Chapter 1: Introduction to Financial Institutions

Learning Objectives

After studying this chapter, you should be able to:

• Describe the five parts of the financial system and explain the two central roles the system plays in the economy.
• Distinguish direct finance from indirect (intermediated) finance and explain what primary and secondary securities are.
• Identify the four costs and risks that households face when they invest directly in primary securities: information and monitoring costs, liquidity costs, price risk, and transaction costs.
• Explain adverse selection and moral hazard, work through numerical examples of each, and describe how screening and monitoring address them.
• Explain the asset transformation and brokerage functions of financial institutions and show, with calculations, how intermediaries reduce each of the four costs of direct finance.
• Explain why financial institutions are considered special, why they attract far heavier regulation than ordinary firms, and describe the six main forms of regulation.
• Identify the main Australian financial regulators (APRA, ASIC, and the RBA) and their US counterparts.
• List the major types of financial institutions and the major risks they face, and connect each risk to the chapters that follow.

1.1 Introduction

Banks and other financial institutions sit at the center of every modern economy. When a household deposits its savings, takes out a mortgage, buys insurance, or contributes to a retirement account, it is dealing with a financial institution (FI). When a corporation raises debt, hedges currency exposure, or clears payments, it too relies on FIs. This book is about how these institutions are managed: how they earn returns, what risks they take on in doing so, and how those risks are measured and controlled.

This first chapter sets the stage. We begin with the financial system as a whole and ask a deceptively simple question: why do financial institutions exist at all? Savers could, in principle, lend directly to businesses. In practice they rarely do, and understanding why reveals what makes FIs valuable, why their failure is so damaging, and why governments regulate them far more intensively than ordinary companies. We then survey the main types of FIs, with an emphasis on the Australian institutional setting in which this course is taught, and preview the major risks that occupy the rest of the book: interest rate risk (Chapters 2 and 3), credit risk (Chapters 4 and 5), foreign exchange risk (Chapter 5), liquidity risk (Chapter 6), capital adequacy (Chapter 7), market and operational risk (Chapter 8), and securitization as a tool for managing several of these exposures (Chapter 9).

Why should you care about this material? If you become a risk manager, this is your job description. If you work in a financial institutions group in investment banking or in equity research covering banks, you must understand how FIs create value and where they can blow up. If you invest in FIs, or one day aspire to run one, the same logic applies. Even if you do none of these things, the global financial crisis of 2008 demonstrated that when large FIs fail, everyone pays.

1.2 An Overview of the Financial System

1.2.1 The five parts of the financial system

The financial system has five parts, each of which plays a fundamental role in the economy.

1. Money. Money serves as a medium of exchange, a unit of account, and a store of value. Without it, every transaction would require barter.
2. Financial instruments. These are legal contracts used to transfer resources and risks between suppliers of funds (savers) and users of funds (borrowers and investors). Shares, bonds, loans, deposits, and insurance policies are all financial instruments.
3. Financial markets. These are the places, physical or electronic, where financial instruments are bought and sold. The Australian Securities Exchange (ASX) and the New York Stock Exchange are examples.
4. Financial institutions. FIs provide a myriad of services that facilitate the flow of funds from savers to investors. Banks, insurance companies, and superannuation funds are all FIs.
5. Regulators. Regulators monitor and stabilize the financial system and the broader economy. In Australia the key regulators are APRA, ASIC, and the Reserve Bank of Australia; in the United States they include the Federal Reserve, the FDIC, the OCC, and the SEC. We return to regulators in Section 1.5.

1.2.2 The two roles of the financial system

The financial system plays two important, and closely related, roles. The first is to channel savings to investments. The second is to allow economic agents to share risks. A household that buys shares in many companies through a managed fund is doing both at once: its savings finance real investment, and the fund's diversification spreads risk across many firms and many savers.

Why is channeling savings to investment so important? Because it produces an efficient allocation of capital. Funds flow to the projects with the highest returns, which raises production and efficiency for the whole economy. A simple example makes the point.

Example 1.1: The gains from channeling savings to investment

Suppose you have saved $1,000 this year and have no productive investment opportunities of your own. Carl, a carpenter, could use $1,000 to buy a new tool that shortens the time it takes him to build a house, earning him an extra $200 per year. If no financial market exists, you simply hold your $1,000 in cash and earn nothing, and Carl never buys the tool. If a financial market exists, you can lend Carl the $1,000 in exchange for a payment of $100 per year.

Solution. With the loan in place, you earn $100 per year on savings that would otherwise have earned $0, a return of $100/$1,000 = 10%. Carl earns the extra $200 per year from the tool, pays you $100 in interest, and keeps $200 - $100 = $100 of additional income per year. Both parties are strictly better off, and total output in the economy is $200 per year higher. The financial system created this gain simply by moving funds from someone who had them to someone who could use them productively.

The example is stylized, but the logic scales up to the entire economy. When the channel from savers to investors works well, capital finds its best uses. When the channel breaks down, as it did during the global financial crisis of 2008, investment collapses and the real economy suffers.

1.3 Direct Finance and Its Problems

1.3.1 Direct finance and primary securities

There are two broad ways funds can flow from savers to users. In direct finance, corporations borrow directly from households in financial markets by selling them securities, which are claims on the corporation's future income or assets. We call these securities primary securities. Corporate shares and corporate bonds bought directly by a household are primary securities.

