金融机构管理习题英文版答案

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ChapterOne

WhyAreFinancialIntermediariesSpecial?

ChapterOutline

Introduction

FinancialIntermediaries’Specialness

InformationCosts

LiquidityandPriceRisk

OtherSpecialServices

OtherAspectsofSpecialness

TheTransmissionofMonetaryPolicy

CreditAllocation

IntergenerationalWealthTransfersorTimeIntermediation

PaymentServices

DenominationIntermediation

SpecialnessandRegulation

SafetyandSoundnessRegulation

MonetaryPolicyRegulation

CreditAllocationRegulation

ConsumerProtectionRegulation

InvestorProtectionRegulation

EntryRegulation

TheChangingDynamicsofSpecialness

TrendsintheUnitedStates

FutureTrends

GlobalIssues

Summary

SolutionsforEnd-of-ChapterQuestionsandProblems:ChapterOne

1. Identifyandbrieflyexplainthefiveriskscommontofinancialinstitutions.

Defaultorcreditriskofassets,interestrateriskcausedbymaturitymismatchesbetweenassetsandliabilities,liabilitywithdrawalorliquidityrisk,underwritingrisk,andoperatingcostrisks.

2. Explainhoweconomictransactionsbetweenhouseholdsaversoffundsandcorporateusers offundswouldoccurinaworldwithoutfinancialintermediaries(FIs).

InaworldwithoutFIstheusersofcorporatefundsintheeconomywouldhavetoapproachdirectlythehouseholdsaversoffundsinordertosatisfytheirborrowingneeds.Thisprocesswouldbeextremelycostlybecauseoftheup-frontinformationcostsfacedbypotentiallenders.Costinefficiencieswouldarisewiththeidentificationofpotentialborrowers,thepoolingofsmallsavingsintoloansofsufficientsizetofinancecorporateactivities,andtheassessmentofriskandinvestmentopportunities.Moreover,lenderswouldhavetomonitortheactivitiesofborrowersovereachloan'slifespan.Thenetresultwouldbeanimperfectallocationofresourcesinaneconomy.

3. Identifyandexplainthreeeconomicdisincentivesthatprobablywoulddampentheflowoffundsbetweenhouseholdsaversoffundsandcorporateusersoffundsinaneconomicworldwithoutfinancialintermediaries.

Investorsgenerallyareaversetopurchasingsecuritiesdirectlybecauseof(a)monitoringcosts,(b)liquiditycosts,and(c)pricerisk.Monitoringtheactivitiesofborrowersrequiresextensivetime,expense,andexpertise.Asaresult,householdswouldprefertoleavethisactivitytoothers,andbydefinition,theresultinglackofmonitoringwouldincreasetheriskinessofinvestingincorporatedebtandequitymarkets.Thelong-termnatureofcorporateequityanddebtwouldlikelyeliminateatleastaportionofthosehouseholdswillingtolendmoney,asthepreferenceofmanyfornear-cashliquiditywoulddominatetheextrareturnswhichmaybeavailable.Third,thepriceriskoftransactionsonthesecondarymarketswouldincreasewithouttheinformationflowsandservicesgeneratedbyhighvolume.

4. IdentifyandexplainthetwofunctionsinwhichFIsmayspecializethatenablethesmoothflowoffundsfromhouseholdsaverstocorporateusers.

FIsserveasconduitsbetweenusersandsaversoffundsbyprovidingabrokeragefunctionandbyengagingintheassettransformationfunction.Thebrokeragefunctioncanbenefitbothsaversandusersoffundsandcanvaryaccordingtothefirm.FIsmayprovideonlytransactionservices,suchasdiscountbrokerages,ortheyalsomayofferadvisoryserviceswhichhelpreduceinformationcosts,suchasfull-linefirmslikeMerrillLynch.Theassettransformationfunctionisaccomplishedbyissuingtheirownsecurities,suchasdepositsandinsurancepoliciesthataremoreattractivetohouseholdsavers,andusingtheproceedstopurchasetheprimarysecuritiesofcorporations.Thus,FIstakeonthecostsassociatedwiththepurchaseofsecurities.

