Imagine that you are the president of Blue Skies Airlines, Inc. and you have decided that Blue Skies should buy a new Boeing 777. The plane will cost $125 million and change. There is one small problem though. Blue Skies only has a few million dollars in its bank account, and those funds are needed to pay fuel bills and the salaries of its employees. How can Blue Skies get enough money to buy this new airplane? It can by tapping into the savings flows of the economy, and this chapter explains how that actually happens.

Blue Skies Airlines might approach the First National Bank and ask for a loan of $125 million. If First National agrees to make the loan, it will require Blue Skies to sign a contract agreeing to certain conditions. These would include, of course, repayment of the $125 million, called the principal, according to a specified time schedule. In addition, the bankwould receive periodic interest payments. The interest to be paid is expressed as a percentage of the unpaid principal, and that percentage is called the interest rate on the loan.

Blue Skies would also be required to pledge the 777 as collateral, giving the bank the right to take possession of the plane if Blue Skies fails to make interest and principal payments on time. If that happens, Blue Skies is said to default on the loan, and the bank can go to court to enforce its contractual rights, repossessing the aircraft if necessary.

Suppose now that the interest rate on this loan is 10% per year. That means that Blue Skies will pay the bank $12,500,000 in interest the first year (assuming it does not repay any principal during the first year). Why would Blue Skies be willing to pay the bank that much money just so that it can own a new 777? Blue Skies expects to make back the interest cost and more through lower operating costs and more ticket sales.

Before making the loan, the First National Bank will study Blue Skies’ estimates of cost savings and ticket sales and it will not approve the loan unless it is convinced that the new plane will more than pay for itself.

Banks make money by collecting interest on loans, not by owning repossessed airplanes. But how did the bank get the $125 million to lend to Blue Skies? It borrowed it in much smaller amounts from households in the form of bank deposits. When a household deposits money in a bank account, it is making a loan to the bank. The depositor receives in return a combination of banking services, such as check cashing and access to automatic teller machines, and interest payments. The bank is willing to incur these costs because it lends the money to Blue Skies at a sufficiently high rate of interest to cover its interest payments to depositors and its administrative expenses and still make a profit.

Services That Banks Provide to Savers and Borrowers

Why don't Blue Skies and the households get together and cut the bank out of the deal, sharing the difference between the interest rate that the bank charges Blue Skies and the much lower interest rate that it pays its depositors? They don't because there are valuable services that the bank renders to both borrowers and savers. What are these services?

First, the borrower, Blue Skies, avoids dealing with thousands of different parties and having to negotiate separate loan contracts with each of them. Thus, Blue Skies’ transactions costs are reduced by borrowing through the bank. Household savers also enjoy lower transactions costs by using their local bank branch where deposits can be made and withdrawn very quickly without negotiation. The bank performs a retailing function for savings just as the neighborhood supermarket does for food. The bank also offers the household saver three other services: lower information costs, liquidity, and diversification.

Let’s look at these in turn.

Information about Blue Skies is costly for an individual saver to acquire. Has Blue Skies met its financial obligations in the past? Does the decision to buy another 777 appear to be a sound one? Banks specialize in collecting and analyzing information about borrowers, and certain banks will specialize further is making loans to airlines. It makes sense for savers to let specialists worry about evaluating the risk that Blue Skies might not pay its debts. On the other hand, it is easy for the saver to obtain information about the bank; for example, is it covered by deposit insurance? By dealing with the bank instead of Blue Skies the saver enjoys lower information costs.

Liquidity

Liquidity is the degree to which something of value can be turned into money on short notice and at low cost. A checking account is very liquid because it can be turned into money by simply writing a check or visiting a cash machine. Other deposits, such as certificates of deposit, are less liquid but pay a higher rate of interest. In contrast, the loan to Blue Skies is very illiquid since the airline has no obligation to make payments earlier than specified by the contract. But the bank has many such loans on which it is collecting payments, so it can offer liquidity to each of its depositors while making illiquid loans. Banks convert illiquid assets, such a the loan to Blue Skies, into liquid assets for their depositors. Providing this service has some risks, as we see below when we discuss the history of Savings and Loans, but depositors are willing to pay the bank for this valuable service.

Diversification

Diversification means spreading risk by participation in a basket of investments, and in this case it results from the participation of each depositor in all of the loans that the bank holds, so that failure of any one lender to repay has only a fractional impact on individual depositors.

In addition, deposits in US banks are insured by the Federal Deposit Insurance Corporation (FDIC), and banks are subject to regulatory oversight by government agencies. By accepting ultimate responsibility for the obligations of banks to their depositors, the government sector diversifies these risks across the economy. We have seen the dramatic realization of this in 2008 with the rescue of major banks costing hundreds of billions of dollars!

