Tuesday, August 18, 2009

Portfolio decisions by financial intermediaries

In acting as a middleman between savers and borrowers, the management of financial intermediary is called upon daily to make portfolio decisions-what uses to make of incoming funds and what sources of funds to draw upon? A number of factors affect these critical decisions. For example, the relative rates of return and risk attached to different sources and uses of funds will affect the composition of the intermediary ‘S portfolio. Obviously, if management is interested in maximizing profits and has minimal aversion to risk, it will tend to pursue the highest-yielding asset available, especially corporate bonds and stocks. A more risk-averse institution, on the other hand, is likely to surrender some yield in return for the greater safety available in acquiring government bonds and high-quality money market instruments.
The cost, volatility, and maturity of incoming funds provided by surplus budget units also has a significant impact upon the loans and investments made by a financial intermediary. Commercial banks, for example, must derive much of their funds from checking accounts, which are relatively inexpensive but highly volatile. Such an institution will tend to concentrate its lending activities in short-term and medium-term loans in order to avoid an embarrassing and expensive liquidity crisis. On the other hand, a financial institution, such as a pension fund, which receives a stable and predictable inflow of savings, is largely freed from concern over short-run liquidity needs. It is able to invest heavily in stocks, bonds, mortgages, and other long-term assets. Thus, the hedging principle- the approximate matching of the maturity of assets held with liabilities taken on- is an important guide for choosing those financial assets that a financial intermediary will hold in its portfolio.
Decisions by intermediaries on what loans and investments to make and what sources of funds to draw upon are also influenced by the size of the individual financial institution. Larger financial intermediaries frequently can take advantage of greater diversification in sources and uses of funds than smaller institutions. This means that the overall risk of portfolio of securities can be reduced by acquiring securities from many different borrowers.

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