In balance sheet terms, direct finance looks like this: the corporation holds real assets (factories, equipment, inventory) on the asset side and issues primary securities on the liability side; the household holds money and primary securities as assets. The primary securities flow from the corporation straight to the household, with no intermediary in between.

Corporation: Assets	Corporation: Liabilities	Household: Assets	Household: Liabilities
Real assets	Primary securities	Money, primary securities	(none)

Illustrative balance sheet view of direct finance. Primary securities issued by the corporation are held directly by the household.

Direct finance sounds efficient, so why does so little household saving actually flow this way? Because households investing directly in primary securities face four costs and risks:

1. Information and monitoring costs
2. Liquidity costs
3. Price risk
4. Transaction costs

We consider each in turn. The first is the richest, because it stems from a deep feature of lending: asymmetric information.

1.3.2 Information and monitoring costs: asymmetric information

The issuers of financial instruments know much more about their own business prospects, and about how hard they intend to work, than potential lenders or investors do. This imbalance is called asymmetric information, and it creates problems on two fronts: before the transaction is entered into, and after.

• Adverse selection is the problem created by asymmetric information before the transaction occurs. It is a hidden information problem: the lender does not know the true credit risk of the borrower. Without screening, adverse selection makes it more likely that loans are made to bad credit risks, and lenders may decide not to lend at all even though good credit risks exist in the marketplace.
• Moral hazard is the problem created by asymmetric information after the transaction occurs. It is a hidden action problem: after obtaining the money, the borrower can take actions that damage the lender's interests. In the extreme case, the borrower can simply abscond with the money.

Both problems are best understood through numbers.

Example 1.2: Adverse selection and screening by interest rate

Suppose there are two firms in the economy, and each needs an investment of $1,000. Their revenues in the two possible states of the economy are:

Economy	Probability	Safe firm revenue	Risky firm revenue
Good	0.5	$1,051	$2,100
Bad	0.5	$1,051	$0

The safe firm earns $1,051 in either state, a certain 5.1% return on the $1,000 invested. The risky firm earns $2,100 (a 110% return) in the good state and nothing in the bad state. You require a minimum expected return of 5% on your investment, but you cannot tell which firm is which. Can you screen out the risky firm by choosing the interest rate you charge? Consider charging 5% or 10%.

Solution.

Case 1: charge 5% interest. A borrower at 5% must repay $1,000 × 1.05 = $1,050. The safe firm earns $1,051 in every state, so it can repay $1,050 and keep $1; it is willing to borrow. The risky firm is also willing to borrow. Your return on each loan:

• Safe firm: repaid $1,050 in both states, so your return is 5% for certain.
• Risky firm: in the good state it earns $2,100 and repays $1,050, so you earn 5%. In the bad state it earns $0 and repays nothing, so you lose your entire $1,000, a return of -100%.

Expected return on the risky firm = 0.5 × 5% + 0.5 × (-100%) = 2.5% - 50% = -47.5%.

Since you cannot tell the firms apart, you are equally likely to be lending to either one (or, equivalently, you lend to both). Your overall expected return is the average:

Expected return = (5% + (-47.5%))/2 = -21.25%

This is far below your required 5%.

Case 2: charge 10% interest. A borrower at 10% must repay $1,000 × 1.10 = $1,100. The safe firm earns only $1,051, so it cannot profitably borrow at 10% and drops out of the market. Only the risky firm still borrows. Your return on the risky firm:

• Good state (probability 0.5): the firm earns $2,100 and repays $1,100, so you earn 10%.
• Bad state (probability 0.5): the firm earns $0 and you lose everything, -100%.

Expected return = 0.5 × 10% + 0.5 × (-100%) = 5% - 50% = -45%

Raising the rate made things worse: the higher interest rate drove out the safe firm and left only the risky firm. This is the essence of adverse selection. The interest rate is not just a price; it also changes the composition of who borrows. A lender who cannot distinguish borrowers cannot fix the problem by charging more, and may rationally refuse to lend at all. The only real solution is to screen: collect information that sorts borrowers by credit risk before lending, and charge each the appropriate rate. Screening is costly, and as we will see, FIs can do it far more cheaply per dollar lent than individual households can.

Example 1.3: Moral hazard and risk shifting

Now suppose the information problem before the loan is solved: you lend $1,000 to a firm at a 5% interest rate, so the firm owes $1,050. After obtaining your funds, the firm can choose between two projects:

Economy	Probability	Safe project revenue	Risky project revenue
Good	0.5	$1,051	$2,100
Bad	0.5	$1,051	$0

Which project will the firm choose, and what does that mean for you as the lender?

Solution. Compute the firm's net profit after repaying the $1,050 loan, remembering that the owners of the firm have limited liability: if revenue is less than the debt owed, they pay what they have and keep zero, they do not pay out of their own pockets.

Economy	Probability	Safe project profit	Risky project profit
Good	0.5	$1,051 - $1,050 = $1	$2,100 - $1,050 = $1,050
Bad	0.5	$1,051 - $1,050 = $1	$0 (limited liability)

Expected profit from the safe project = 0.5 × $1 + 0.5 × $1 = $1. Expected profit from the risky project = 0.5 × $1,050 + 0.5 × $0 = $525.

