Lange 4e Chapter 1 End of Chapter Solutions

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Chapter 1 Why are financial institutions special?

Chapter outline
Financial institutions’ specialness
FI function as broker
FI function as asset transformer
Information costs
Liquidity and price risk
Other special services
Other aspects of specialness
The transmission of monetary policy
Credit allocation
Intergenerational wealth transfers or time intermediation
Payment services
Denomination intermediation
Specialness and regulation
Safety and soundness regulation
Monetary policy regulation
Credit allocation regulation
Consumer and investor protection regulation
Entry regulation
The changing dynamics of specialness
Trends in Australia
Global trends
The rise of financial services holding companies
The shift away from risk measurement and management and the global financial crisis

Appendix 1A: The US sub-prime crisis, the global financial crisis and the failure of financial
services institution specialness
Appendix 1B: Implementation of monetary policy by the Reserve Bank of Australia

Learning objectives
1.1 Understand why financial institutions (FIs) are different from commercial firms (which is
why, for example, the failure of a large bank may have more serious effects on the
economy than the failure of a large steel or car producer).
1.2 Learn how financial institutions—especially banks—provide a special set of services to
households and firms.
1.3 Discover why FIs’ very specialness results in increased regulation and regulatory
oversight that other corporations do not require, which imposes a regulatory burden on
financial institutions.
1.4 Gain knowledge of how regulation can and does affect the efficiency with which financial
institutions produce financial services.
1.5 Understand how the failure of FIs to perform the specialist functions of risk measurement
and management can lead to systemic risk in the domestic and global financial systems.
1.6 Comprehend the causes of the sub-prime crisis in the US and how this led to the global
financial crisis.

Overview of chapter
The major theme of this book is the measurement and management of the risks of financial
institutions (FIs). Although we might categorise or group FIs and label them ‘life insurance
companies’, ‘banks’, ‘finance companies’ and so on, the particular risks that they face are
more common than different. Specifically, all the FIs described in this chapter (1) hold some
assets that are potentially subject to default or credit risk and (2) tend to mismatch the
maturities of their balance sheets to a greater or lesser extent and are thus exposed to interest

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rate risk. Moreover, all are exposed to some type of underwriting risk, whether through the
sale of securities or by issuing various types of credit guarantees on or off the balance sheet.
Finally, all are exposed to operating cost risks because the production of financial services
requires the use of real resources and back-office support systems.
This chapter describes the various factors and forces impacting FIs and the specialness of
the services they provide. These forces suggest that in the future, FIs that have historically
relied on making profits by performing traditional special functions—such as asset
transformation and the provision of liquidity services—will need to expand into selling
financial services that interface with direct security market transactions, such as asset
management, insurance and underwriting services. This is not to say that specialised or niche
FIs cannot survive, but rather that only the most efficient FIs will prosper as the competitive
value of a specialised FI charter declines.
Because of these risks and the special role that FIs in particular play in the financial
system, FIs are singled out for special regulatory attention. In this chapter, we first examine
questions related to this specialness. In particular, what are the special functions that FIs—
both depository institutions (banks, building societies and credit unions) and non-depository
institutions (insurance companies, securities brokers, investment banks, finance companies
and managed funds)—provide? How do these functions benefit the economy? Second, we
investigate what makes some FIs more special than others. Third, we look at how unique and
long-lived the special functions of FIs really are. As a part of this discussion, we briefly
examine how changes in the way FIs deliver services played a major part in the events leading
up to the global financial crisis (GFC), commencing in the late 2000s. A more detailed
discussion of the causes of major events during and regulatory and industry changes resulting
from the financial crisis is provided in Appendix 1A to the chapter. Appendix 1B describes
the way the RBA decides and carries out monetary policy in Australia.

