I.  Financial Institutions

• Provider of financial services such as
• transforming financial assets in terms of maturity of liquidity  (these are financial intermediaries)
• trading financial assets for themselves and others
• creating financial assets and then selling those assets on the behalf of customers
• giving professional investment advice to others
• managing investment portfolios for others
• Depository institutions acquire most of their funds through accepting deposits
• Non depository institutions receive funds from other sources

• Make direct investments by purchasing bonds, stocks or making loans.  These are their assets
• Raise money for these investments by issuing their own financial assets such as deposits, insurance policies, mutual fund shares.  These are liabilities for the intermediary and are indirect investments for the investors.
• The activities above accomplish several things:
• maturity intermediation
• diversification with limited funds
• reduction of transactions costs
• facilitating payment mechanisms

• Not all liabilities of financial intermediaries are created equal!  They differ in terms of the certainty of their amount and timing
• Type I liabilities:  timing and amount are certain
• example:  bank fixed rate CD.  Bank knows how much it owes the depositor and when.
• Type II liabilities:  amount is certain but timing is not
• example:  term life insurance policy.  Insurance company knows amount of policy but uncertain when the policy holder will die.
• Type III liabilities:  amount is not certain but timing is
• example:  variable rate CD.  Bank knows the maturity date, but the interest owed is not known when the CD is issued.
• Type IV liabilities:  time and amount are uncertain
• example:  auto insurance policy.  The timing and payout for an auto accident is not known when the policy is issued.
• The type of liabilities created by a financial intermediary will determine how they invest their funds (i.e. the type of assets that they hold)

• What is it?
• creation of new financial assets or new ways to use financial assets
• Why does it happen?
• changing circumstances:  increased volatility in interest rates, stock prices and exchange rates led to the development of derivative securities
• advances in technology make new trading strategies feasible
• competition among institutions for unique products and strategies
• desire to circumvent regulations or tax laws
• greater ability of market professionals to understand and price complex securities and strategies
• Example:  Asset Securitization
• process where individual loans are pooled together and securities are issued with payments backed by the pool of loan payments
• common for mortgage loans
• old way:  bank originates a mortgage and holds the loan until it is paid off
• new way:  bank originates mortgage, sells loan to other institution for securitization
• advantages
• frees up capital for new loans
• loans are more liquid, so easier and cheaper to get loans
• spreads around the default and interest rate risk of the loans
• different institutions can specialize in different steps in the process