The firm strongly prefers the risky project. From your perspective as lender, the safe project would have given you a sure 5%, but under the risky project your expected return is 0.5 × 5% + 0.5 × (-100%) = -47.5%.

Why does this happen? A debt contract lets the owners keep all the profits in excess of the fixed loan repayment, while limited liability caps their downside at zero. The upside belongs to the borrower and much of the downside falls on the lender, so debt contracts encourage risk taking after the money changes hands. The solution to moral hazard is to monitor the borrower's actions after lending, for example through loan covenants, periodic financial reporting, and site visits. Like screening, monitoring is costly.

1.3.3 Why households cannot solve these problems cheaply

The remedies for adverse selection and moral hazard are clear: collect sufficient information before investing (screening) and check on the borrower afterward (monitoring). The trouble is that when household savers invest directly in corporations, each household must do its own screening and monitoring, duplicating everyone else's effort. Because each household's stake in any one borrower is small, these costs are typically too high to justify the return on the investment. Moreover, households usually lack the expertise to process financial information and monitor managers effectively. The result is that information and monitoring costs alone can make direct finance unattractive.

1.3.4 Liquidity costs, price risk, and transaction costs

Three further problems compound the difficulty.

Liquidity costs. Household savers want ready access to their funds: a car breaks down, a medical bill arrives, a deposit on a home is needed. But corporate equity and debt are usually long term in nature, and some securities lack a liquid secondary market in which households can quickly sell at a fair price. A household locked into an illiquid ten year corporate bond bears a real cost when it needs cash today.

Price risk. The prices of corporate equity and debt can change significantly over even short periods. Household savers are usually more concerned with preserving the value of their savings than with speculation, so they dislike this price risk. A saver with only enough wealth to hold two or three stocks bears substantial firm specific risk that a diversified investor would not.

Transaction costs. Household investors often face prohibitively high transaction costs when investing directly, because their trades are small. Brokerage fees, bid ask spreads, and minimum investment sizes all loom large relative to a small portfolio.

1.3.5 The consequence: a world with only direct finance

Because of (1) information and monitoring costs, (2) liquidity costs, (3) price risk, and (4) transaction costs, households in a world without FIs would find direct investment in corporate securities unattractive. Many would prefer either not to save at all or to save in the form of cash. Three things would follow: the flow of funds from savers to productive investment would be low; little or no monitoring of firms would occur; and the riskiness of the investments that did get funded would rise. The efficient allocation of capital described in Example 1.1 would break down. This is the gap that financial institutions evolved to fill.

1.4 Indirect Finance and the Functions of FIs

1.4.1 Asset transformation and brokerage

The economy has developed an alternative channel from savings to investment: indirect finance, also called intermediated finance. In indirect finance, FIs serve as intermediaries between the lender and the borrower. FIs perform two broad functions.

The asset transformation function. This is indirect finance proper. The FI borrows from households by issuing secondary securities to them (for example, bank deposits, insurance policies, or units in a managed fund), and then provides the funds to borrowers by investing in the primary securities the borrowers issue (loans, bonds, shares). The FI stands in the middle as a principal: the household's claim is on the FI, not on the ultimate borrower. In effect, the FI transforms costly and risky primary securities into secondary securities that are less costly and less risky, and therefore far more appealing to households. A bank deposit is safer, more liquid, and simpler than the portfolio of business loans that backs it. That is asset transformation.

The brokerage function. Here the FI assists direct finance rather than replacing it. Acting as a broker, the FI provides information and transaction services: executing trades, distributing new securities, producing research. In this role the FI acts as an agent, not a principal, and is usually compensated with a fee. A stockbroker who buys shares on your behalf never owns the shares; it simply reduces your cost of participating in direct finance.

For asset transformation to be viable, FIs must be able to handle the four costs and risks of investing in primary securities better than households can. They can, and it is worth seeing exactly how, cost by cost.

1.4.2 How FIs reduce information and monitoring costs

FIs have a decisive advantage in lowering the costs of collecting information about firms and monitoring them. An FI aggregates funds from a large number of households, so it holds a much larger stake in any given borrower than a single household could. This has two consequences. First, there are economies of scale: the fixed costs of screening a borrower and monitoring a loan are spread over a large investment, so the cost per dollar invested falls dramatically. One credit analysis serves thousands of depositors; in direct finance, each of those depositors would have had to do (or skip) the analysis individually. Second, incentives improve: with a large stake, the FI has a much greater incentive to actually collect information about how funds are used and how hard management is working, and to monitor the borrower, than any small individual investor would. The FI becomes a delegated monitor, doing the screening and monitoring on behalf of all the households whose funds it pools, which eliminates the wasteful duplication described in Section 1.3.3. FIs also develop specialist expertise, credit models, industry knowledge, and legal capability, that households lack.