Chapter 1 Teaching Suggestions


This chapter is very useful to commence any course on financial institutions management or
bank management. Or indeed any course which examines regulatory structures and the
reasons for them.
One way to commence the topic is to ask the question ‘Why are the banks, or more
generally, the financial services industry, so heavily regulated?’ One of the answers to this
question is the special nature of the financial institutions and the role that they play in the
transition of money in the economy—and the transmission of government policy (both fiscal
and monetary). A follow-up question could be ‘why do we have a course specifically on the
management of banks/FIs—that is, why are they different from other businesses?’ This
question allows the development of a discussion of the specific products, the interaction with
customers—that is, the facilitation of business through financial transactions, etc., and the role
of FIs in enabling business to take place. It also allows for a discussion of the ways that FIs
affect the economy as a whole and not just a specific part (such as manufacturing).
From here, it is possible to develop a discussion of the economy with and without banks—
and the role of intermediation in assisting commerce, and from this develop the discussion of
the various functions of FIs which are useful.
For example, ask students to think about the different roles that FIs may undertake which
assist business activity:
1. Monitoring function
2. Intermediation
a. Liquidity intermediation
b. Currency intermediation
c. Time intermediation

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d. Asset intermediation
e. Risk intermediation
3. Transmission of monetary policy and role in funding for fiscal policy through
purchase and sale of government bonds
4. Credit allocation mechanisms
5. Payment system and the transmission of payments generally

As each of these points arise in the discussion, the lecturer can expand on each and provide
examples from their own experience and draw on the experience of students to bring the topic
alive. Encouraging students to see the relevance of this discussion to their own lives at this
point in the subject will assist you in making the important point about the need for
conservative management of FIs—to protect our savings and future financial health and
capability—and more generally, to protect the future underlying financial security of the
Australian economy.
It is important to set the tone for the subject in this introductory lecture, using Chapter 1,
as by capturing the imagination of students through their own experience and expression, they
will better understand why the identification of risks in FIs is so important, as of course is the
management of those risks.
From an understanding of the role of FIs’ various functions, and their impact on the
economy, it is an easy step to argue why FIs are regulated. You may like to ask some
questions about potential scenarios such as:
1. What would happen if you couldn’t withdraw your money from the bank?
2. What would happen if none of the banks would lend to you to buy a house?
3. What would happen if the banks would not lend to small businesses?
4. What would happen if you had to wait two weeks to withdraw your funds?
5. What would happen if you could only withdraw US dollars, and not Australian
dollars?
6. What would happen if you could only use cheques and these are only cleared on a
weekly basis?
7. What if my bank deposits were not safe?
8. What if all of my bank’s deposits were invested in high risk entrepreneurial activities?
9. Who can open and bank—or what businesses can call themselves a bank?

From these types of questions, you can then discover through discussion of the issues
involved, the types of regulation that may be useful, so that a set of main types of regulations
are identified:
1. Safety—capital and liquidity regulation
2. Monetary policy regulation
3. Credit allocation regulation
4. Consumer protection regulation
5. Investor protection regulation
6. Entry and chartering regulation

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Throughout the discussion, you should emphasise the risks faced by FIs and the
importance of their management. The fact that much of the regulation of FIs is towards the
limit on risk taking is a particularly important point.
The changing structure and dynamics of the FI firm in the modern global financial markets
should also be examined through a discussion of the modern versus the traditional product
type FI: that is, now we have FI conglomerates/holding companies which provide all types of
financial services, whereas only 30 years ago, we had banks, insurance companies, fund
managers, etc., each providing one type of service. The Australian and global trends are
telling, and this could lead to a discussion of how the changing structure of FIs may have
changed the effectiveness of risk management within these FIs. You may also wish to discuss
in more detail the role of this particular issue in the causes and consequences of the global
financial crisis of the late 2000s—a great case study, and which is the subject of Appendix
1A. Depending on the subject curriculum, the next chapter covered could be either Chapters 2
and 3 (which describe the institutional characteristics of depository institutions and other FIs)
or Chapter 4, which introduces students to the key financial risks faced by FIs.

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Answers to end-of-chapter questions

Questions and problems


1 What are five risks common to financial institutions? LO 1.1

Default or credit risk of assets; interest rate risk caused by maturity mismatches between
assets and liabilities; liability withdrawal or liquidity risk; underwriting risk; and operating
cost risks.

2 Explain how economic transactions between household savers of funds and corporate
users of funds would occur in a world without FIs. LO 1.1, 1.2

In a world without FIs, the users of corporate funds in the economy would have to approach
the household savers of funds directly in order to satisfy their borrowing needs. This process
would be extremely costly because of the upfront information costs faced by potential lenders.
Cost inefficiencies would arise with the identification of potential borrowers, the pooling of
small savings into loans of sufficient size to finance corporate activities and the assessment of
risk and investment opportunities. Moreover, lenders would have to monitor the activities of
borrowers over each loan’s life span. The net result would be an imperfect allocation of
resources in an economy.

