Financial Institutions Flashcards
(23 cards)
What are Financial Institutions
They are organisations that facilitate the movement of funds between savers and borrowers
This ensures efficient capital allocation in the economy
They operate in financial systems like banks, stock markets and other intermediaries
What are the 3 Main Roles of Financial Institutions
Facilitating Capital Allocation - Moving Funds from savers (businesses, governments with excess) to borrowers (entrepreneurs, governments without)
Ensuring Liquidity - Providing platforms for buying and selling financial assets. Allowing businesses and investors to access said assets without disruption
Risk Management & Stability - Offering financial instruments like insurance and stabilising markets
What are the 5 Types of Financial Institutions
Bank & Credit Institutions:
-commercial banks accept deposits and provide loans and enable payments
-central banks control money supply and regulate financial stability
Stock Markets:
-stock exchanges (LSE, NYSE)
-enable trading of share and companies to raise capital and investors to buy equity
Insurance Companies:
-provide financial protection against risk
Pension Funds:
-Manage retirement savings for long term financial security
The Three Components of a Financial System
Financial Institutions - Bank, Insurance Companies, Pension Funds
Financial Markets - Stock and Bond Markets where securities are traded
Financial Instruments:
-Equities (stocks) that represent company ownership
-Debt securities (bonds, loans) that are contracts where borrowers pay lenders over time
-Derivatives (futures, options)
What are Stock Markets
Places where companies sell shares (ownership stakes) to investors in exchange for money to expand businesses
What are Bond Markets
Markets where governments and companies make money selling bonds
When buying a bond you give money in exchange for interest payments till you get your money
What are Equities
These are stocks that represent ownership in a company
When you own shares, you own part of the company and receive dividends or can ell shares for a higher price
What are Derivatives
Financial contracts who’s value is based on underlying assets (stocks, bonds)
They help investors manage risk or speculate on price movements in financial markets
Sources of External Funds
Indirect Funds - Business securing funds via financial intermediaries like banks
Direct Finance - Businesses raise funds by issuing stocks or bonds
What’s the Importance of Indirect Finance
SMEs struggle to attract direct investors
Banks reduce borrowing risks through screening and loan structure
What are the 4 Roles of Financial Intermediaries
To bridge the gap between savers and borrowers
To reduce transaction costs through economies of scale (spreading costs over multiple transactions)
Providing Liquidity (easy access to cash and credit)
Managing risk (assessing creditworthiness and diversifying investments)
Access to Securities (Bond/ Stocks) Markets
Large corporations can issue stocks and bonds easily (rep, resources market confidence)
SME rely on banks due to regulatory and financial barriers (fees, track record)
What are Debt Contracts
Agreements between borrowers (gov, business) and lenders (bank, bondholder) outlining loan terms (rates, schedule, restrictions)
Key Features of Debt Contracts
Restrictions on Borrower Behaviour - Covenants that limit borrowers action like taking on more debt or large investments, to ensure original contract is paid first
Collateral - An asset (property inventory) that the lender can claim if borrower doesn’t pay loan
What’s Asymmetric Information in Finance
It’s when one party in a transaction has better information than the other party
This imbalance leads to adverse selection and moral hazard
What’s Adverse Selection
Occurs before a transaction, when high risk borrowers are more likely to seek funding
Since lenders can’t tell between high and low risk borrowers, they hesitate to give funding, leading to market inefficiencies
What’s the Lemon Problem
If buyers can’t tell if a car is good or not
They will only for average priced cars
So owners will only sell average/ bad cars
Leaving only bad cars left in the market
Disrupting the car market
Impact of Adverse Selection on Financial Structure
Investors hesitating to buy securities will reduce market efficiency
Capital won’t flow efficiently to investments
4 Tools to Address Adverse Selection
Private Production and Sale of Info - Credit rating agencies to provide insight on products
Government Regulations - Disclosure laws that force firms to give info
Financial Intermediaries - Banks assess borrowers’ creditworthiness and lending
Collateral - Reduces risk for lenders
What’s Moral Hazard
Occurs after a transaction, when one party engages in risky or self serving behaviour because there are no full consequences
Moral Hazard in Equity Contracts (Agency Problem)
Managers may not work in the best interest of shareholders, prioritising personal gain over profits
Moral Hazard in Debt Contracts
Borrowers may take excessive risk, knowing they only need to repay a fixed amount
If borrower in financial trouble, they may engage in high risk, high reward projects since they have little to lose
3 Tools used to Solve Moral Hazard
Government Regulation - Improve corporate transparency and governance
Financial Intermediaries - Reduces risk through monitoring and enforcement
Debt Contracts over Equity - Provide structured repayment obligations like collateral, reducing reckless behaviour
