CHAPTER 2
AN OVERVIEW OF
FINANCIAL INSTITUTIONS
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The Financial Sector:
Provides for the efficient
allocation of saving to real
investment or consumption.
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Surplus Spending Unit
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Has more cash income flow than expenditure on
consumption and real investments in a period of
time. The surplus then is allocated to the
financial sector.
Other terms for surplus unit are saver, lender,
buyer of financial assets, financial investor,
supplier of loanable funds, buyer of securities.
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Surplus Spending Unit (concluded)
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The surplus unit may buy financial assets, hold
more money, pay off financial liabilities issued
earlier when in a deficit situation.
The household sector is usually a surplus sector.
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Deficit Spending Unit
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Has more expenditures on real goods and
services in the real sector than income during a
period of time.
The deficit unit must participate (borrow) in the
financial sector to balance cash inflows with
outflows.
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Deficit Spending Unit (concluded)
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Other terms for deficit spending unit are
borrower, demander of loanable funds, seller of
securities.
The deficit spending unit may issue financial
liabilities, reduce money balances, sell financial
assets acquired previously when in a surplus
situation.
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Financial claims--the contracts related
to the transfer of funds from surplus to
deficit budget units.
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Financial claims are also called financial assets
and liabilities, securities, loans, financial
investments.
For every financial asset, there is an offsetting
financial liability.
– Total receivables equal total payables in the
financial system.
– Loans outstanding match borrowers' liabilities.
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Financial claims (concluded)

Financial markets offer opportunity for:
– financing for DSUs (primary).
– financial investing for SSUs (primary and
secondary).
– trading financial claims (secondary).
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Direct financing
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DSUs and SSUs negotiate and exchange money
for financial claims.
DSUs issue direct financial claims; SSUs
participate in direct lending.
The sale of securities by an industrial firm directly
to an investor (SSU or financial institution) is a
private placement.
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Direct financing (concluded)
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Brokers bring DSUs and SSUs together; dealers
buy the securities from DSUs and resell to the
SSUs.
Investment bankers act as dealers in direct
financial markets, purchasing securities from
DSUs and selling to original SSUs.
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Indirect financial investment is
called intermediation financing
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A financial "intermediary" writes a separate
contract with the SSU (bank depositor) and DSU
(auto loan), providing each some economic
value.
Financial intermediaries hold direct claims on
DSUs as financial assets and issue indirect
financial claims to SSUs as liabilities.
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Benefits of Financial
Intermediation
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Economies of scale from specialization.
Transaction and search costs are lowered for
SSUs and DSUs.
Financial intermediaries may be able to gather
DSU information more effectively and discreetly.
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Intermediation services
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Denomination Divisibility -- Issue varying sized
contracts of assets and liabilities.
Currency Transformation -- buying and selling
financial claims denominated in various
currencies.
Maturity Flexibility -- Offer contracts with varying
maturities to suit both DSUs and SSUs.
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Intermediation services (concluded)
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Credit Risk Diversification -- Assume credit risks
of DSUs and keep the risks manageable by
spreading the risk over many varied types of
DSUs (loan portfolio).
Liquidity -- Provide a place to store liquidity for
SSUs (deposits); a place to find (borrow) liquidity
for DSUs.
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Types of financial intermediaries
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Deposit-Type Institutions -- Offer liquid,
government- insured claims to SSUs, such as
demand deposits, savings deposits, time
deposits, and share accounts.
– Commercial Banks -- Make a variety of consumer
and commercial loans (direct claim) to DSUs.
– Thrift Institutions -- Make mortgage loans (direct
claim) to DSUs.
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Types of financial intermediaries
(continued)
– Credit Unions -- Receive share account deposits
and make consumer loans. Membership requires
a common bond, such as a church or labor union.
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Types of financial intermediaries
(continued)
Percent of Total Financial Assets
FINANCIAL ASSET HOLDINGS OF DEPOSIT-TYPE
INTERMEDIARIES (1998)
100%
U.S. Government
securities
Municipal bonds
90%
80%
70%
Corporate and foreign
bonds
Consumer loans
60%
50%
40%
30%
Business loans
20%
Real estate loans
10%
0%
Commercial
Banks
Thrift
Institutions
Credit Unions
Other financial assets
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, December 11, 1998.
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Types of financial intermediaries
(continued)
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Contractual Savings Institutions -- Issue longterm claims to SSUs in the form of insurance
policies and pension fund obligations.
– Life Insurance Companies -- Issue life insurance
policies and purchase long-term, high-yield direct
financial securities.
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Types of financial intermediaries
(continued)
– Casualty Insurance Companies -- Purchase longterm, liquid, direct financial securities from paid-inadvance premiums from insurance purchasers.
– Pension Funds -- issue claims to SSUs (pension
reserves) and invest financially in direct financial
securities (stocks and bonds).
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Types of financial intermediaries
(continued)
FINANCIAL ASSET HOLDINGS OF CONTRACTUAL SAVINGS
INSTITUTIONS (1998)
100%
Percent of Total Financial Assets
90%
U.S. Government securities
80%
Municipal bonds
70%
Corporate and foreign
bonds
Real estate loans
60%
50%
40%
Corporate equities
30%
Other financial assets
20%
10%
0%
Life Insurance
Companies
Casualty
Insurance
Companies
Private
State and Local
Pension Funds Gov. Pension
Funds
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, December 11, 1998.
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Types of financial intermediaries
(continued)

