Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu
11. How do financial institutions help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal?
Money placed in any financial institution will result in a claim on a more diversified portfolio. as long as the returns on different investments are not perfectly positively correlated, by exploiting the benefits of size, FIs diversify away significant amounts of portfolio risk—especially the risk specific to the individual firm issuing any given security. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk-free return on its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk. FIs best able to achieve this goal include banks that lend money to many different types of corporate, consumer, and government customers. Insurance companies have investments in many different types of assets. Investments in a mutual fund may generate the greatest diversification benefit because of the fund’s investment in a wide array of stocks and fixed income securities. As long as an FI is sufficiently large to gain from diversification and monitoring, its financial claims are likely to be viewed as liquid and attractive to small savers compared with direct investments in the capital market.
12. How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers?
FIs exploit the law of large numbers in their investments, achieving a significant amount of diversification, whereas because of their small size, many household savers are constrained to holding relatively undiversified portfolios. This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk- free return on its assets. As a result, it can credibly fulfill its promise to households to supply highly liquid claims with little price or capital value risk.
13. How can individual savers use financial institutions to reduce the transaction costs of investing in financial assets?
By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are designed to deal in large volumes typically are more efficient than those activities designed for small volumes. By grouping their assets in FIs that purchase assets in bulk—such as in mutual funds and pension funds—household savers can reduce the transaction costs of their asset purchases.
14. What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?
If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. A dimension of FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts. By investing in a portfolio of long- and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products.
15. What are five areas of institution-specific FI specialness and which types of institutions are most likely to be the service providers?
First, commercial banks and other depository institutions are key players for the transmission of monetary policy from the central bank to the rest of the economy. Second, specific FIs often are identified as the major source of financing for certain sectors of the economy. For example, savings institutions traditionally serve the credit needs of the residential real estate market. Third, life insurance companies and pension funds commonly are encouraged to provide mechanisms to transfer wealth across generations. Fourth, depository institutions efficiently provide payment services to benefit the economy. Finally, money market and debt-equity mutual funds provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs and commercial paper issues.