1.4.3 How FIs reduce liquidity costs

FIs handle liquidity better than households because they can diversify the sources of their funds. A bank with millions of depositors knows that not everyone will want their money back on the same day. By diversifying its funding, the FI can predict its expected daily withdrawals quite accurately, set aside enough cash to meet them, and invest the rest in long term, higher yielding assets, without having to liquidate those long term investments at a loss whenever one depositor wants cash. The law of large numbers is doing the work: individual withdrawal needs are unpredictable, but the average across many independent depositors is highly predictable. A small numerical example shows the principle in miniature.

Example 1.4: Diversifying deposit withdrawals

Suppose the probability that any one household withdraws its deposit over the next year is 20%, and households' withdrawal needs are independent of one another. Compare two FIs:

1. FI A has 2 households, each depositing $1,000 (total deposits $2,000).
2. FI B has 4 households, each depositing $500 (total deposits $2,000).

For each FI, what is the probability that it still has at least $1,000 of deposits at the end of the year? Which probability is higher?

Solution. Withdrawals are independent, each with probability p = 0.2 (so each household stays with probability 0.8). The number of withdrawals therefore follows a binomial distribution.

FI A (2 households at $1,000 each). Deposits remain at or above $1,000 as long as at most 1 of the 2 households withdraws. Equivalently, the only bad outcome is that both withdraw:

P(both withdraw) = 0.2 × 0.2 = 0.04

P(at least $1,000 remains) = 1 - 0.04 = 0.96

(As a check, computing directly: P(0 withdrawals) = 0.8^2 = 0.64 and P(1 withdrawal) = 2 × 0.2 × 0.8 = 0.32, and 0.64 + 0.32 = 0.96.)

FI B (4 households at $500 each). At least $1,000 remains as long as at least 2 households stay, that is, at most 2 of the 4 withdraw. Using the binomial formula P(k withdrawals) = C(4, k) × 0.2^k × 0.8^(4-k):

• P(0 withdrawals) = C(4,0) × 0.2^0 × 0.8^4 = 1 × 1 × 0.4096 = 0.4096
• P(1 withdrawal) = C(4,1) × 0.2^1 × 0.8^3 = 4 × 0.2 × 0.512 = 0.4096
• P(2 withdrawals) = C(4,2) × 0.2^2 × 0.8^2 = 6 × 0.04 × 0.64 = 0.1536

P(at most 2 withdrawals) = 0.4096 + 0.4096 + 0.1536 = 0.9728

Comparison. FI B's probability of retaining at least $1,000 is 97.28%, versus 96% for FI A, even though both hold the same $2,000 in total deposits. Spreading the same funding across more, smaller, independent depositors makes total withdrawals more predictable and extreme outflows less likely. Scale this up from 4 depositors to 4 million and the FI's daily net withdrawals become highly predictable, which is exactly why a bank can safely fund long term loans with deposits that are individually withdrawable on demand. (When this logic fails, because withdrawals suddenly become highly correlated, the result is a bank run; that is the subject of Chapter 6 on liquidity risk, and it is precisely what destroyed Silicon Valley Bank in 2023, whose depositors were concentrated, uninsured, and moved as one.)

1.4.4 How FIs reduce price risk

The key to reducing price risk is diversification: investing in many different firms at the same time. Many household savers hold relatively undiversified portfolios simply because their wealth is limited; you cannot spread $5,000 across 300 stocks at reasonable cost. By pooling funds from many households, an FI can invest in many firms simultaneously. As long as the returns on different investments are not perfectly positively correlated, the FI diversifies away a significant amount of firm specific risk. This makes the return on the FI's asset portfolio far more predictable, which in turn allows the FI to issue secondary securities (like deposits) whose value is stable. The household gets a claim with low price risk, backed by a portfolio it could never have assembled alone.

1.4.5 How FIs reduce transaction costs

Finally, size itself lowers transaction costs. Because FIs transact in bulk, they execute trades far more efficiently and at a much lower average cost than a household placing a small order. An FI collects many small investors' funds and invests them in large blocks, negotiating lower fees and tighter spreads. This is another economies of scale effect: the cost of a transaction does not rise in proportion to its size, so cost per dollar invested falls as scale rises.

In summary, FIs are special because they simultaneously solve all four problems of direct finance. They screen and monitor as delegated monitors with economies of scale (information costs); they offer liquid claims backed by diversified funding (liquidity costs); they diversify asset portfolios (price risk); and they transact in bulk (transaction costs). Households respond by entrusting FIs with the bulk of their savings, and the flow of funds to productive investment is vastly larger than direct finance alone could achieve.

1.5 The Specialness of FIs and Regulation

1.5.1 Why FIs are heavily regulated

FIs are heavily regulated, much more so than ordinary commercial firms. If a furniture retailer fails, its shareholders and creditors lose money and its customers shop elsewhere; the damage is largely contained. FIs are different, for exactly the reasons developed above. The services FIs provide, channeling savings to investment, screening and monitoring borrowers, supplying liquidity, operating the payments system, and transmitting monetary policy, are crucial to the entire economy. A distressed FI therefore creates negative externalities: costs that fall on parties well beyond the FI's own shareholders and creditors. When a bank fails, depositors may lose savings, creditworthy borrowers lose access to credit, other banks face contagious runs as confidence evaporates, and the payments system itself can seize up. The failure of an FI affects not only the private claimants on its assets but many other parties in society. Regulation exists to reduce the probability of such failures and to contain the damage when they happen.