Investment Funds -- Issue shares to investors
and use these funds to purchase direct financial
claims.
– Mutual Funds -- Offer indirect mutual fund shares
to SSUs and purchase direct financial assets
(stocks and bonds).
– Money Market Mutual Funds -- Offer (indirect)
shares and purchase direct (commercial paper)
and indirect (bank CDs) money market financial
assets. Most MMMFs offer check-writing
privileges.
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Types of financial intermediaries
(continued)
FINANCIAL ASSET HOLDINGS OF INVESTMENT FUNDS (1998)
100%
Percent of Total Financial Assets
90%
U.S. Government securities
80%
Municipal bonds
70%
50%
Corporate and foreign
bonds
Corporate equities
40%
Commercial Bank CDs
30%
Commercial Paper
20%
Other financial assets
60%
10%
0%
Money Market Mutual
Funds
Mutual Funds
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, December 11, 1998.
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Types of financial intermediaries
(continued)

Other Types of Financial Intermediaries
– Finance Companies -- Borrow (issue liabilities)
directly from banks and directly from SSUs
(commercial paper) and purchase consumer and
business loans.
– Federal Agencies -- Sell direct claims in capital
markets and lend to socially deserving DSUs
(farmers, homebuyers).
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Transfer of Funds from Surplus to
Deficit Spending Units
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Intermediation and
Disintermediation

Disintermediation is a shift of funds from
intermediated markets to direct credit markets.
– Historically occurred when market rates of interest
rose above the Regulation Q limits placed on the
rates that depository institutions could legally pay.
– More recently, gross disintermediation has
occurred as SSUs shift funds from one financial
intermediary (e.g., commercial banks) to another
financial intermediary (e.g., mutual funds).
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Relative Size of Financial
Intermediaries in the U.S.
Finance Companies
100%
Percent of Total Financial Assets
Mutual Funds
80%
Money Market Mutual
Funds
State and Local Gov.
Pension Funds
Private Pension Funds
60%
Casualty Insurance
Companies
Life Insurance
Companies
Credit Unions
40%
20%
Thrift Institutions
0%
1955 1965 1975 1985 1990 1995 1998
Commercial Banks
Source: Board of Governors, Federal Reserve System, Z1 Statistical Release, December 11, 1998.
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Risks faced by Financial
Institutions
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Credit or default risk is the risk that a direct DSU
issuer will not pay as agreed, thus affecting the
rate of return on a loan or security.
Interest rate risk is the risk of fluctuations in a
security's price or reinvestment income caused
by changes in market interest rates.
Liquidity risk is the risk that the financial
institution will be unable to generate sufficient
cash flow to meet required cash outflows.
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Risks faced by Financial
Institutions (continued)
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Foreign exchange risk is the risk that foreign
exchange rates will vary in the future affecting
the profit of the financial institution.
Political risk is the cost or variation in returns
caused by actions of sovereign governments or
regulators.
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