5. InwhatsensearethefinancialclaimsofFIsconsideredsecondarysecurities,whilethefinancialclaimsofcommercialcorporationsareconsideredprimarysecurities?Howdoesthetransformationprocess,orintermediation,reducetherisk,oreconomicdisincentives,tothesavers?

Thefundsraisedbythefinancialclaimsissuedbycommercialcorporationsareusedtoinvestinrealassets.Thesefinancialclaims,whichareconsideredprimarysecurities,arepurchasedbyFIswhosefinancialclaimsthereforeareconsideredsecondarysecurities.SaverswhoinvestinthefinancialclaimsofFIsareindirectlyinvestingintheprimarysecuritiesofcommercialcorporations.However,theinformationgatheringandevaluationexpenses,monitoringexpenses,liquiditycosts,andpriceriskofplacingtheinvestmentsdirectlywiththecommercialcorporationarereducedbecauseoftheefficienciesoftheFI.

6. Explainhowfinancialinstitutionsactasdelegatedmonitors.Whatsecondarybenefitsoftenaccruetotheentirefinancialsystembecauseofthismonitoringprocess?

Byputtingexcessfundsintofinancialinstitutions,individualinvestorsgivetotheFIstheresponsibilityofdecidingwhoshouldreceivethemoneyandofensuringthatthemoneyisutilizedproperlybytheborrower.InthissensethedepositorshavedelegatedtheFItoactasamonitorontheirbehalf.TheFIcancollectinformationmoreefficientlythanindividualinvestors.Further,theFIcanutilizethisinformationtocreatenewproducts,suchascommercialloans,thatcontinuallyupdatetheinformationpool.Thismorefrequentmonitoringprocesssendsimportantinformationalsignalstootherparticipantsinthemarket,aprocessthatreducesinformationimperfectionandasymmetrybetweentheultimatesourcesandusersoffundsintheeconomy.

7. WhatarefivegeneralareasofFIspecialnessthatarecausedbyprovidingvariousservicestosectorsoftheeconomy?

First,FIscollectandprocessinformationmoreefficientlythanindividualsavers.Second,FIsprovidesecondaryclaimstohouseholdsaverswhichoftenhavebetterliquiditycharacteristicsthanprimarysecuritiessuchasequitiesandbonds.Third,bydiversifyingtheassetbaseFIsprovidesecondarysecuritieswithlowerprice-riskconditionsthanprimarysecurities.Fourth,FIsprovideeconomiesofscaleintransactioncostsbecauseassetsarepurchasedinlargeramounts.Finally,FIsprovidematurityintermediationtotheeconomywhichallowstheintroductionofadditionaltypesofinvestmentcontracts,suchasmortgageloans,thatarefinancedwithshort-termdeposits.

8. HowdoFIssolvetheinformationandrelatedagencycostswhenhouseholdsaversinvestdirectlyinsecuritiesissuedbycorporations?Whatareagencycosts?

Agencycostsoccurwhenownersormanagerstakeactionsthatarenotinthebestinterestsoftheequityinvestororlender.Thesecoststypicallyresultfromthefailuretoadequatelymonitortheactivitiesoftheborrower.Ifnootherlenderperformsthesetasks,thelenderissubjecttoagencycostsasthefirmmaynotsatisfythecovenantsinthelendingagreement.BecausetheFIinveststhefundsofmanysmallsavers,theFIhasagreaterincentivetocollectinformationandmonitortheactivitiesoftheborrower.

9. Whatoftenisthebenefittothelenders,borrowers,andfinancialmarketsingeneralofthesolutiontotheinformationproblemprovidedbythelargefinancialinstitutions?

Onebenefittothesolutionprocessisthedevelopmentofnewsecondarysecuritiesthatallowevenfurtherimprovementsinthemonitoringprocess.Anexampleisthebankloanthatisrenewedmorequicklythanlong-termdebt.Therenewalprocessupdatesthefinancialandoperatinginformationofthefirmmorefrequently,therebyreducingtheneedforrestrictivebondcovenantsthatmaybedifficultandcostlytoimplement.

