1. Financial Markets and Banks
1.1 Roles of the Financial Markets
In Financial Intermediation, the main functions of the financial markets are summarized as monitoring, signaling, smoothing, providing liquidity, and improving capital allocation. In A Conceptual Framework for Analyzing the Financial Environment, the roles of the financial system consist of the following 6 basic functions:
(1) Clearing and Settling Payments: The financial markets allow for the exchange of payments for goods and services.
(2) Pooling Resources and Subdividing Shares: The financial markets allow firms to borrow from pooled resource of multiple investors and allow investors to diversify by investing in various…show more content… Banks use on-demand retail deposits and other short-term wholesale funding to finance longer-term loans and offer liquid asset to savers.
(2) Liquidity Transformation
Liquidity provision is essential to financial intermediation. In Financial Intermediaries and Liquidity Creation, the key insight is that bank debts need to be information-insensitive and thus provide liquidity. Most banks are required to hold only a portion of their bank deposits as cash available for immediate withdrawals. Therefore, the assets of a bank are less liquid than its liabilities.
(3) Credit Transformation
Credit transformation involves the arbitrage of a bank’s credit risk by making loans and investing in securities with a lower credit standing and higher yield than the bank’s financing instruments.
Banks also facilitate the clearing and settling of payments and help overcome asymmetrical information.
2. Wholesale Funding
2.1 Repurchase Agreement (Repo)
How it functions:
A repo is selling a security with a promise to redeem it in the future. In substance, a repo is a collateralized loan.
For bilateral repo, borrower and lender transact directly with one another. In a bilateral repo, the borrower sells a security to the lender on the understanding that the borrower will repurchase the security on the following day at a premium, which is implicitly an interest payment to the lender for the use of its funds.