Susie has inherited $500,000 from her grandparents and is thinking of investing them. She is thinking if she would be better off lending the money to her brother in his existing business, or putting them into fixed deposits in a bank. Susie’s brother is offering an interest of 8% p.a. for her lending and the bank’s 1-year fixed deposit rate is at 3.2% p.a. By using what you learnt about benefits of financial intermediation, what advantages would she have if she puts her money in a fixed deposit in a bank rather than lending it to her brother?

There are several issues to consider here.

  1. Regardless of whatever option we choose, there will be transaction costs. In fact, every time you open a bank account with a financial institution, or take out a loan, there are many documentations that need to be filled out, contracts to be signed. There are legal fees, stamp fees, etc. Even something very simple as renting out an apartment has a hefty percentage of agent/legal fees. For a small-time investor like Susie and her brother, these can amount to huge costs. But because banks run on a massive scale–think of economies of scale–they reduce these costs substantially. So, in short, if you are a small/retail investor, your transaction cost is very high. Susie should be careful about this aspect.
  2. If Susie invests the money with her brother, she is essentially putting all her eggs in one basket. She is exposed to her brother’s business risk and business profitability 100%. Being a small investor, Susie does not have the resources to spread out that risk by dividing her capital up to many smaller chunks and give them money to deserving/reliable business-people in the economy. On the other hand, banks have a huge advantage here because of their size and expertise. They are able to spread their risk through risk sharing. Through financial intermediaries, banks borrow from many customers, and lend to many as well. They allow depositors to share the risk of many borrowers from default.
  3. Another important issue to consider is liquidity. Imagine, after 3 months of lending the money, Susie wishes to take withdraw some amount–or even the entire amount. This poses many problems to her brother. What is the guarantee that he will be able to honor this request? Maybe he already invested all of it? Maybe he can’t generate enough cash from sales that month to pay it back? Maybe he invested it on a fixed asset (like plants or equipment or land lease) and cannot easily convert it into cash? Susie would get stuck at this point. Banks or Financial Institutions are great at managing this risk of liquidity demand. They always keep enough on their reserve to meet customers’ withdrawal demands. Moreover, if you are familiar with several insurance schemes, many of your deposits in banks are also covered by the federal government (e.g., FDIC in the US, PIDM in Malaysia). This is an added layer of protection.
  4. Finally, risk appetite. Even after Susie accounts for all these factors, what if she is willing to take on extra risk? Maybe she is young and adventurous and a small 3.2% return is not what she is looking for. After all, with that small amount of return, nobody is getting rich anytime soon. So perhaps maybe her brother’s offer is better for her. It’s also possible that liquidity is not much of an issue for her. Maybe Susie has a decent job which gives her a good cash flow from salary every month and all her monthly needs are taken care of. She wants her money to jump high and fast as quickly as possible. As such, withdrawal is not a worry for her. In those cases, maybe her brother’s offer is a smart choice. But of course, the same situation is much unlikely for a 55 year old government official who is about to head to retirement. They want a safe, secure, and steady stream of returns. For a client like that, the bank is safer. Therefore, the ultimate answer to this question depends on the risk-profile, risk-appetite, and risk-tolerance of the person in question. There is no one size fits all Nevertheless, regardless of which answer you choose, be careful to back it up with solid reasoning; similar to the factors we have discussed so far.

Financial markets play three key roles in a modern economy: (a) informational role, (b) consumption timing, and (c) risk allocation. Informational role entails that markets perform a vital function of generating price signals. How do we know something is worth XYZ dollars? We know because of market consensus. Markets are highly sophisticated and efficient in generating these price signals which then allow people to use them for various investment or consumption purposes. Come to think of it, investment is basically delayed consumption. When we invest, we sacrifice enjoying the resources right now because we want to enjoy a bigger amount in future. But how do we time these consumption choices? Financial markets allow us this flexibility by giving us a HUGE range of products to choose from for almost every type of risk profile; from government bonds to corporate bonds to preferred stocks to common stocks to derivatives. The list is endless. Investors or portfolio managers can then mix and match these products and allocate their money in specific sectors or products in a way that matches their investment goals or preferences. There are some examples of this available in the Susie Case Study video. In addition to these roles financial markets work like a straw. They channel funds from the haves to the have-nots. In other words, from those who do not have a productive use for them to those who do. This makes an economy more efficient. The more efficient a country’s financial market is, the more efficiently that country uses its money.

