is Real interest rate
in is nominal interest rate
E(i) is expected inflation rate
Since ir cannot be negative , higher inflation tends to push up interest rates
Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of interest rates in foreign countries
Conclusion
Financial Intermediaries through financial
markets and instruments…. coordinate
borrowing and lending and thereby help
allocate the economy’s scarce resources
efficiently.
The price in the loanable funds market -
interest rate… Price discovery-process - is
governed by the forces of supply and demand
of funds.
More on Interest Rates
Interest Rates Determined by
Default Risk
For most securities, there is some risk that
the borrower will not repay the interest
and/or principal on time, or at all.
The greater the chance of default, the
greater the interest rate the investor
demands and the issuer must pay.
More on Interest Rates
Expected Inflation
Inflation erodes the purchasing power of money.
Example: If you loan someone $1,000 and they pay it back one year
later with 10% interest, you will have $1,100. But if prices have
increased by 5%, then something that would have cost $1,000 at the
outset of the loan will now cost $1,000(1.05) = $1,050.
More on Interest Rates
Maturity Risk
kk== k*
k* ++IRP
IRP++ DRP
DRP++ MP
MP++ ILP
ILP
Term Structure
Relationship between long and short
term interest rates
Yield (Interest Rate) curve
Yield Curve
8.00%
7.50%
33month
month
7.00% T-Bill
T-Bill
6.50%
6.00%
5.50%
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Yield Curve
8.00%
7.50%
7.00%
66month
month
6.50% T-Bill
T-Bill
6.00%
5.50%
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Yield Curve
8.00%
7.50% 11year
year
7.00%
T-Bill
T-Bill
6.50%
6.00%
5.50%
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Yield Curve
8.00% 22year
year
T-Note
T-Note
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Yield Curve
8.00%
7.50%
7.00%
6.50%
6.00%
5.50% 33year
year
T-Note
T-Note
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Yield Curve
8.00%
7.50%
7.00%
6.50%
55year
year
6.00% T-Bond
T-Bond
5.50%
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Treasury Yield Curve
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
June 10, 2010
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
Treasury Yield Curve
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
June 10, 2010
4.50% June 10, 2009
June 10, 2008
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr maturities
. .
The ‘Lemons’ Problem
Potential buyer of a used car can’t tell whether the car he wants to
buy is a good car that will run well ‘peach’ or a ‘lemon’ that will give
him continuous grief
The owner of the car is more likely to know whether the car is a
‘lemon’ or a ‘peach’
The ‘used car’ market will then function poorly if the buyer pays
average price for bad used car
The ‘Lemons’ Problem
Life Insurance :
Suppose that there are two groups among the population, smokers and non-smokers.
An insurer selling life policies can't tell who is what, so they set premium at the
average level and each pay the same premiums, while people buying insurance know
whether they are smokers or not,
Non-smokers, on the average, are more likely to live longer, while smokers, on the
average, are more likely to die younger. So the life policy is a better buy for the
smokers' beneficiaries.
Premiums set according to average risk will not be sufficient to cover claims because
buyers will be selected for higher risk (buyers carrying less risk are less likely to
purchase insurance.)
So the insurer end up selecting only the ‘lemons’ as its clients. May lead to failure of
the business and drive the insurer out of the market completely.
If the insurance company knew who smokes and who doesn't, it could set rates
differently for each group and there would be no adverse selection
Problem of lemons…
Lemons Problem is also important for Financial Market
The lender ( net savers) doesn’t have exact idea about the risk of lending
to the borrower. However, the borrower knows about the risk associated
with him. Therefore, the lender will charge average rate of interest to the
borrower.
Adverse Selection
Belief: Potential bad credit risks are the ones who most
actively seek out loans
- Firms with average to low financial performance (low credit rating) end up
with ‘Indirect finance’ and incur a higher cost of intermediation
- And … Firms with good financial performance (high credit rating)
pursue ‘direct finance’ and hence incur a lower cost of borrowing
In developing countries, ‘financial intermediation’, i.e. indirect
finance, is pursued more often (why?)
Moral Hazard in Debt
Instruments
Borrower takes on projects that are riskier is perceived by the
lender
Cooperative Banks
Credit Societies
Pension Funds
Mutual Funds
Categories of Financial Intermediaries
Depository Institutions
They are financial intermediaries which are allowed to accept deposits from
individuals and institutions and make loans.
Strictly speaking, depository institutions or banks should be able to repay
the deposits taken, on demand and hence they should confine their
investments to outlets of very liquid nature.
Non Depository Institutions:
Development Financial Institutions ( DFIs) :
These DFIs could be state level or national level.
State Level : State Finance Corporation , State Industrial Development
Corporation
National level : Small Industries development Bank of India( SIDBI), Export
Import bank of India ( EXIM Bank), Industrial Investment bank of India ( IIBI) and
National Bank for Agricultural and Rural Development ( NABARD), Industrial
Finance Corporation of India ( IFCI), National Housing Bank ( NHB) etc.
NABARD, SIDBI and NHB are typically refinance institutions i.e they finance
the loans to other financial institutions for specific purpose.
Categories of Financial Intermediaries
Investment Intermediaries
Mutual funds :
Pools resources of the net savers and uses that pool of resources to
invest on behalf of these net savers in different financial instruments
Pension Funds :
It is a contractual intermediary wherein the net savers have a contract
with the Pension Funds to save for a specified period of time which is
the liability side of the Pension Funds
Pension funds provide retirement income in the form of annuities to
employees who are covered by a pension plan.
Insurance Companies
It is a contractual intermediary
The money multiplier (also called the credit multiplier or the deposit multiplier) is
a measure of the extent to which the creation of money in the banking
system causes the growth in the money supply….(M3) to exceed growth in
the monetary base…. (RM)
Money Supply Measures….
M3 = C + TD
RM = C + R
M3/RM = (C + TD)/ (C + R) = (C/TD + TD/TD)/ (C/TD + R/TD)
M3/RM = (1 + c)/(c+ r )
M3 = (1 + c)/(c+ r )* RM