10. HowdoFIsalleviatetheproblemofliquidityriskfacedbyinvestorswhowishtoinvestinthesecuritiesofcorporations?

Liquidityriskoccurswhensaversarenotabletoselltheirsecuritiesondemand.Commercialbanks,forexample,offerdepositsthatcanbewithdrawnatanytime.Yetthebanksmakelong-termloansorinvestinilliquidassetsbecausetheyareabletodiversifytheirportfoliosandbettermonitortheperformanceoffirmsthathaveborrowedorissuedsecurities.Thusindividualinvestorsareabletorealizethebenefitsofinvestinginprimaryassetswithoutacceptingtheliquidityriskofdirectinvestment.

11. Howdofinancialinstitutionshelpindividualsaversdiversifytheirportfoliorisks?Whichtypeoffinancialinstitutionisbestabletoachievethisgoal?

Moneyplacedinanyfinancialinstitutionwillresultinaclaimonamorediversifiedportfolio.Bankslendmoneytomanydifferenttypesofcorporate,consumer,andgovernmentcustomers,andinsurancecompanieshaveinvestmentsinmanydifferenttypesofassets.Investmentinamutualfundmaygeneratethegreatestdiversificationbenefitbecauseofthefund’sinvestmentinawidearrayofstocksandfixedincomesecurities.

12. Howcanfinancialinstitutionsinvestinhigh-riskassetswithfundingprovidedbylow-riskliabilitiesfromsavers?

Diversificationofriskoccurswithinvestmentsinassetsthatarenotperfectlypositivelycorrelated.OneresultofextensivediversificationisthattheaverageriskoftheassetbaseofanFIwillbelessthantheaverageriskoftheindividualassetsinwhichithasinvested.Thusindividualinvestorsrealizesomeofthereturnsofhigh-riskassetswithoutacceptingthecorrespondingriskcharacteristics.

13. Howcanindividualsaversusefinancialinstitutionstoreducethetransactioncostsofinvestinginfinancialassets?

Bypoolingtheassetsofmanysmallinvestors,FIscangaineconomiesofscaleintransactioncosts.ThisbenefitoccurswhethertheFIislendingtoacorporateorretailcustomer,orpurchasingassetsinthemoneyandcapitalmarkets.Ineithercase,operatingactivitiesthataredesignedtodealinlargevolumestypicallyaremoreefficientthanthoseactivitiesdesignedforsmallvolumes.

14. Whatismaturityintermediation?Whataresomeofthewaysinwhichtherisksofmaturityintermediationaremanagedbyfinancialintermediaries?

Ifnetborrowersandnetlendershavedifferentoptimaltimehorizons,FIscanservicebothsectorsbymatchingtheirassetandliabilitymaturitiesthroughon-andoff-balancesheethedgingactivitiesandflexibleaccesstothefinancialmarkets.Forexample,theFIcanoffertherelativelyshort-termliabilitiesdesiredbyhouseholdsandalsosatisfythedemandforlong-termloanssuchashomemortgages.Byinvestinginaportfoliooflong-andshort-termassetsthathavevariable-andfixed-ratecomponents,theFIcanreducematurityriskexposurebyutilizingliabilitiesthathavesimilarvariable-andfixed-ratecharacteristics,orbyusingfutures,options,swaps,andotherderivativeproducts.

15. Whatarefiveareasofinstitution-specificFIspecialness,andwhichtypesofinstitutionsaremostlikelytobetheserviceproviders?

First,commercialbanksandotherdepositoryinstitutionsarekeyplayersforthetransmissionofmonetarypolicyfromthecentralbanktotherestoftheeconomy.Second,specificFIsoftenareidentifiedasthemajorsourceoffinanceforcertainsectorsoftheeconomy.Forexample,S&Lsandsavingsbankstraditionallyservethecreditneedsoftheresidentialrealestatemarket.Third,lifeinsuranceandpensionfundscommonlyareencouragedtoprovidemechanismstotransferwealthacrossgenerations.Fourth,depositoryinstitutionsefficientlyprovidepaymentservicestobenefittheeconomy.Finally,mutualfundsprovidedenominationintermediationbyallowingsmallinvestorstopurchasepiecesofassetswithlargeminimumsizessuchasnegotiableCDsandcommercialpaperissues.

