SLIDE 2A

ROLE FUNCTIONS OF BANKS & FIs

AND
THEIR SPECIALNESS

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TOPIC OUTLINE/LEARNING OBJECTIVES

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Process

of Financial Intermediation
Different types of Intermediation and
various risks of Financial Intermediation.

Why

Banks and FIs are special ? Why

they are regulated ?

Key

Words/Terminologies/Glossary.

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ROLE AND FUNCTIONS OF BANKS AND FIs

Objectives:

Develop the tools needed to measure and

manage the risks of FIs.
Explain the special role of FIs in the financial
system and the functions they provide.
Explain why the various FIs receive special
regulatory attention.
Discuss what makes some FIs more special
than others.

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FINANCIAL INTERMEDIATION
Financial

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Institutions : Institutions that

perform the essential function of channeling
funds/savings from those with surplus funds
(Supplier of funds/Net Savers) to those with
shortages of funds (Users of funds/Net
Borrowers) (e.g. of FIs are commercial and
savings banks, thrifts, insurance companies,
securities firms and investment banks,
finance companies, mutual funds, pension
funds)

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Flow of Funds in a World

without FIs : Direct Transfer

Users of Funds
(Corporations)

Financial Claims
(Equity and debt
instruments or
securities)

Suppliers of
Funds
(Households)

Cash
Example: A firm sells shares or debentures directly to investors
without going through a financial institution.

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FIs Specialness
Without

Higher Transaction Costs (Search Costs +

Information/Monitoring costs) :

FIs: Low level of fund flows.

Economies of scale reduce costs for FIs to screen

and monitor borrowers

Less liquidity
Substantial Price Risk
Maturity Mismatch Risk
High Default Risk/Credit Risk

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Flow of Funds in a world

with FIs : Indirect transfer

Users of Funds

Cash

FI
(Brokers)

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Suppliers of Funds

FI
(Asset
transformers)

Financial Claims
(Equity and debt securities, loans
and mortgages etc.)
PRIMARY SECURITIES

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Cash

Financial Claims
(Deposits and insurance policies)
SECONDARY SECURITIES

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PROCESS OF INDIRECT TRANSFER OF

FUNDS FINANCIAL
INTERMEDIATION

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BENEFITS
With the Banks & FI Intermediation, enormous reduction in
the Search Costs, Monitoring Costs, Liquidity Risks, Price
Risks, Default Risks, Maturity Mismatch Risks, Transaction
Costs etc. facing the suppliers of funds compared to when
they directly invest in financial claims issued by the
ultimate fund users.
Because of diversification Bank is able to offer highly
liquid, instantly withdrawable demand deposits with
little price risk as liabilities while investing in risky,
non-tradable and often illiquid loans as assets.

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PROCESS OF FINANCIAL INTERMEDIATION

AND ITS BENEFITS Contd..

Aggregation/Pooling of Funds of Net Savers/Suppliers,

Large Size of FIs and Economies of Scale and Scope of
Operations allows the collection of information on fund
borrowers and monitoring the use of funds at a lower
average cost
Large FIs have much greater incentive to hire employees
with superior skills and training in analysis and monitoring
In an economic sense, fund suppliers have appointed the FI
as a delegated monitor. An important part of the FIs
function is their ability and incentive to monitor the ultimate
fund users
Diversification of FIs asset/loan portfolios help reduce
some of the investment risks like the liquidity risk, default
risk, maturity mismatch risk

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Functions of FIs
Brokerage

function

Acting as an agent for investors:

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e.g. Merchant/Investment Banks, Brokerage Houses

Reduce costs through economies of scale
Encourages higher rate of savings

Asset transformer:

Purchase primary securities by selling financial

claims or secondary Securities to households
These secondary securities (Deposits and Insurance
Policies) often more marketable because of their liquidity
and safety attributes that are superior to those of primary
securities (Equity and Debt Securities, Loans and
Mortgages)

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Role of FIs in Cost Reduction

Information

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costs:

Investors exposed to Agency Costs

Role of FI as Delegated Monitor

Shorter term debt contracts easier to monitor than bonds
FI likely to have informational advantage

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KINDS OF FINANCIAL
INTERMEDIATION
Banks and FIs actually performs various
kinds of intermediation. They are :