Major Types of Financial Intermediaries

Instead of borrowing from a bank, Blue Skies might borrow instead from an insurance company or a pension fund. These are different from banks but are also financial intermediaries, firms which pool the savings of households and invest them in other firms. While all financial intermediaries provide the four fundamental services to households in some degree, each type offers a particular mix of these. Each also combines them with other services which distinguish it. Let’s take a brief look at the major types of financial intermediary, in addition to banks, which are important in the U.S. economy today.

Life insurance companies

Life insurance companies offer savings plans which protect against the possibility that the saver may not live long enough to meet an objective such as putting their children through college. Because life insurance policies typically remain in force for many years, insurance companies do not need to hold highly liquid assets so they can make long-term loans to finance office buildings, airplanes, and ships. The expertise of insurance companies in this type of lending could not be duplicated by an individual, and they hold a diversified portfolio of such loans. Life insurance policies also enjoy tax benefits.

Pension funds

Pension funds accumulate the contributions employers and employees make to retirement plans. Generally, the contributions to such plans are not subject to federal income tax until they are withdrawn, and the income from these savings accumulate tax free as well. Their sheer size, professional management, and long time horizon make it possible for pension funds to engage in highly sophisticated investment strategies that would not be available to the individual employee. Assets of pension funds have grown rapidly in recent decades with the popularity of “defined contribution plans” in which the employee has ownership of funds accumulated in their name. In contrast, the older “defined benefit plans” promised only to pay a specified benefit, usually a fraction of salary at retirement based on years of service.

Mutual funds

Mutual funds pool together the savings of many individuals and invest in stocks and bonds. Mutual funds offer low transaction costs, because the saver is making one investment instead of many, and low information costs, because it is easier for savers to get information on one mutual fund than on hundreds of individual stocks and bonds.

Mutual fund shares are also extremely liquid. Most mutual funds are “open-end” funds that stand ready to redeem existing shares and sell new ones every day at net asset value, the market value of the fund’s portfolio divided by the number of shares. This is possible because mutual funds are permitted to invest only in marketable securities, stocks and bonds for which a market price can readily be determined from recent transactions. Mutual funds also provide a high degree of diversification because they invest in a large number of different securities, often hundreds. However, mutual funds still carry risk since there is a tendency for stocks to fall or rise together. Likewise, bonds tend to all rise or fall in value at the same time, for reasons we will discuss later. Thus, a mutual fund cannot eliminate the common “market factor” by diversification.

Mutual funds developed in the 1930s as a way for the individual investor to own part of a large, diversified, and professionally managed portfolio of stocks and bonds. Over time, the mutual fund industry has developed a staggering array of different types of mutual funds. Some funds invest in a mix of bonds and stocks, others only in stocks of small firms, or stocks of firms in only one industry, or stocks of foreign firms, or only in tax-exempt bonds issued by local governments in one state!

One of the newest and fastest growing financial products is the variable annuity which combines features of life insurance, a pension fund, and a mutual fund. The customer chooses from a menu of mutual funds, and the investment earnings are untaxed as long as they remain in the plan. At some date in the future, the accumulated sum is used to purchase an annuity, a stream of payments that continue for life, generally at retirement. The size of the future annuity will depend on the investment results of the mutual fund chosen, so there is risk just as there is in any mutual fund investment. A feature of many plans is a minimum guaranteed payment, regardless of investment results, and that insurance is part of what the customer pays for. There is typically also a death benefit, another insurance feature.

What all financial intermediaries have in common is that they serve as a conduit for the flow of household savings to investment in new capital. Though the idea of stocks and bonds will be familiar to most readers, we now move on to discuss just what is meant by “stock” and “bond”, how we can locate and interpret information about them, and what determines their market value.

Exercises 3.1

A. Explain briefly the role of financial intermediaries in the economy. What are the four fundamental services provided by financial intermediaries that make using them attractive to household savers? Give specific examples of these services in the case of mutual funds.

B. Give several examples of firms in your area that are financial intermediaries. What are the services they offer to savers and borrowers?

C. Find the mutual funds table in the Friday issue of the Wall Street Journal or similar source. What are some of the types of securities that funds invest in? Identify some of the largest “families” of funds. Which types of funds have had the highest and lowest return over the past year?

D. Why would the way that open-end mutual funds operate make it infeasible for them to invest in office buildings and hotels?

E. What features of life insurance, a pensions fund, and a mutual fund are combined in a variable annuity?

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