16. Howdodepositoryinstitutionssuchascommercialbanksassistintheimplementationandtransmissionofmonetarypolicy?

TheFederalReserveBoardcaninvolvedirectlythecommercialbanksintheimplementationofmonetarypolicythroughchangesinthereserverequirementsandthediscountrate.TheopenmarketsaleandpurchaseofTreasurysecuritiesbytheFedinvolvesthebanksintheimplementationofmonetarypolicyinalessdirectmanner.

17. Whatismeantbycreditallocationregulation?Whatsocialbenefitisthistypeofregulationintendedtoprovide?

CreditallocationregulationreferstotherequirementfacedbyFIstolendtocertainsectorsoftheeconomy,whichareconsideredtobesociallyimportant.Thesemayincludehousingandfarming.Presumablytheprovisionofcredittomakehousesmoreaffordableorfarmsmoreviableleadstoamorestableandproductivesociety.

18. Whichintermediariesbestfulfilltheintergenerationalwealthtransferfunction?Whatisthiswealthtransferprocess?

Lifeinsuranceandpensionfundsoftenreceivespecialtaxationreliefandothersubsidiestoassistinthetransferofwealthfromonegenerationtoanother.Ineffect,thewealthtransferprocessallowstheaccumulationofwealthbyonegenerationtobetransferreddirectlytooneormoreyoungergenerationsbyestablishinglifeinsurancepoliciesandtrustprovisionsinpensionplans.Oftenthiswealthtransferprocessavoidsthefullmarginaltaxtreatmentthatadirectpaymentwouldincur.

19. Whataretwoofthemostimportantpaymentservicesprovidedbyfinancialinstitutions?Towhatextentdotheseservicesefficientlyprovidebenefitstotheeconomy?

Thetwomostimportantpaymentservicesarecheckclearingandwiretransferservices.Anybreakdowninthesesystemswouldproducegridlockinthepaymentsystemwithresultingharmfuleffectstotheeconomyatboththedomesticandpotentiallytheinternationallevel.

20. Whatisdenominationintermediation?HowdoFIsassistinthisprocess?

Denominationintermediationistheprocesswherebysmallinvestorsareabletopurchasepiecesofassetsthatnormallyaresoldonlyinlargedenominations.Individualsaversofteninvestsmallamountsinmutualfunds.ThemutualfundspoolthesesmallamountsandpurchasenegotiableCDswhichcanonlybesoldinminimumincrementsof$100,000,butwhichoftenaresoldinmilliondollarpackages.Similarly,commercialpaperoftenissoldonlyinminimumamountsof$250,000.Thereforesmallinvestorscanbenefitinthereturnsandlowriskwhichtheseassetstypicallyoffer.

21. Whatisnegativeexternality?Inwhatwaysdotheexistenceofnegativeexternalitiesjustifytheextraregulatoryattentionreceivedbyfinancialinstitutions?

Anegativeexternalityreferstotheactionbyonepartythathasanadverseaffectonsomethirdpartywhoisnotpartoftheoriginaltransaction.Forexample,inanindustrialsetting,smokefromafactorythatlowerssurroundingpropertyvaluesmaybeviewedasanegativeexternality.Forfinancialinstitutions,oneconcernisthecontagioneffectthatcanarisewhenthefailureofoneFIcancastdoubtonthesolvencyofotherinstitutionsinthatindustry.