3 Identify and explain three economic disincentives that probably would dampen the flow
of funds between household savers of funds and corporate users of funds in an economic
world without FIs. LO 1.2

Investors generally are averse to purchasing securities directly because of (a) monitoring
costs, (b) liquidity costs and (c) price risk. Monitoring the activities of borrowers requires
extensive time, expense and expertise. As a result, households would prefer to leave this
activity to others and, by definition, the resulting lack of monitoring would increase the
riskiness of investing in corporate debt and equity markets. The long-term nature of corporate
equity and debt would likely eliminate at least a portion of those households willing to lend
money, as the preference of many for near-cash liquidity would dominate the extra returns
that may be available. Third, the price risk of transactions on the secondary markets would
increase without the information flows and services generated by high volume.

4 Identify and explain the two functions in which FIs may specialise that enable the smooth
flow of funds from household savers to corporate users. LO 1.1, 1.2

FIs serve as conduits between users and savers of funds by providing a brokerage function
and by engaging in the asset transformation function. The brokerage function can benefit both
savers and users of funds and can vary according to the firm. FIs may only provide transaction
services—such as discount brokerages—or they also may offer advisory services which help
reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation
function is accomplished by issuing their own securities, such as deposits and insurance
policies that are more attractive to household savers and using the proceeds to purchase the
primary securities of corporations. Thus, FIs take on the costs associated with the purchase of
securities.

5 In what sense are the financial claims of FIs considered secondary securities, while the
financial claims of commercial corporations are considered primary securities? How does
the transformation process, or intermediation, reduce the risk, or economic disincentives,
to the savers? LO 1.2

The funds raised by the financial claims issued by commercial corporations are used to invest
in real assets. These financial claims, which are considered primary securities, are purchased

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by FIs whose financial claims are therefore considered secondary securities. Savers who
invest in the financial claims of FIs are indirectly investing in the primary securities of
commercial corporations. However, the information-gathering and evaluation expenses,
monitoring expenses, liquidity costs and price risk of placing the investments directly with the
commercial corporation are reduced because of the efficiencies of the FI.

6 Explain how FIs act as delegated monitors. What secondary benefits often accrue to the
entire financial system because of this monitoring process? LO 1.2

By putting excess funds into FIs, individual investors give to the FIs the responsibility of
deciding who should receive the money and of ensuring that the money is utilised properly by
the borrower. In this sense the depositors have delegated the FI to act as a monitor on their
behalf. The FI can collect information more efficiently than individual investors. Further, the
FI can utilise this information to create new products, such as commercial loans, that
continually update the information pool. This more frequent monitoring process sends
important informational signals to other participants in the market, a process that reduces
information imperfection and asymmetry between the ultimate sources and users of funds in
the economy.

7 What are five general areas of FI specialness that are caused by providing various services
to sectors of the economy? LO 1.2

First, FIs collect and process information more efficiently than individual savers. Second, FIs
provide secondary claims to household savers which often have better liquidity characteristics
than primary securities such as equities and bonds. Third, by diversifying the asset base FIs
provide secondary securities with lower price–risk conditions than primary securities. Fourth,
FIs provide economies of scale in transaction costs because assets are purchased in larger
amounts. Finally, FIs provide maturity intermediation to the economy, which allows the
introduction of additional types of investment contracts, such as mortgage loans, that are
financed with short-term deposits.

8 What are agency costs? How do FIs solve the information and related agency costs when
household savers invest directly in securities issued by corporations? What is the ‘free-
rider’ problem? LO 1.2

Agency costs occur when owners or managers take actions that are not in the best interests of
the equity investor or lender. These costs typically result from a failure to adequately monitor
the activities of the borrower. Because the cost is high, individual investors may do an
incomplete job of collecting information and monitoring under the assumption that someone
else is doing these tasks. In this case, the individual becomes a free rider. But if no other
lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy
the covenants in the lending agreement. Because the FI invests the funds of many small
savers, the FI has a greater incentive to collect information and monitor the activities of the
borrower.

9 How do large FIs solve the problem of high information collection costs for lenders,
borrowers and financial markets in general? LO 1.2

One way FIs solve this problem is that they develop secondary securities that allow for
improvements in the monitoring process. An example is the bank loan that is renewed more
quickly than long-term debt. The renewal process updates the financial and operating
information of the firm more frequently, thereby reducing the need for restrictive bond
covenants that may be difficult and costly to implement.

