Question

1. Why insurance companies are considered financial intermediaries? Explain what moral hazard in insurance business is and how can insurance companies reduce the hazard?

2. What are the principal activities of investment banks? What are the main differences between investment banks and commercial banks?

Answer 1

A.

• A financial intermediary is a financial institution such as bank, building society, insurance company, investment bank or pension fund.
• A financial intermediary offers a service to help an individual/ firm to save or borrow money. A financial intermediary helps to facilitate the different needs of lenders and borrowers.
• For example, if you need to borrow £1,000 – you could try to find an individual who wants to lend £1,000. But, this would be very time consuming and you would find it difficult to know how reliable the lender was.
• Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank (a financial intermediary) to borrow money. The bank raises funds from people looking to deposit money, and so can afford to lend out to those individuals who need it.

A non-bank financial intermediary does not accept deposits from the general public. The intermediary may provide factoring, leasing, insurance plans or other financial services. Many intermediaries take part in securities exchanges and utilize long-term plans for managing and growing their funds. The overall economic stability of a country may be shown through the activities of financial intermediaries and the growth of the financial services industry.

Financial intermediaries move funds from parties with excess capital to parties needing funds. The process creates efficient markets and lowers the cost of conducting business. For example, a financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate, and other assets. Banks connect borrowers and lenders by providing capital from other financial institutions and from the Federal Reserve. Insurance companies collect premiums for policies and provide policy benefits. A pension fund collects funds on behalf of members and distributes payments to pensioners.

So insurance companies are considered financial intermediaries.

In the health insurance market, when the insured party or individual behaves in such a way that costs are raised for the insurer, moral hazard has occurred. Individuals who don't have to pay for medical services have an incentive to seek more expensive and even riskier services that they would otherwise not require. For these reasons, health insurance providers generally institute a co-pay and deductibles, which requires individuals to pay for at least part of the services they receive. Such a policy and usage of deductible amounts is an incentive for the insured to cut down on services and to avoid making claims. Accordingly, insurance companies reduce the hazard by taking the reinsurance.

B.

Investment banks serve a number of purposes in the financial and investment world, including underwriting of new stock issues, handling mergers and acquisitions, and acting as a financial advisor.

Other roles of investment banks include asset management for large investment funds and personal wealth management for high-net-worth individuals.

Principal activities of investment banks

Underwriting New Stock Issues

Financial Advisory Roles

Mergers and Acquisitions

Research

Trading and Sales

Asset Management

Wealth Management

Securitized Products

2. Main differences between investment banks and commercial banks

• Investment banks and commercial banks provide different services.
• Investment banks underwrite new debt and equity securities, help with selling securities, and drive mergers and acquisitions, reorganizations, and broker trades.
• Commercial banks make loans to people and small businesses and offer checking and savings accounts and certificates of deposit.
• Most financial services firms operate as either an investment bank or a commercial bank, although some combine functions.

Investment Banks

Investment banks are primarily financial middlemen, helping corporations set up IPOs, get debt financing, negotiate mergers and acquisitions, and facilitate corporate reorganization. Investment banks also act as a broker or advisor for institutional clients.

Commercial Banks

Commercial banks take deposits, provide checking and debit account services, and provide business, personal, and mortgage loans. They also offer basic bank products such as certificates of deposit (CDs) and savings accounts to individuals and small businesses. Most people hold a commercial bank account, rather than an investment bank account, for their personal banking needs.