If the financial market is absent in a country or not effective, that means that smart, talented, industrious people with an entrepreneurial spirit or a business idea cannot get their hands-on funds since they cannot connect with people who have those funds. As a result, new businesses do not appear or grow. The economy similarly cannot grow. Financial markets like the equity and bond market accelerates economy expansion by allowing businesses to acquire funds more rapidly, thus increasing productivity in a country. In fact, research shows that financial markets provide essential services in an economy by facilitating technological innovation and economic growth—mobilizing savings, evaluating projects, managing risk, monitoring managers and facilitating transactions, etc. Thus, it does make sense that countries with developed financial markets would prosper more.

Both direct and indirect finance involve channeling funds from the haves to the have-nots. From savers to borrowers. From lenders to spenders.

In direct finance, only one financial instrument is involved. More specifically, lenders and borrowers directly do business with each other. The borrower pays the lender directly. The terms and conditions of these transactions are recorded in ONE instrument.

In indirect financing, borrowers borrow money from the financial market through indirect means, such as a bank or other financial intermediaries. E.g., when you seek out a loan from a bank, the bank is lending it to you from a pool of depositors’ money. In a sense, you are borrowing the depositors’ money. Hence, you are indirectly being financed by that bank’s depositing customers. The bank is merely an intermediary facilitator. So, unlike direct finance, we get two instruments: one between the bank and the depositor, and one between the borrower and the bank.

Why diversify?

I’m sure most of you are familiar with the term: putting all your eggs in one basket. So, why is it a bad idea to put all eggs in one basket? Well, because if an accident occurs or something bad happens to the basket, all the eggs are ruined. So, if you spread them out, you will be exposed to less risk. How? Well, the chances of all the baskets suffering an accident at the same time is quite low. So, if an accident does happen, only a few eggs will be damaged. So, how does this relate to financial inter-mediation? We have to remember that all investments carry a risk. The more returns we seek, the higher the risk we must be willing to tolerate. Each investment carries the possibility that it will fail. Meaning, we will not receive our expected return. We may even lose our principal amount if, say, a bond issuing company goes bankrupt. If we can diversify our investments in a portfolio form by spreading them across a collection of different instruments, we can design a portfolio with an acceptable return and an acceptable risk exposure.

Financial intermediaries such as investment companies help in risk sharing by providing the means for individuals and businesses to diversify their asset holdings no matter how small or big the deposit amount is. Risk sharing occur as investors pool their funds together in order to purchase many financial assets, therefore collectively benefiting from diversification.

In terms of banks, depositors also benefit from diversification when banks borrow from many and lend to many.

  • Secured loans give the lender extra security because if the borrower defaults, the bank can sell the collateral and recover some losses.
  • This reduces the risk for the bank.
  • Thus, banks can charge less.
  • Low Risk = Low Return
  • Income gap = effect of interest rate ↨ on interest income of the bank
  • Duration gap = effect of interest rate ↨ on market value of net worth of the bank

Calculate the income gap for a financial institution with rate-sensitive assets of RM20 million and rate-sensitive liabilities of RM48 million. If interest rates rise from 4% to 4.8%, what is the expected change in income? 

Income Gap = Gap * ΔIR = (Rate Sensitive Assets – Rate Sensitive Liabilities) * ΔIR

= (4.8% – 4%) * (20 – 48) = – RM 224,000

The GFC was caused by:

(1) Low interest rate

(2) High property prices

(3) Sub-prime mortgage lending

Please watch the following two videos to have a better understanding of the GFC (also known as the Great Recession in the US):

https://www.youtube.com/watch?v=nBh6PlC9_1g

https://www.youtube.com/watch?v=yM0uonkloXY

 

Solution will be posted here 24 hours after the in-class tutorial demonstration.