Question

What are the economic functions that financial intermediaries perform that benefit society? In your answer, discuss the relationship of financial intermediaries and financial markets to the savings-investment process within an economy and to each other. As part of your discussion provide an analysis of the differences in preferences among economic agents as an explanation for the wide variety of primary and secondary securities found in financial markets. Be sure to explain how depository intermediaries, like banks and thrifts, differ from other financial institutions such as investment banking firms, securities brokerage companies or life and casualty insurance companies, and how financial intermediaries profit from the transformation of primary securities into secondary claims. As part of your answer discuss what is meant by specialness of depository institutions and contrast this with the Dodd-Frank created “systemically important financial intermediaries/institutions” (SIFIs) and financial utilities. Define your terms.

Answer 1

Economic functions that financial intermediaries perform that benefit society:

• Financial intermediaries serve as middlemen for financial transactions, generally between banks or funds.
• These intermediaries help create efficient markets and lower the cost of doing business.
• Intermediaries can provide leasing or factoring services, but do not accept deposits from the public.
• Financial intermediaries offer the benefit of pooling risk, reducing cost, and providing economies of scale, among others.

The relationship of financial intermediaries and financial markets to the savings-investment process:

• Through a financial intermediary, savers can pool their funds, enabling them to make large investments, which in turn benefits the entity in which they are investing. At the same time, financial intermediaries pool risk by spreading funds across a diverse range of investments and loans

Variety of primary and secondary securities found in financial markets:

• The primary market is where securities are created, while the secondary market is where those securities are traded by investors.
• In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).
• The secondary market is basically the stock market and refers to the New York Stock Exchange, the Nasdaq, and other exchanges worldwide.

Difference between depository intermediaries and Retail bank:

• Retail banking is the kind of banking done by the general public, where we deposit our paycheck, take out a mortgage, buy CD's and establish savings accounts. Their primary business is taking in deposits and lending against them - home, auto, student, unsecured loans.
• Investment banking is a service provided to companies involving the issuance of securities - either debt (bonds) or equity (stock), to help further the company's goals. UPS used Morgan Stanley as their investment bank when they went public with a stock offering.

Specialness of depository institutions:

• Products on both sides of the balance sheet. For example: Loans, Business and Commercial Deposits.

Systemically important financial intermediaries/institutions:

• A systemically important financial institution (SIFI) is a firm that U.S. regulators determine would pose a serious risk to the economy if it were to collapse.
• This label imposes extra regulatory requirements and increased scrutiny, including strict oversight by the Federal Reserve, higher capital requirements, periodic stress tests, and the need to produce "living wills”.