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Denomination Intermediation
Default-risk Intermediation
Maturity Intermediation
Liquidity Intermediation
Information Intermediation
Time Intermediation
Risk Pooling and Diversification (Economies of
Scale & Scope)

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Risks Faced by Financial

Institutions

Interest
Interest Rate
Rate Risk
Risk

Foreign
Foreign Exchange
Exchange Risk
Risk

Market
Market Risk
Risk

Credit
Credit Risk
Risk

Liquidity
Liquidity Risk
Risk

Off-Balance-Sheet
Off-Balance-Sheet Risk
Risk

Technology
Technology Risk
Risk

Operational
Operational Risk
Risk

Country
Country or
or Sovereign
Sovereign Risk
Risk

Insolvency
Insolvency Risk
Risk
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Specialness of FIs
Liquidity

and Price Risk

Secondary claims issued by FIs have less price

risk
FIs have advantage in diversifying risks

Reduced

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transaction & information costs

economies of scale

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Other Special Services

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Maturity intermediation
Transmission of monetary policy.
Credit allocation (Areas of special need such as
Priority Sector Loans including Agriculture
Loans, MSME loans, home loans, educational
loans, Export Credit etc.).
Intergenerational
transfers
or
time
intermediation.
Payment services (FedWire and CHIPS, in India
ECS, NEFT, RTGS & SWIFT).
Denomination intermediation.

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Specialness and Regulation

FIs

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receive special regulatory attention.

Reasons:
Special services provided by FIs in general.
Institution-specific
functions such as money
supply transmission (banks), credit allocation,
payment
& settlement services, capital
formation and economic development etc.
Negative externalities arise if these services are
not provided.

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MULTIPLE CREDIT CREATION ROLE 1-17

OF COMMERCIAL BANKS

EVERY DEPOSIT CREATES A LOAN; EVERY LOAN

CREATES A DEPOSIT : CBs have potential for multiple
credit creation and thereby providing additional
money/purchasing power and thus increasing overall
money supply in the economy.
LIMIT TO CREDIT CREATION CAPACITY OF BANKS :
- Reserve Requirements
- Availability of primary deposits
- Availability of good securities
- Economic Conditions/Business Cycles

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Regulation of FIs
Important

features of regulatory policy:

Protect ultimate sources and users of savings.

Including prevention of unfair practices

Primary role:
Ensure soundness of the system as a whole.

Regulation

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is not costless

Net regulatory burden.

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Regulation
Safety

Regulations to increase diversification

No more than 10 percent of equity to single

shareholder

Minimum capital requirements : CAR/CRAR

Guarantee funds:

and soundness regulation:

Bank Deposit Insurance (FDIC/DICGC)

Securities Investors Protection Fund (SIPC)
Solvency Margin for Insurance Companies

Monitoring and surveillance.

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Regulation
Monetary

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policy regulation

Federal Reserve/RBI directly controls outside

money.
Bulk of money supply is inside money
(deposits).
Reserve requirements like CRR/SLR facilitate
transmission of monetary policy.

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Regulation
Credit

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allocation regulation

Supports socially important sectors such as

Priority Sector Loans to Agriculture, MSMEs,
Education, Housing, Exports etc.

Requirements for minimum amounts of assets in a

particular sector or maximum interest rates or fees
called SELECTIVE CREDIT CONTROL.
Fair Practices Code for Lenders
Loan Recovery Policy/Guidelines
Fair Practices code for Customer Service
Banking Ombudsman Scheme, BCSBI and various
Customer Service Committees
Consumer Protection Act (COPRA), 1985

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KEY WORDS/TERMINOLOGIES/GLOSSARY

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Transaction Costs (Search and Monitoring/Information

Costs)
Denomination Intermediation, Default-risk Intermediation,
Maturity
Intermediation,
Liquidity
Intermediation,
Information Intermediation, Time Intermediation, Risk
Pooling and Diversification, Economies of Scale &
Economies of Scope
FINANCIAL CLAIMS (PRIMARY AND SECONDARY
SECURITIES), FI as Broker and FI as Asset
Transformer, Delegated Monitor
Liquidity Risk, Maturity Mismatch Risk, Price Risk,
Credit/Default Risk etc.
Credit Creation Capacity of Banks

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