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10 How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest
in the securities of corporations? LO 1.2

Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, for
example, offer deposits that can be withdrawn at any time. Yet the banks make long-term
loans or invest in illiquid assets because they are able to diversify their portfolios and better
monitor the performance of firms that have borrowed or issued securities. Thus individual
investors are able to realise the benefits of investing in primary assets without accepting the
liquidity risk of direct investment.

11 How do FIs help individual savers diversify their portfolio risks? Which type of financial
institution is best able to achieve this goal? LO 1.2

Money placed in any FI will result in a claim on a more diversified portfolio. Banks lend
money to many different types of corporate, consumer and government customers, and
insurance companies have investments in many different types of assets. Investment 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.

12 How can FIs invest in high-risk assets with funding provided by low-risk liabilities from
savers? LO 1.2

Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of
an FI will be less than the average risk of the individual assets in which it has invested. Thus
individual investors realise some of the returns of high-risk assets without accepting the
corresponding risk characteristics.

13 How can individual savers use FIs to reduce the transaction costs of investing in financial
assets? LO 1.2

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.

14 What is maturity intermediation? What are some of the ways in which the risks of
maturity intermediation are managed by financial intermediaries? LO 1.2

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. For example, the FI can offer
the relatively short-term liabilities desired by households and also satisfy the demand for
long-term loans such as home mortgages. 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 utilising 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? LO 1.2

First, 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 are often
identified as the major source of finance for certain sectors of the economy. For example,

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regional banks, building societies and credit unions tend to concentrate on the credit needs of
the residential home market. Third, life insurance and superannuation funds are commonly
encouraged to provide mechanisms to transfer wealth across generations. Fourth, depository
institutions efficiently provide payment services to benefit the economy. Finally, managed
funds and unit trusts provide denomination intermediation by allowing small investors to
purchase pieces of assets with large minimum sizes such as negotiable CDs, commercial
property and commercial paper issues.

16 How do depository institutions such as banks assist in the implementation and


transmission of monetary policy? LO 1.3

The Reserve Bank of Australia (RBA) involves banks directly in the implementation of
monetary policy through changes in the reserve requirements and the official rate. The open
market sale and purchase of treasury securities by the RBA in the RBA’s open market
operations also involves the banks the implementation of monetary policy in a less direct
manner.

17 What is meant by ‘credit allocation regulation’? What social benefit is this type of
regulation intended to provide? LO 1.3

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. For example, it is presumed that 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 fulfil the intergenerational wealth transfer function? What is
this wealth transfer process? LO 1.2

Life insurance and superannuation 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 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 FIs? To what extent do
these services efficiently provide benefits to the economy? LO 1.2, 1.3

The two most important payment services are payments clearing and transmission of funds
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? LO 1.2

Denomination intermediation is the process whereby small investors are able to purchase
pieces of assets that normally are sold only in large denominations. Individual savers often
invest small amounts in managed funds, for example. The managed funds pool these small
amounts and purchase negotiable CDs, which can only be sold in minimum increments of
$100 000, but which are often sold in million dollar packages. Similarly, commercial paper is
often sold only in minimum amounts of $500 000 lots and, of course, multi-million dollar
commercial property is often purchased by managed funds. Therefore, small investors can
benefit in the returns and low risk which these assets typically offer.

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21 What is negative externality? In what ways does the existence of negative externalities
justify the extra regulatory attention received by FIs? LO 1.3, 1.4

A negative externality refers to the action by one party that has an adverse effect on some
third party who is not part of the original transaction. For example, in an industrial setting,
smoke from a factory that lowers surrounding property values may be viewed as a negative
externality. For financial institutions, one concern is the contagion effect that can arise when
the failure of one FI can cast doubt on the solvency of other institutions in that industry.

22 If financial markets operated perfectly and without cost, would there be a need for
financial intermediaries? LO 1.1, 1.2, 1.3

To a certain extent, financial intermediation exists because of financial market imperfections.


If information is available without cost to all participants, savers would not need
intermediaries to act as either their brokers or their delegated monitors. However, if there are
social benefits to intermediation, such as the transmission of monetary policy or credit
allocation, then FIs would exist even in the absence of financial market imperfections.

