Instructors Resource Manual ta Financial Institutions Management 4e by Lange, Saunders Cornett

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 1 of 12 (c) McGraw-Hill Education (Australia) 2015 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 (Financial Institutions Management (Australian Edition) 4e Lange Saunders Millon) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 3

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 2 of 12 (c) McGraw-Hill Education (Australia) 2015 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:

• Monitoring function
• Intermediation
• Liquidity intermediation
• Currency intermediation
• Time intermediation 2 / 3

Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 3 of 12 (c) McGraw-Hill Education (Australia) 2015

• Asset intermediation
• Risk intermediation
• Transmission of monetary policy and role in funding for fiscal policy through

purchase and sale of government bonds

• Credit allocation mechanisms
• 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:

• What would happen if you couldn’t withdraw your money from the bank?
• What would happen if none of the banks would lend to you to buy a house?
• What would happen if the banks would not lend to small businesses?
• What would happen if you had to wait two weeks to withdraw your funds?
• What would happen if you could only withdraw US dollars, and not Australian

dollars?

• What would happen if you could only use cheques and these are only cleared on a

weekly basis?

• What if my bank deposits were not safe?
• What if all of my bank’s deposits were invested in high risk entrepreneurial activities?
• 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:

• Safety—capital and liquidity regulation
• Monetary policy regulation
• Credit allocation regulation
• Consumer protection regulation
• Investor protection regulation
• Entry and chartering regulation
• / 3