1.5.2 The GFC and the bailouts

The clearest modern demonstration of FI specialness is the global financial crisis of 2008 (GFC). As losses on US mortgage related assets spread through the system, governments concluded that letting major FIs collapse would be catastrophic for their economies, and spent trillions of dollars of taxpayer money to prevent it.

In the United States, Congress passed the Emergency Economic Stabilization Act, which created the Troubled Asset Relief Program (TARP) to inject capital into banks and purchase distressed assets. The roll call of institutions rescued or absorbed in 2008 alone is remarkable: Bear Stearns (sold to JPMorgan Chase with government support), Merrill Lynch (sold to Bank of America), the mortgage giants Fannie Mae and Freddie Mac (placed into government conservatorship), the insurer American International Group (AIG, bailed out with an enormous government loan), Washington Mutual (seized and sold to JPMorgan Chase), and Citigroup (supported with capital injections and asset guarantees). Notably, Lehman Brothers was allowed to fail in September 2008, and the ensuing panic in global markets is widely seen as proof of why the other rescues were undertaken. In the United Kingdom, the 2008 bank rescue package saw the government take large ownership stakes in Lloyds and the Royal Bank of Scotland.

Why did governments bail out their big FIs while letting ordinary companies fail? The answer is precisely the FIs' roles and functions in the economy. Their failure would have destroyed the credit channel, the payments system, and household savings simultaneously. The bailouts, however, create a problem you can now name: if FI managers know they will be rescued in a crisis, they face moral hazard at the institutional level, an incentive to take more risk because the downside is partly borne by taxpayers. This "too big to fail" problem motivates much of the capital regulation we study in Chapter 7.

1.5.3 Six forms of protection and regulation

Regulation of FIs takes six main forms.

1. Safety and soundness regulation. This aims to keep individual FIs solvent. FIs are required to diversify their assets (limiting exposure to any single borrower); they must meet capital adequacy requirements, holding a cushion of shareholders' funds to absorb unexpected losses (the subject of Chapter 7); regulators establish guaranty funds that protect claimholders if an FI fails, such as the Deposit Insurance Fund (DIF) administered by the FDIC for US commercial banks, or Australia's Financial Claims Scheme, which guarantees deposits up to $250,000 per account holder per ADI; and FIs are subject to periodic monitoring and surveillance by supervisors.
2. Investor protection regulation. This governs conduct in securities markets: it prohibits insider trading and other market abuses and requires disclosure of material information so that investors can make informed decisions.
3. Consumer protection regulation. This governs FIs' dealings with retail customers, for example by preventing discrimination in lending and requiring fair treatment and clear disclosure of fees.
4. Monetary policy regulation. Because bank liabilities are a large part of the money supply, regulators require FIs to hold minimum levels of cash reserves and to serve as the conduit through which central bank monetary policy is transmitted to the economy.
5. Credit allocation regulation. This supports lending to socially important sectors such as farming and housing, sometimes imposing price restrictions (such as interest rate ceilings) or quantity requirements on such lending.
6. Entry regulation. Establishing an FI is deliberately made difficult. Regulators impose high direct costs of entry, such as minimum equity and capital requirements, and high indirect costs, such as restrictions on who may establish an FI (licensing and fit and proper tests). Entry regulation protects the safety of the system, though it also softens competition.

1.5.4 Financial regulators in Australia (with US parallels)

Australia divides these regulatory tasks among three main agencies, an arrangement often called the "twin peaks" model plus the central bank.

• APRA, the Australian Prudential Regulation Authority, is responsible for the prudential regulation and supervision of the financial services industry: banks and other authorized deposit-taking institutions, insurance companies, and superannuation funds. APRA administers safety and soundness regulation, including capital adequacy. Its closest US analogues are the prudential functions of the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the FDIC.
• ASIC, the Australian Securities and Investments Commission, is responsible for market integrity and consumer protection across the financial system. It sets standards for financial market behavior with the aim of protecting investor and consumer confidence, and it administers the corporations law to promote honesty and fairness in companies and markets. Its US counterpart is primarily the Securities and Exchange Commission (SEC), together with the Consumer Financial Protection Bureau (CFPB) on the consumer side.
• The RBA, the Reserve Bank of Australia, is Australia's central bank. It develops and implements monetary policy and is responsible for overall financial stability, including oversight of the payments system. Its US counterpart is the Federal Reserve.

Note the division of labor: APRA watches the safety of individual institutions, ASIC watches conduct in markets, and the RBA watches the stability of the system as a whole. In the United States these functions are spread across a larger and more overlapping set of agencies, which is one reason the Australian model is often cited internationally as a clean regulatory design.

1.6 The Financial Services Industry

There are many different types of FIs. Each performs one or more of the functions discussed in Section 1.4, and each also performs certain institution specific functions. The main categories are depository institutions, finance companies, securities firms and investment banks, superannuation and managed funds, and insurance companies.

1.6.1 Depository institutions

Depository institutions (DIs) accept deposits from individuals and institutions and make loans. They are the largest group of FIs by balance sheet size, and they are the central subject of this book. In Australia, deposit takers are licensed by APRA as authorized deposit-taking institutions (ADIs), a category that includes:

• Banks, the largest DIs by size, with the most varied assets and liabilities;
• Building societies, which operate on a cooperative basis and historically specialized in housing finance; and
• Credit unions, mutual cooperative organizations formed around a common bond such as an employer or industry.