23 Why are FIs among the most regulated sectors in the world? When is net regulatory
burden positive? LO 1.3, 1.4

FIs are required to enhance the efficient operation of the economy. Successful financial
intermediaries provide sources of financing that fund economic growth opportunity that
ultimately raises the overall level of economic activity. Moreover, successful financial
intermediaries provide transaction services to the economy that facilitate trade and wealth
accumulation.

Conversely, distressed FIs create negative externalities for the entire economy. That is, the
adverse impact of an FI failure is greater than just the loss to shareholders and other private
claimants on the FI’s assets. For example, the local market suffers if an FI fails and other FIs
may also be thrown into financial distress by a contagion effect. Therefore, since some of the
costs of the failure of an FI are generally borne by society at large, the government intervenes
in the management of these institutions to protect society’s interests. This intervention takes
the form of regulation.

However, the need for regulation to minimise social costs may impose private costs on the
firms that would not exist without regulation. This additional private cost is defined as a net
regulatory burden. Examples include the cost of holding excess capital and/or excess reserves
and the extra costs of providing information. Although they may be socially beneficial, these
costs add to private operating costs. To the extent that these additional costs help to avoid
negative externalities and to ensure the smooth and efficient operation of the economy, the net
regulatory burden is positive.

24 What forms of protection and regulation do regulators of FIs impose to ensure their safety
and soundness? LO 1.3, 1.4

Regulators have issued several guidelines to insure the safety and soundness of FIs:
(a) FIs are required to diversify their assets. For example, banks must get special
permission from the regulators to lend more than 10 per cent of their equity to a single
borrower.
(b) FIs are required to maintain minimum amounts of capital to cushion any unexpected
losses. In the case of banks, the Basel standards require a minimum core and
supplementary capital of 8 per cent of their risk-adjusted assets.

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(c) The Australian Banking Act requires regulators to protect Australian dollar depositors
and, as such, while this does not represent a guarantee of deposits, it requires positive
action by regulators to protect depositor funds.
(d) Regulators also engage in periodic monitoring and surveillance, such as on-site
examinations, and request periodic information from the FIs.

25 In the transmission of monetary policy, what is the difference between inside money and
outside money? How does the Reserve Bank of Australia (RBA) try to control the amount
of inside money? How can this regulatory position create a cost for the depository
financial institutions? LO 1.3, 1.4

Outside money is that part of the money supply directly produced and controlled by the RBA,
for example, coins and currency. Inside money refers to bank deposits not directly controlled
by the RBA. The RBA and central banks more generally can influence this amount of money
by reserve requirement and official interest rate policies. In cases where the level of required
reserves exceeds the level considered optimal by the FI, the inability to use the excess
reserves to generate revenue may be considered a tax or cost of providing intermediation.

26 What are some examples of credit allocation regulation? How can this attempt to produce
social benefits create costs to the private institution? LO 1.3, 1.4

In the US, the qualified thrift lender test (QTL) requires savings and loans organisations to
hold 65 per cent of their assets in residential mortgage-related assets to retain the thrift
charter. Some US states have also enacted usury laws that place maximum restrictions on the
interest rates that can be charged on mortgages and/or consumer loans. These types of
restrictions often create additional operating costs for the FI and almost certainly reduce the
amount of profit that could be realised without such regulation. There is no such regulation in
Australia.

27 How do regulations regarding barriers to entry and the scope of permitted activities affect
the charter value of FIs? LO 1.3, 1.4

The profitability of existing firms will be increased as the direct and indirect costs of
establishing competition increase. Direct costs include the actual physical and financial costs
of establishing a business. In the case of FIs, the financial costs include raising the necessary
minimum capital to receive a charter. Indirect costs include permission from regulatory
authorities to receive a charter. Again, in the case of FIs, this cost involves acceptable
leadership to the regulators. As these barriers to entry are stronger, the charter value for
existing firms will be higher.

28 What reasons have been given for the growth of superannuation funds and investment
companies at the expense of ‘traditional’ banks and insurance companies? LO 1.3

The recent growth of superannuation funds and investment companies can be attributed to
three major factors:
(a) Investors have demanded increased access to direct securities markets. Investment
companies and superannuation funds allow investors to take positions in direct
securities markets while still obtaining the risk diversification, monitoring and
transactional efficiency benefits of financial intermediation. Some experts would
argue that this growth is the result of increased sophistication on the part of investors;
others would argue that the ability to use these markets has caused the increased
investor awareness. The growth in these assets is inarguable.
(b) Recent episodes of financial distress in both the banking and insurance industries
have led to an increase in regulation and governmental oversight, thereby increasing
the net regulatory burden of ‘traditional’ companies. As such, the costs of

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intermediation have increased, which increases the cost of providing services to
customers.
(c) The legislation requiring compulsory superannuation for all working people in
Australia since the late 1980s has significantly increased the funds of superannuation
funds and a consequent reduction in savings in traditional forms of investment such as
bank deposits.

