An investor’s guide to financial intermediation and key risks

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Financial intermediation

Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke on “Simplicity, Transparency, and Market Discipline in Regulatory Reform” at a joint conference held at the Philadelphia Fed on April 8, 2014. Plosser provided a high-level perspective on financial regulations and financial stability. In his speech, he also discussed the economic role of financial markets and intermediaries (banks and other financial institutions) and the types of risks that could arise from financial intermediation.

Part 2

What is financial intermediation?

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Financial intermediaries are essentially market-makers for the sources and uses of capital in the economy. They pool funds from savers and investors (through checking accounts and deposits) and allocate these funds to their most productive uses, which may be by lending to businesses or individuals in the economy requiring funds. In allocating funds, financial intermediaries assess the risks (credit risk, duration, or interest rate risk) and returns arising from various risky claims. By selling some of the risks to investors and those who are willing to bear it, intermediaries help allocate resources and risks throughout the economy, thereby improving efficiency and productivity. Financial intermediation can result in concentration of risks that increase the fragility of the financial system. These risks are referred to as systemic risks.

2008 financial crisis management: Enter the Dodd-Frank Act

Financial supervision and regulation seek to monitor and reduce systemic risks, without interfering with the healthy functioning of financial markets and institutions. After the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by Congress in 2010. The act includes provisions for enhanced liquidity, capital, and risk-management requirements for large financial intermediaries—financial firms like JP Morgan Chase (JPM) and the Bank of New York Mellon (BK), thought to be systemically important. Dodd-Frank also requires large financial firms like the ones named above to conduct stress tests in order to assess whether they can withstand the effects of a severe economic downturn. For more on the recently concluded bank stress tests, please see Market Realist’s Must know: Stress tests and the likely timing for rate increases.

The SPDR S&P Bank ETF (KBE) tracks the S&P Banks Select Industry Index. KBE is invested in financial intermediaries like JP Morgan Chase (JPM) and the Bank of New York Mellon (BK). Both JPM and BK form part of the S&P 100 Index (OEF).

About changes in risk analysis after the 2008 financial crisis

Plosser also said that besides new regulations, the 2008 financial crisis also brought about important changes in supervision:

  • Supervisors are taking a macroprudential approach to their responsibilities by analyzing risks across firms rather than focusing on one institution.
  • Large financial firms are now required to have stronger data and information systems so they can better monitor and manage their own risks. The data reporting requirements to supervisors are more stringent. The U.S. Fed utilizes this data in tandem with other information it receives to conduct more in-depth and timely assessments of emerging risks.

In the following parts of this series, we’ll discuss what Charles Plosser had to say about the efficacy of some of the individual elements of the Dodd-Frank Act. To read about three broad principles Plosser outlined that need to be considered for financial market stability, read on to Part 3 of this series.

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