In the United States the corresponding institutions are commercial banks, savings institutions (thrifts), and credit unions.

DIs matter beyond their size for two reasons. First, they provide the economy's core payment services; wages, bills, and business transactions overwhelmingly settle across bank accounts. Second, DI liabilities (deposits) are a significant component of the money supply, which influences the rate of inflation, so DIs play a key role in transmitting monetary policy from the central bank to the rest of the economy. When the RBA changes the cash rate, it is largely through banks' lending and deposit rates that the change reaches households and firms.

Trends in Australian banking. The structure of the industry has changed markedly over recent decades. Australia had only 13 banks in 1985 but around 70 by 2014, an increase driven by the relaxation of entry requirements and by regulatory changes that allowed non-bank depository institutions (many building societies and credit unions) to convert to bank status. Despite the growth in numbers, the industry remains highly concentrated: in 2014 the "Big 4" banks (Commonwealth Bank, Westpac, ANZ, and NAB) held about 54.77% of the assets of all Australian banks.

Bank balance sheets have also shifted. Over roughly the last two decades of that period there was a pronounced move from commercial lending toward residential housing lending, driven by structural change in the industry and by the introduction of capital adequacy regulation in 1989, which assigned lower risk weights to housing loans (a mechanism explained in Chapter 7). Foreign currency assets and liabilities grew as regulation of banks' foreign currency holdings was relaxed and banks gained access to Eurodollar funding markets, an exposure that creates the foreign exchange risk studied in Chapter 5. Liabilities raised through Australian dollar deposits fell as retail savings migrated into superannuation accounts. Finally, off-balance-sheet (OBS) activities have become increasingly important. OBS activities involve items, such as loan commitments, guarantees, and derivative positions, that do not appear on the balance sheet today but move onto it when a contingent event occurs; banks use them to generate additional fee income, but they carry risks of their own (Section 1.7). More broadly, whereas an FI of the 1950s typically supplied one narrow service (banking, or insurance, or broking), the largest modern FIs are conglomerates supplying banking, wealth management, insurance, and securities services under one roof.

To make this concrete, the general shape of a large Australian bank's balance sheet, such as Commonwealth Bank's in 2022, is: assets dominated by loans (with housing loans the largest single category), plus cash, securities, and derivative assets; liabilities dominated by customer deposits, plus wholesale debt and derivative liabilities; and a thin layer of shareholders' equity, typically in the vicinity of only 5 to 7% of total assets. That thin equity layer is why capital adequacy (Chapter 7) matters so much: small percentage losses on assets can consume a large fraction of equity.

1.6.2 Finance companies

Finance companies raise funds by selling commercial paper (a short term debt instrument) and by issuing stocks and bonds; unlike DIs, they do not take deposits. They lend the funds to consumers and small businesses, for example through car loans and consumer loans. Some finance companies are organized by a parent corporation specifically to help sell its products; think of the finance arm of a car manufacturer.

1.6.3 Securities firms and investment banks

Securities firms and investment banks primarily help net suppliers of funds transfer funds to net users of funds at low cost and with maximum efficiency. Unlike most other FIs, they operate chiefly through the brokerage function of Section 1.4.1, intermediating as agents between fund suppliers and users rather than transforming assets on their own balance sheets. Their activities fall into two groups. Investment banking involves raising debt and equity securities for corporations and governments, including the origination, underwriting, and placement of securities in money and capital markets. Securities services involve assisting the trading of securities in secondary markets, through brokerage services and market making.

1.6.4 Superannuation funds, managed funds, and unit trusts

Superannuation funds manage the savings accumulated over an employee's working life with the aim of providing a retirement income. In Australia, compulsory employer contributions have made superannuation an enormous pool of assets; the US parallels are 401(k) plans and pension funds. Managed funds and unit trusts (mutual funds, in US terminology) pool the financial resources of individuals and companies and invest in diversified portfolios of assets. These institutions are almost pure examples of FIs solving price risk and transaction costs through pooled diversification.

1.6.5 Insurance companies

Insurance companies protect people and businesses against financial hazards and also sell annuities. Life insurance and property insurance are the main lines. Insurers acquire funds from the premiums that policyholders pay to keep their policies in force, and invest those funds mainly in corporate bonds and mortgages; they also hold stocks, though regulation restricts the amounts. Insurance is the clearest example of the financial system's risk sharing role: many policyholders each pay a small premium, and the pool compensates the few who suffer losses.

1.7 The Major Risks of FIs: A Roadmap for This Book

Intermediation is not free lunch. In performing asset transformation, FIs concentrate on their own balance sheets the very risks they remove from households. Managing those risks is the core of FI management, and each major risk anchors a later chapter of this book.

