Chapter 01 - Why Are Financial Institutions Special?
1-1
Solutions for End-of-Chapter Questions and Problems: Chapter One
1. What are five risks common to all financial institutions?
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 risks.
2. Explain how economic transactions between household savers of funds and corporate users
of funds would occur in a world without financial institutions.
In a world without FIs the users of corporate funds in the economy would have to directly
approach the household savers of funds in order to satisfy their borrowing needs. This process
would be extremely costly because of the up-front 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 would dampen the flow of funds
between household savers of funds and corporate users of funds in an economic world
without financial institutions.
Investors generally are averse to directly purchasing securities 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 securities
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 which may be
available. Finally, 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 FIs perform that would enable the smooth flow of
funds from household savers to corporate users.
FIs serve as conduits between users and savers of funds by providing a brokerage function and
by engaging in an asset transformation function. The brokerage function can benefit both savers
and users of funds and can vary according to the firm. FIs may provide only 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.

Chapter 01 - Why Are Financial Institutions Special?
1-2
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?
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 by FIs
whose financial claims therefore are 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 financial institutions act as delegated monitors. What secondary benefits often
accrue to the entire financial system because of this monitoring process?
By putting excess funds into financial institutions, individual investors give to the FIs the
responsibility of deciding who should receive the money and of ensuring that the money is
utilized properly by the borrower. In this sense, depositors have delegated the FI to act as a
monitor on their behalf. Further, the FI can collect information more efficiently than individual
investors. The FI can utilize 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 providers 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?
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
experienced when household savers invest directly in securities issued by corporations?
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 the failure to adequately monitor the
activities of the borrower. 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

Chapter 01 - Why Are Financial Institutions Special?
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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 financial institutions solve the problem of high information collection costs
for lenders, borrowers, and financial markets?
One way financial institutions solve this problem is that they develop of 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.
10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy
securities issued by corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand. Commercial
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 realize the benefits of investing in primary assets without accepting the
liquidity risk of direct investment.
11. How do financial institutions help individual savers diversify their portfolio risks? Which
type of financial institution is best able to achieve this goal?
Money placed in any financial institution will result in a claim on a more diversified portfolio.
Banks lend money to many different types of corporate, consumer, and government customers.
Insurance companies have investments in many different types of assets. Investments in a mutual
fund may generate the greatest diversification benefit because of the fund’s investment in a wide
array of stocks and fixed income securities.
12. How can financial institutions invest in high-risk assets with funding provided by low-risk
liabilities from savers?
Diversification of risk occurs with investments in assets whose returns 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 assets in which the individual has invested.
Thus, individual investors realize some of the returns of high-risk assets without accepting the
corresponding risk characteristics.
13. How can individual savers use financial institutions to reduce the transaction costs of
investing in financial assets?
By pooling the assets of many small investors, FIs can gain economies of scale in transaction
costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or
purchasing assets in the money and capital markets. In either case, operating activities that are

Chapter 01 - Why Are Financial Institutions Special?
1-4
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 institutions?
If net borrowers and net lenders have different optimal time horizons, FIs can service both
sectors by matching their asset and liability maturities through on- and off-balance sheet hedging
activities and flexible access to the financial markets. 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 utilizing liabilities that
have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and
other derivative products.
15. What are five areas of institution-specific FI specialness and which types of institutions are
most likely to be the service providers?
First, commercial banks and other depository institutions are key players for the transmission of
monetary policy from the central bank to the rest of the economy. Second, specific FIs often are
identified as the major source of financing for certain sectors of the economy. For example,
savings institutions traditionally serve the credit needs of the residential real estate market.
Third, life insurance companies and pension funds commonly are encouraged to provide
mechanisms to transfer wealth across generations. Fourth, depository institutions efficiently
provide payment services to benefit the economy. Finally, mutual funds provide denomination
intermediation by allowing small investors to purchase pieces of assets with large minimum sizes
such as negotiable CDs and commercial paper issues.
16. How do depository institutions such as commercial banks assist in the implementation and
transmission of monetary policy?
The Federal Reserve Board can directly involve commercial banks in the implementation of
monetary policy through changes in the reserve requirements and the discount rate. The open
market sale and purchase of Treasury securities by the Fed involves banks in 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?
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.

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Solution Manual for Financial Institutions Management: A Risk Management Approach, 8th Edition

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