29 What significant events in the US in particular, but which spread globally, resulted from
the trend for banks to shift from the traditional banking model of ‘originate and hold’ to a
model of ‘originate and distribute’? LO 1.4, 1.5

A major event that changed and reshaped the financial services industry was the financial
crisis of the late 2000s. As FIs in the US moved to an ‘originate and distribute’ model, one
result was a dramatic increase in systemic risk of the financial system, caused in large part by
a shift in the banking model from that of ‘originate and hold’. In the traditional model, banks
take short-term deposits and other sources of funds and use them to fund longer term loans to
businesses and consumers. Banks typically hold these loans to maturity and thus have an
incentive to screen and monitor borrower activities even after a loan is made. However, the
traditional banking model exposes the institution to potential liquidity, interest rate and credit
risk. In attempts to avoid these risk exposures and generate improved return–risk trade-offs,
banks shifted to an underwriting model in which they originated or warehoused loans and
then quickly sold them. Indeed, most large banks organised as financial service holding
companies to facilitate these new activities. These innovations removed risk from the balance
sheet of financial institutions and shifted risk off the balance sheet and to other parts of the
financial system. Since the FIs, acting as underwriters, were not exposed to the credit,
liquidity and interest rate risks of traditional banking, they had little incentive to screen and
monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as
specialists in risk measurement and management.

30 How did the boom in the housing market in the early and mid-2000s exacerbate FIs’
transition away from their role as specialists in risk measurement and management? LO
1.4, 1.5

The boom (‘bubble’) in the housing markets began building in 2001, particularly after the
terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to
create stability in the financial markets by providing liquidity to FIs. For example, the Federal
Reserve lowered the short-term money market rate that banks and other financial institutions
pay in the federal funds market and even made lender of last resort funds available to non-
bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the
increased liquidity provided by central banks resulted in a rapid expansion in consumer,
mortgage and corporate debt financing. Demand for residential mortgages and credit card debt
rose dramatically. As the demand for mortgage debt grew, especially among those who had
previously been excluded from participating in the market because of their poor credit ratings,
FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the
market now popularly known as the ‘sub-prime market’, banks and other mortgage-supplying
institutions often offered relatively low ‘teaser’ rates on adjustable rate mortgages (ARMs) at
exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate
period expired two or three year later and if market rates rose in the future. Under the
traditional banking structure, banks might have been reluctant to so aggressively pursue low
credit quality borrowers for fear that the loans would default. However, under the originate-
to-distribute model of banking, asset securitisation and loan syndication allowed banks to
retain little or no part of the loans and hence the default risk on loans that they originated.
Thus, as long as the borrower did not default within the first months after a loan’s issuance
and the loans were sold or securitised without recourse back to the bank, the issuing bank

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(c) McGraw-Hill Education (Australia) 2015
could ignore longer term credit risk concerns. The result was deterioration in credit quality, at
the same time as there was a dramatic increase in consumer and corporate leverage.

Web questions
31 Go to the APRA website, and list the features and bank ‘specialness’ described in this
chapter and identify the related regulation and legislation for each of the ‘specialness’
features. LO 1.3, 1.4

The answer will depend on the date of the assignment. At the APRA website, click on
‘Authorised Deposit-taking Institutions’. Then click on ‘ADI Prudential Standards and
Guidance Notes’ and investigate the various legislation and its match to the key items of
specialness identified in the chapter.

32 Go to the website of the Reserve Bank of Australia and find details of the way the RBA
implements monetary policy. See www.rba.gov.au/monetary-policy/about.html, for
example, and answer the following questions: LO 1.3, 1.4
1 What are the tools used by the RBA to implement monetary policy?
2 How does a decrease in the target cash rate affect credit availability and money
supply?
3 Which of the monetary tools available to the RBA is used most often? Why?

The answer will depend on the date of the assignment. At the website, click on ‘Monetary
Policy’ and then read the material provided on the site to answer the questions asked.

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(c) McGraw-Hill Education (Australia) 2015

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