• Interest rate risk. In mismatching the maturities of its assets and liabilities as part of the asset transformation function (typically borrowing short through deposits and lending long through loans), an FI exposes itself to changes in interest rates. Rising rates can raise funding costs faster than asset returns, and can reduce the market value of long term assets. Chapter 2 measures this risk with the repricing model; Chapter 3 uses the duration model.
• Market risk. The value of assets in an FI's trading portfolio changes with market variables such as interest rates, exchange rates, and equity prices. Trading losses can accumulate with frightening speed. Market risk is covered in Chapter 8.
• Credit risk. This is the risk that promised cash flows from loans and securities are not paid in full. It is the oldest and, for most banks, the largest risk. Chapter 4 analyzes the credit risk of individual loans; Chapter 5 extends the analysis to loan portfolios.
• Liquidity risk. A sudden surge in liability withdrawals can force an FI to liquidate assets in a very short period and at fire sale prices. In the extreme, this becomes a bank run. Example 1.4 showed why diversified funding normally keeps this risk manageable; Chapter 6 shows what happens when it is not.
• Foreign exchange (FX) risk. Exchange rate changes affect the value of an FI's assets and liabilities denominated in foreign currencies. An Australian bank funding itself in US dollars bears FX risk on that funding. FX risk is covered in Chapter 5.
• Sovereign risk. This is a distinct type of credit risk that arises when an FI purchases assets issued by foreign governments or holds claims on foreign corporations. A foreign borrower may be unable to repay even if it is willing, because its government prohibits or limits repayments (for example through capital controls). Sovereign risk is discussed alongside credit and FX risk in Chapter 5.
• Off-balance-sheet risk. OBS activities, such as loan commitments, letters of credit, and derivatives, generate fee income today but can move onto the balance sheet when a contingent event occurs, sometimes bringing large losses with them. OBS risk appears throughout the book, particularly in Chapters 7 and 8.
• Technology and operational risk. Technology risk is the risk that investments in technology do not produce the anticipated cost savings, for example because of diseconomies of scale. Operational risk is the risk that existing technology or support systems malfunction or break down, and it also includes fraud and human error. These risks are covered in Chapter 8.

Finally, Chapter 9 examines securitization, the packaging and sale of loans as marketable securities, which FIs use to manage several of these risks at once (and which, used badly, helped cause the GFC).

These risks are not independent. A rise in interest rates (interest rate risk) can push borrowers into default (credit risk), depress the value of trading assets (market risk), and trigger deposit outflows (liquidity risk). Good FI management means understanding the risks jointly, and the remainder of this book builds the tools to do so.

Key Terms

• Adverse selection: the hidden information problem, arising before a transaction, in which lenders cannot distinguish good credit risks from bad, so that raising interest rates tends to drive away safe borrowers and attract risky ones.
• Asset transformation: the FI function of issuing low risk, liquid secondary securities to savers and investing the proceeds in the riskier, less liquid primary securities of borrowers.
• Asymmetric information: a situation in which one party to a transaction (typically the borrower) knows more about its prospects and intentions than the other party (the lender).
• Authorized deposit-taking institution (ADI): an institution licensed by APRA to accept deposits in Australia, including banks, building societies, and credit unions.
• Brokerage function: the FI function of assisting direct finance by providing information and transaction services as an agent for a fee, without becoming a principal.
• Capital adequacy: the regulatory requirement that an FI hold a minimum cushion of equity capital to absorb unexpected losses.
• Credit risk: the risk that promised cash flows from loans and securities are not paid in full.
• Depository institution (DI): an FI that accepts deposits and makes loans.
• Direct finance: the channeling of funds from savers to users through the sale of primary securities directly to savers, without an intermediary.
• Diversification: spreading investments (or funding sources) across many imperfectly correlated exposures to reduce overall risk.
• Economies of scale: the reduction in average cost per unit (of investment, information collection, or transacting) as scale increases.
• Foreign exchange risk: the risk that exchange rate changes affect the value of assets and liabilities denominated in foreign currencies.
• Indirect finance: the channeling of funds from savers to users through an intermediary that issues secondary securities to savers and holds primary securities of borrowers.
• Interest rate risk: the risk to an FI's earnings and value from changes in interest rates, arising from mismatched maturities of assets and liabilities.
• Liquidity risk: the risk that a sudden surge in liability withdrawals forces an FI to liquidate assets quickly and at low prices.
• Moral hazard: the hidden action problem, arising after a transaction, in which a borrower takes actions (such as choosing riskier projects) that harm the lender's interests.
• Negative externality: a cost imposed by one party's actions (such as an FI's failure) on others who are not party to the transaction.
• Off-balance-sheet (OBS) activities: contingent items, such as commitments, guarantees, and derivatives, that are not on the balance sheet today but move onto it when a contingent event occurs.
• Operational risk: the risk that technology or support systems malfunction or break down, including fraud and errors.
• Price risk: the risk that the market price of a security changes significantly, reducing the value of a saver's investment.
• Primary securities: securities issued by the ultimate users of funds (corporations and governments), such as shares, bonds, and loans.
• Secondary securities: claims issued by FIs to savers, such as deposits, insurance policies, and fund units, backed by the FI's holdings of primary securities.
• Sovereign risk: the risk that a foreign borrower cannot repay because its government prohibits or limits repayment.
• Transaction costs: the costs of executing financial trades, such as fees and spreads, which weigh most heavily on small investors.

