Banking & Credit Markets Flashcards
Financial Systems
Markets in which funds are transferred from people and firms who have an excess of funds to people who need funds
Functions of financial markets:
Direct Finance
Indirect Finance
Direct Finance
Channels funds from economic players who have saved surplus funds to those who have a shortage of funds e.g. borrowers borrow funds from lenders in FM through debt instruments e.g. bonds. Promotes Economic efficiency as efficient allocation of capital which increases production. Directly improves wellbeing of consumers allowing them to time purchases better
Indirect Finance
Financial Intermediaries reduce transaction costs. EoS: reduce transaction cost and enhances liquidity services. Risk Sharing/Asset transformation: reduces risk exposure by spreading returns earned on risky assets. Diversification and pooling of assets not new safe assets for investors. Expertise in monitoring borrowers thus reducing risk of losses due to moral hazard
Financial Intermediaries
Institutions that borrow funds from people who have saved and make loans to people who need funds
Banks accept deposits and make loans
Financial Innovation
Development of new financial products and services
Makes financial system more efficient
E finance - deliver financial services electronically
Financial Crisis
Disruption in FM characterised by declines in asset prices and failures of many financial firms
Lemons Problem
How adverse selection influences financial structure
If quality cannot be assessed the buyer is willing to pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at average quality price
The buyer will not buy at all because all that is left in the market is poor quality items
Tools to help solve adverse selection problems
Private production & sale of information - free rider problem
Gvt regulation to increase information
Financial Intermediation
Collateral
How moral hazard affects the choice between debt and equity contracts
Sellers of securities may have incentives to hide information & engage in undesirable activities for stockholder
called principal agent problem Principal - Stockholder
Agent - Manager
Separation of ownership and control of firm - managers pursue personal benefits rather than profitability of firm
Tools to help solve principal agent problem
Monitoring e.g. Audits
Gvt regulation to increase information
Financial Intermediation - e.g. venture capital (participants as board members)
Debt contracts - Fixed periodic payments without demand
Tools to help solve moral hazard in debt contracts - Borrowers have incentive to take on projects that are riskier than lenders would like. Prevents borrower paying back the loan.
Net worth & collateral
Monitoring
Financial intermediation
