Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu
16. How do depository institutions such as commercial banks assist in the implementation and transmission of monetary policy?
Because the liabilities of depository institutions are a significant component of the money supply that impacts the rate of inflation, they play a key role in the transmission of monetary policy from the central bank to the rest of the economy. That is, depository institutions are the conduit through which monetary policy actions impact the rest of the financial sector and the economy in general. Indeed, a major reason the United States and world governments bailed out many depository institutions and increased the deposit insurance limit from $100,000 to $250,000 per person per bank during the financial crisis was so that central banks could implement aggressive monetary policy actions to combat collapsing financial markets. Monetary policy actions include open market operations (the purchase and sale of securities in the U.S. Treasury securities market), setting the discount rate (the rate charged on “lender of last resort” borrowing from the Federal Reserve), and setting reserve requirements (the minimum amount of reserve assets depository institutions must hold to back deposits held as liabilities on their balance sheets).
17. What is meant by credit allocation regulation? What social benefit is this type of regulation intended to provide?
Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy which are considered to be socially important. These may include housing and farming. Presumably the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society.
18. Which intermediaries best fulfill the intergenerational wealth transfer function? What is this wealth transfer process?
Life insurance companies and pension funds often receive special taxation relief and other subsidies to assist in the transfer of wealth from one generation to another. In effect, the wealth transfer process allows for the accumulation of wealth by one generation to be transferred directly to one or more younger generations by establishing life insurance policies and trust provisions in pension plans. Often this wealth transfer process avoids the full marginal tax treatment that a direct payment would incur.
19. What are two of the most important payment services provided by financial institutions? To what extent do these services efficiently provide benefits to the economy?
The two most important payment services are check clearing and wire transfer services. Any breakdown in these systems would produce gridlock in the payment system with resulting harmful effects to the economy at both the domestic and potentially the international level.
20. What is denomination intermediation? How do FIs assist in this process?
Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are sold only in large denominations. Because they are sold in very large denominations, many assets are either out of reach of individual savers or would result in savers’ holding highly undiversified asset portfolios. For example, the minimum size of a negotiable certificate of deposit (CD) is $100,000 and commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individually, a saver may be unable to purchase such instruments. However, by buying shares in a money market mutual fund along with other small investors, household savers overcome the constraints to buying assets imposed by large minimum denomination sizes. Such indirect access to these markets may allow small savers to generate higher returns on their portfolios as well.
21. What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions?
A negative externality refers to the action by one party that has an adverse effect on another party who is not part of the original transaction. For example, bank failures may destroy household savings and at the same time restrict a firm’s access to credit. Insurance company failures may leave households totally exposed in old age to catastrophic illnesses and sudden drops in income on retirement. Further, individual FI failures may create doubts in savers’ minds regarding the stability and solvency of FIs in general and cause panics and even runs on sound institutions. FIs are special because of the various services they provide to sectors of the economy. Failure to provide these services or a breakdown in their efficient provision can be costly to both the ultimate sources (households) and users (firms) of savings. FIs are regulated to prevent this from happening.