Chapter Summary

1. The financial system has five parts: money, financial instruments, financial markets, financial institutions, and regulators. Its two central roles are channeling savings to investment and enabling risk sharing; doing both well produces an efficient allocation of capital and higher output (Section 1.2).
2. In direct finance, households buy primary securities directly from corporations. Doing so exposes them to four costs and risks: information and monitoring costs (rooted in asymmetric information, which creates adverse selection before the transaction and moral hazard after it), liquidity costs, price risk, and transaction costs. The adverse selection example showed that raising the interest rate from 5% to 10% lowered the lender's expected return from -21.25% to -45% by driving out the safe borrower; the moral hazard example showed that a borrower with a $1,050 debt prefers a risky project with expected profit $525 to a safe one with expected profit $1. Left unsolved, these problems shrink the flow of funds and raise the riskiness of investment (Section 1.3).
3. FIs solve these problems through the asset transformation function (issuing safe, liquid secondary securities and holding primary securities) and the brokerage function (agency services for a fee). FIs reduce information costs through delegated monitoring and economies of scale, liquidity costs through diversified funding (a 4-depositor FI keeps at least $1,000 with probability 97.28% versus 96% for a 2-depositor FI of equal size), price risk through portfolio diversification, and transaction costs through bulk transacting (Section 1.4).
4. Because their services are crucial and their failure creates negative externalities, FIs are regulated far more heavily than ordinary firms, a specialness demonstrated by the trillion dollar GFC bailouts (TARP in the US; Lloyds and RBS in the UK). Regulation takes six forms: safety and soundness, investor protection, consumer protection, monetary policy, credit allocation, and entry regulation. In Australia, APRA handles prudential regulation, ASIC handles market integrity and consumer protection, and the RBA handles monetary policy and financial stability (Section 1.5).
5. The main types of FIs are depository institutions (in Australia, ADIs: banks, building societies, and credit unions), finance companies, securities firms and investment banks, superannuation and managed funds, and insurance companies. Australian banking is highly concentrated in the Big 4 and has shifted toward housing lending and off-balance-sheet activity (Section 1.6).
6. The major risks of FIs, and the roadmap for this book, are interest rate risk (Chapters 2 and 3), credit risk (Chapters 4 and 5), FX and sovereign risk (Chapter 5), liquidity risk (Chapter 6), capital adequacy (Chapter 7), market, OBS, technology, and operational risk (Chapter 8), and securitization (Chapter 9) (Section 1.7).

End-of-Chapter Questions

1. List the five parts of the financial system and briefly describe the role each plays. Which two roles does the financial system as a whole perform?
2. Define direct finance and indirect finance. In your answer, explain the difference between primary securities and secondary securities, and give one example of each.
3. Explain the difference between adverse selection and moral hazard. Why is one described as a "hidden information" problem and the other as a "hidden action" problem? What is the standard solution to each?
4. Households could, in principle, screen and monitor borrowers themselves. Give three reasons why FIs can perform screening and monitoring more effectively than individual households.
5. "If a lender is worried about lending to risky borrowers, it should simply charge a higher interest rate to compensate." Using the logic of adverse selection, explain what is wrong with this statement.
6. Why are FIs regulated more heavily than ordinary commercial firms? In your answer, use the concept of negative externalities and refer to at least two of the six forms of regulation.
7. Identify the three main financial regulators in Australia and state the primary responsibility of each. For each one, name a US institution that performs a broadly similar role.
8. (Numerical) Two firms each seek a $1,000 loan for one year. The safe firm's project returns $1,060 with certainty. The risky firm's project returns $2,400 with probability 0.5 and $0 with probability 0.5. The lender cannot tell the firms apart and lends to any firm willing to borrow, with each firm type equally likely. (a) If the lender charges 5% interest, which firms borrow, and what is the lender's expected return? (b) If the lender charges 8% interest, which firms borrow, and what is the lender's expected return? (c) What do your answers illustrate?
9. (Numerical) A firm borrows $1,000 at 6% interest (so it owes $1,060). It can invest in a safe project returning $1,070 with certainty, or a risky project returning $2,200 with probability 0.4 and $0 with probability 0.6. The firm's owners have limited liability. (a) Compute the firm's expected profit under each project. Which does it choose? (b) Compute the lender's expected return under each project. (c) Which feature of the debt contract drives the firm's choice, and what can the lender do about it?
10. (Numerical) The probability that any one household withdraws its deposit over the next year is 20%, and withdrawal needs are independent across households. FI X has 2 depositors of $1,000 each; FI Y has 4 depositors of $500 each; FI Z has 5 depositors of $400 each. For each FI, compute the probability that at least $1,000 of deposits remains at year end. Rank the three FIs and explain the pattern.
11. (Numerical) Using the same setting as Question 10, compute the expected value of end-of-year deposits for FI X and FI Y, and the standard deviation of end-of-year deposits for each. What do you notice about the expected values, and what does the comparison of standard deviations tell you about why FIs diversify their funding?
12. For each of the following FIs, give one example of a primary security the FI typically invests in and one example of a secondary security it issues to savers: (a) a bank; (b) a superannuation fund or managed fund; (c) an insurance company; (d) a finance company. Explain why a securities firm acting purely as a broker does not fit this pattern.