22. Iffinancialmarketsoperatedperfectlyandcostlessly,wouldtherebeaneedforfinancialintermediaries?

Toacertainextent,financialintermediationexistsbecauseoffinancialmarketimperfections.Ifinformationisavailablecostlesslytoallparticipants,saverswouldnotneedintermediariestoactaseithertheirbrokersortheirdelegatedmonitors.However,iftherearesocialbenefitstointermediation,suchasthetransmissionofmonetarypolicyorcreditallocation,thenFIswouldexistevenintheabsenceoffinancialmarketimperfections.

23. Whatismortgageredlining?

Mortgageredliningoccurswhenalenderspecificallydefinesageographicareainwhichitrefusestomakeanyloans.Thetermarosebecauseoftheareaoftenwasoutlinedonamapwitharedpencil.

24. WhyareFIsamongthemostregulatedsectorsintheworld?Whenisnetregulatoryburdenpositive?

FIsarerequiredtoenhancetheefficientoperationoftheeconomy.Successfulfinancialintermediariesprovidesourcesoffinancingthatfundeconomicgrowthopportunitythatultimatelyraisestheoveralllevelofeconomicactivity.Moreover,successfulfinancialintermediariesprovidetransactionservicestotheeconomythatfacilitatetradeandwealthaccumulation.

Conversely,distressedFIscreatenegativeexternalitiesfortheentireeconomy.Thatis,theadverseimpactofanFIfailureisgreaterthanjustthelosstoshareholdersandotherprivateclaimantsontheFI'sassets.Forexample,thelocalmarketsuffersifanFIfailsandotherFIsalsomaybethrownintofinancialdistressbyacontagioneffect.Therefore,sincesomeofthecostsofthefailureofanFIaregenerallybornebysocietyatlarge,thegovernmentintervenesinthemanagementoftheseinstitutionstoprotectsociety'sinterests.Thisinterventiontakestheformofregulation.

However,theneedforregulationtominimizesocialcostsmayimposeprivatecoststothefirmsthatwouldnotexistwithoutregulation.Thisadditionalprivatecostisdefinedasanetregulatoryburden.Examplesincludethecostofholdingexcesscapitaland/orexcessreservesandtheextracostsofprovidinginformation.Althoughtheymaybesociallybeneficial,thesecostsaddtoprivateoperatingcosts.Totheextentthattheseadditionalcostshelptoavoidnegativeexternalitiesandtoensurethesmoothandefficientoperationoftheeconomy,thenetregulatoryburdenispositive.

25. WhatformsofprotectionandregulationdoregulatorsofFIsimposetoensuretheirsafetyandsoundness?

RegulatorshaveissuedseveralguidelinestoinsurethesafetyandsoundnessofFIs:

a. FIsarerequiredtodiversifytheirassets.Forexample,bankscannotlendmorethan10percentoftheirequitytoasingleborrower.

b. FIsarerequiredtomaintainminimumamountsofcapitaltocushionanyunexpectedlosses.Inthecaseofbanks,theBaslestandardsrequireaminimumcoreandsupplementarycapitalof8percentoftheirrisk-adjustedassets.

c. RegulatorshavesetupguarantyfundssuchasBIFforcommercialbanks,SIPCforsecuritiesfirms,andstateguarantyfundsforinsurancefirmstoprotectindividualinvestors.

d. Regulatorsalsoengageinperiodicmonitoringandsurveillance,suchason-siteexaminations,andrequestperiodicinformationfromtheFIs.

26. Inthetransmissionofmonetarypolicy,whatisthedifferencebetweeninsidemoneyandoutsidemoney?HowdoestheFederalReserveBoardtrytocontroltheamountofinsidemoney?Howcanthisregulatorypositioncreateacostforthedepositoryfinancialinstitutions?

OutsidemoneyisthatpartofthemoneysupplydirectlyproducedandcontrolledbytheFed,forexample,coinsandcurrency.InsidemoneyreferstobankdepositsnotdirectlycontrolledbytheFed.TheFedcaninfluencethisamountofmoneybyreserverequirementanddiscountratepolicies.IncaseswherethelevelofrequiredreservesexceedsthelevelconsideredoptimalbytheFI,theinabilitytousetheexcessreservestogeneraterevenuemaybeconsideredataxorcostofprovidingintermediation.

