Maturity Intermediation An additional dimension of financial institutions' ability to reduce risk by diversification is their greater ability, compared to a small saver, to bear the risk of mismatching the maturities of their assets and liabilities. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, by maturity mismatching, FIs can produce long-term contracts such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts such as deposits. In addition, although such mismatches can subject an FI to interest rate risk (see Chapters 3 and 23), a large FI is better able than a small investor to manage this risk through its superior access to markets and instruments for hedging the risks of such loans (see Chapters 7, 10, 21, and 25). Denomination Intermediation Some FIs, especially mutual funds, perform a unique service relating to denomination intermediation. Because many assets are sold in very large denominations, they are either out of reach of individual savers or would result in savers holding very undiversified asset portfolios. For example, the minimum size of a negotiable CD is $100,000, while commercial paper (short-term corporate debt) is often sold in minimum packages of $250,000 or more. Individual small savers may be unable to purchase such instruments directly. However, by pooling the funds of many small savers (such as by buying shares in a mutual fund with other small investors), small savers overcome constraints to buying assets imposed by large minimum denomination size. Such indirect access to these markets may allow small savers to generate higher returns (and lower risks) on their portfolios as well. As financial institutions perform the various services described previously, they face many types of risk. Specifically, all FIs hold some assets that are potentially subject to default or credit risk (such as loans, stocks, and bonds). As FIs expand their services to non-U.S. customers or even domestic customers with business outside the United States, they are exposed to both foreign exchange risk and country or sovereign risk as well. Further, FIs tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. If FIs actively trade these assets and liabilities rather than hold them for longer-term investments, they are further exposed to market risk or asset price risk. Increasingly, FIs hold contingent assets and liabilities off the balance sheet, which presents an additional risk called off-balance-sheet risk. Moreover, all FIs are exposed to some degree of liability withdrawal or liquidity risk, depending on the type of claims they have sold to liability holders. All FIs are exposed to technology risk and operational risk because the production of financial services requires the use of real resources and back-office support systems (labor and technology combined to provide services). Finally, the risk that an FI may not have enough capital reserves to offset a sudden loss incurred as a result of one or more of the risks it faces creates insolvency risk for the FI. Chapters 20 through 25 provide an analysis of how FIs measure and manage these risks. The preceding section showed that financial institutions provide various services to sectors of the economy. Failure to provide these services, or a breakdown in their efficient provision, can be costly to both the ultimate suppliers of funds and users of funds as well as to the economy overall. The financial crisis of the late 2000s is a prime example of how such a breakdown in the provision of financial services can cripple financial markets worldwide and bring the world economy into a deep recession. For example, bank failures may destroy household savings and at the same time restrict a firm's access to credit. Insurance company failures may leave household members totally exposed in old age to the cost of catastrophic illnesses and to sudden drops in income upon retirement. In addition, individual FI failures may create doubts in savers'minds regarding the stability and solvency of FIs and the financial system in general and cause panics and even withdrawal runs on sound institutions. Indeed, this possibility provided the reasoning in 2008 for an increase in the deposit insurance cap to $250,000 per person per bank. At this time, the Federal Deposit Insurance Corporation (FDIC) was concerned about the possibility of contagious runs as a few major FIs (e.g., IndyMac and Washington Mutual) failed or nearly failed. The FDIC wanted to instill confidence in the banking system and made the change to avoid massive depositor runs from many of the troubled (and even safer) FIs, more FI failures, and an even larger collapse of the financial system. FIs are regulated in an attempt to prevent these types of market failures and the costs they would impose on the economy and society at large. Although regulation may be socially beneficial, it also imposes private costs, or a regulatory burden, on individual FI owners and managers. Consequently, regulation is an attempt to enhance the social welfare benefits and mitigate the costs of the provision of FI services. Chapter 13 describes regulations (past and present) that have been imposed on U.S. financial institutions. 14. What is meant by maturity intermediation? (LG 1-6) 15. What is meant by denomination intermediation? (LG 1-6) 16. What other services do FIS provide to the financial system? (LG 1-6) 17. What types of risks do FIs face? (LG 1-7) 18. Why are FIs regulated? (LG 1-8) 19. What events resulted in banks' shift from the traditional banking model of originate-and-hold to a model of originate-and-distribute? ( LG 1-6, LG 1-7, LG 1-8) 20. How did the boom in the housing market in the early and mid-2000s exacerbate FIs' transition away from their role as specialists in risk measurement and management? (LG 1-6, LG 1-7, LG 1-8)