27. Whataresomeexamplesofcreditallocationregulation?Howcanthisattempttocreatesocialbenefitscreatecoststotheprivateinstitution?

Thequalifiedthriftlendertest(QTL)requiresthriftstohold65percentoftheirassetsinresidentialmortgage-relatedassetstoretainthethriftcharter.Somestateshaveenactedusurylawsthatplacemaximumrestrictionsontheinterestratesthatcanbechargedonmortgagesand/orconsumerloans.ThesetypesofrestrictionsoftencreateadditionaloperatingcoststotheFIandalmostcertainlyreducetheamountofprofitthatcouldberealizedwithoutsuchregulation.

28. WhatisthepurposeoftheHomeMortgageDisclosureAct?Whatarethesocialbenefitsdesiredfromthelegislation?Howdoestheimplementationofthislegislationcreateanetregulatoryburdenonfinancialinstitutions?

TheHMDAwaspassedbyCongresstopreventdiscriminationinmortgagelending.Thesocialbenefitistoensurethateveryonewhoqualifiesfinanciallyisprovidedtheopportunitytopurchaseahouseshouldtheysodesire.Theregulatoryburdenhasbeentorequireawrittenstatementindicatingthereasonswhycreditwasorwasnotgranted.Since1990,thefederalregulatorshaveexaminedmillionsofmortgagetransactionsfrommorethan7,700institutionseachcalendarquarter.

29. Whatlegislationhasbeenpassedspecificallytoprotectinvestorswhouseinvestmentbanksdirectlyorindirectlytopurchasesecurities?Givesomeexamplesofthetypesofabusesforwhichprotectionisprovided.

TheSecuritiesActsof1933and1934andtheInvestmentCompanyActof1940werepassedbyCongresstoprotectinvestorsagainstpossibleabusessuchasinsidertrading,lackofdisclosure,outrightmalfeasance,andbreachoffiduciaryresponsibilities.

30. Howdoregulationsregardingbarrierstoentryandthescopeofpermittedactivitiesaffectthechartervalueoffinancialinstitutions?

Theprofitabilityofexistingfirmswillbeincreasedasthedirectandindirectcostsofestablishingcompetitionincrease.Directcostsincludetheactualphysicalandfinancialcostsofestablishingabusiness.InthecaseofFIs,thefinancialcostsincluderaisingthenecessaryminimumcapitaltoreceiveacharter.Indirectcostsincludepermissionfromregulatoryauthoritiestoreceiveacharter.AgaininthecaseofFIsthiscostinvolvesacceptableleadershiptotheregulators.Asthesebarrierstoentryarestronger,thechartervalueforexistingfirmswillbehigher.

31. Whatreasonshavebeengivenforthegrowthofinvestmentcompaniesattheexpenseof“traditional”banksandinsurancecompanies?

Therecentgrowthofinvestmentcompaniescanbeattributedtotwomajorfactors:

a. Investorshavedemandedincreasedaccesstodirectsecuritiesmarkets.Investmentcompaniesandpensionfundsallowinvestorstotakepositionsindirectsecuritiesmarketswhilestillobtainingtheriskdiversification,monitoring,andtransactionalefficiencybenefitsoffinancialintermediation.Someexpertswouldarguethatthisgrowthistheresultofincreasedsophisticationonthepartofinvestors;otherswouldarguethattheabilitytousethesemarketshascausedtheincreasedinvestorawareness.Thegrowthintheseassetsisinarguable.

b. Recentepisodesoffinancialdistressinboththebankingandinsuranceindustrieshaveledtoanincreaseinregulationandgovernmentaloversight,therebyincreasingthenetregulatoryburdenof“traditional”companies.Assuch,thecostsofintermediationhaveincreased,whichincreasesthecostofprovidingservicestocustomers.

32. Whataresomeofthemethodswhichbankingorganizationshaveemployedtoreducethenetregulatoryburden?Whathasbeentheeffectonprofitability?

Throughregulatorychanges,FIshavebegunchangingthemixofbusinessproductsofferedtoindividualusersandprovidersoffunds.Forexample,bankshaveacquiredmutualfunds,haveexpandedtheirassetandpensionfundmanagementbusinesses,andhaveincreasedthesecurityunderwritingactivities.Inaddition,legislationthatallowsbankstoestablishbranchesanywhereintheUnitedStateshascausedawaveofmergers.Asthesizeofbankshasgrown,anexpansionofpossibleproductofferingshascreatedthepotentialforlowerservicecosts.Finally,theemphasisinrecentyearshasbeenonproductsthatgenerateincreasesinfeeincome,andtheentirebankingindustryhasbenefitedfromincreasedprofitabilityinrecentyears.

33. Whatcharacteristicsoffinancialproductsarenecessaryforfinancialmarketstobecomeefficientalternativestofinancialintermediaries?Canyougivesomeexamplesofthecommoditizationofproductswhichwerepreviouslythesolepropertyoffinancialinstitutions?

FinancialmarketscanreplaceFIsinthedeliveryofproductsthat(1)havestandardizedterms,(2)servealargenumberofcustomers,and(3)aresufficientlyunderstoodforinvestorstobecomfortableinassessingtheirprices.Whenthesethreecharacteristicsaremet,theproductsoftencanbetreatedascommodities.Oneexampleofthisprocessisthemigrationofover-the-counteroptionstothepubliclytradedoptionmarketsastradingvolumegrowsandtradingtermsbecomestandardized.

34. InwhatwayhasRegulation144AoftheSecuritiesandExchangeCommissionprovidedanincentivetotheprocessoffinancialdisintermediation?

Changingtechnologyandareductionininformationcostsarerapidlychangingthenatureoffinancialtransactions,enablingsaverstoaccessissuersofsecuritiesdirectly.Section144AoftheSECisarecentregulatorychangethatwillfacilitatetheprocessofdisintermediation.Theprivateplacementofbondsandequitiesdirectlybytheissuingfirmisanexampleofaproductthathistoricallyhasbeenthedomainofinvestmentbankers.Althoughhistoricallyprivateplacementassetshadrestrictionsagainsttrading,regulatorshavegivenpermissionfortheseassetstotradeamonglargeinvestorswhohaveassetsofmorethan$100million.Asthemarketgrows,thisminimumassetsizerestrictionmaybereduced.

ChapterSeven

RisksofFinancialIntermediation

ChapterOutline

Introduction

InterestRateRisk

MarketRisk

CreditRisk

Off-Balance-SheetRisk

TechnologyandOperationalRisk

ForeignExchangeRisk

CountryorSovereignRisk

LiquidityRisk

InsolvencyRisk

OtherRisksandtheInteractionofRisks

Summary

SolutionsforEnd-of-ChapterQuestionsandProblems:ChapterSeven

Whatistheprocessofassettransformationperformedbyafinancialinstitution?Whydoesthisprocessoftenleadtothecreationofinterestraterisk?Whatisinterestraterisk?

AssettransformationbyanFIinvolvespurchasingprimaryassetsandissuingsecondaryassetsasasourceoffunds.TheprimarysecuritiespurchasedbytheFIoftenhavematurityandliquiditycharacteristicsthataredifferentfromthesecondarysecuritiesissuedbytheFI.Forexample,abankbuysmedium-tolong-termbondsandmakesmedium-termloanswithfundsraisedbyissuingshort-termdeposits.

Interestrateriskoccursbecausethepricesandreinvestmentincomecharacteristicsoflong-termassetsreactdifferentlytochangesinmarketinterestratesthanthepricesandinterestexpensecharacteristicsofshort-termdeposits.Interestrateriskistheeffectonprices(value)andinterimcashflows(interestcouponpayment)causedbychangesinthelevelofinterestratesduringthelifeofthefinancialasset.

Whatisrefinancingrisk?Howisrefinancingriskpartofintere