Financial Institutions Overview Flashcards
(33 cards)
What are Financial Institutions
Financial institutions are organisations that make profit by engaging in financial transactions, such as lending, investing, or managing risk.
Examples:
Banks, insurance companies, mutual funds, pension funds.
Why They Matter:
They channel funds from savers to borrowers, reduce transaction costs through economies of scale, and help solve information problems like adverse selection and moral hazard.
What are the Key Functions of Financial Institutions
- Reduce Transaction Costs:
They pool resources and expertise to make financial transactions cheaper and faster. - Provide Liquidity:
They let investors access cash when needed, making financial assets more attractive. - Solve Information Asymmetries:
They screen borrowers (prevent adverse selection) and monitor behaviour (prevent moral hazard).
In Finance:
Banks assess creditworthiness before issuing loans; insurance firms set terms to reduce reckless behaviour.
What is Financial Structure
The financial structure refers to how companies raise funds externally to support operations and investment.
Key Insight:
Across countries like the U.S., Japan, Germany, and Canada, the most common way businesses get funding is not by issuing shares, but through loans from financial institutions.
Why It Matters:
This contradicts the myth that most corporate finance comes from the stock market.
What is External Finance
External finance means money that businesses raise from outside sources (not internal profits or owner investment).
Main Sources:
Indirect finance (loans from banks and intermediaries)
Direct finance (selling bonds or shares to investors)
Reality:
Most businesses use indirect finance, especially smaller or younger firms.
Why is Debt More Common than Equity
Companies (SMEs), especially smaller ones, are more likely to borrow (debt) than issue new shares (equity).
Reasons:
Debt is less risky for investors when backed by collateral.
Equity issuance may dilute ownership and signal weakness.
In Practice:
Most firms prefer loans because it’s easier, cheaper, and doesn’t reduce control.
Why is Collateral So Important
Collateral is an asset pledged by the borrower that the lender can seize if the loan isn’t repaid.
Why It’s Used:
Reduces risk for the lender
Encourages honest behaviour
Helps deal with asymmetric information
Common Collateral:
Property, equipment, inventory, or vehicles.
What are Restrictive Covenants in Debt Contracts
Restrictive covenants are legal conditions in loan agreements that limit what the borrower can do.
Purpose:
To reduce moral hazard — making sure borrowers don’t take excessive risks after getting the loan.
Examples:
Limits on additional borrowing
Requirements to maintain insurance
Regular financial reporting
In Finance:
These are standard in corporate lending, especially for high-risk borrowers.
Why are Stocks are not the most important Source of External Financial
Explanation:
Issuing equity (stocks) is a minor source of external financing for most businesses, especially in developed economies.
Companies rely more on debt and loans than on selling shares.
Rationalisation (Moral Hazard):
Equity contracts suffer from principal-agent problems.
Shareholders (owners) and managers (agents) have misaligned interests.
Managers might shirk responsibilities or pursue private benefits, making investors hesitant to fund firms through equity due to difficulty monitoring behaviour.
Why is Direct Finance (Issuing Securities) NOT the Primary Financing Method
Explanation:
Companies rarely rely on direct finance (selling stocks or bonds to investors).
Instead, they prefer indirect finance via banks or other intermediaries.
Rationalisation (Adverse Selection):
In financial markets, it’s hard for investors to tell good firms from bad ones.
This creates the “lemons problem”: investors offer only average prices, discouraging high-quality firms from issuing securities.
Thus, firms avoid direct markets to escape undervaluation.
Why is Indirect Finance MORE Important than Direct Finance
Explanation:
Most external funding comes through financial intermediaries, not directly from investors.
Rationalisation:
Transaction Costs: Banks lower these through scale and specialisation (e.g., standard loan contracts).
Adverse Selection: Intermediaries use expert screening to separate good borrowers from bad, solving information problems better than individual investors.
Why are Banks the MOST Important Source of External Finance
Explanation:
Banks and similar intermediaries provide the majority of external business finance, especially through loans.
Rationalisation:
Banks have the expertise to overcome both transaction costs and information asymmetries, making them the most efficient source of external funding—particularly for small and medium firms that cannot easily access securities markets.
Why are Financial Systems HEAVILY Regulated
Explanation:
Governments impose extensive regulations on financial markets and institutions to ensure transparency, stability, and fairness.
Rationalisation (Asymmetric Information):
Regulations like mandatory financial disclosures reduce adverse selection by providing credible information to investors.
This helps overcome the free-rider problem, where investors might otherwise rely on others to generate costly information.
Why do Only Large Firms have Easy Access to Securities Markets
Large, well-known firms (e.g., FTSE 100 companies) can more easily issue shares or bonds to the public.
Rationalisation (Adverse Selection):
These firms have long track records, reputations, and publicly available information, which lowers the lemons problem. Investors are more willing to fund them directly because they are easier to evaluate.
Why is Collateral Common in Debt Contracts
Explanation:
Firms and households usually need to pledge assets (like land or equipment) to get loans. If they default, the lender can claim the asset.
Rationalisation:
Adverse Selection: Willingness to pledge collateral signals borrower confidence in their project.
Moral Hazard: Borrowers are less likely to take excessive risks when they have something valuable to lose.
Why do Debt Contracts Include Restrictive Covenants
Explanation:
Debt agreements have detailed legal restrictions (covenants) that limit borrower behaviour (e.g., not taking on more debt, maintaining certain ratios).
Rationalisation (Moral Hazard):
Restrictive covenants help lenders monitor and control risk by discouraging undesirable actions and ensuring access to information. They align borrower behaviour with lender expectations and protect the value of collateral.
What are Transaction Costs
Transaction costs are the frictions or expenses incurred when carrying out a financial transaction. They reduce efficiency in the flow of funds from savers to borrowers.
Examples:
Legal fees for drafting contracts
Time spent searching for creditworthy borrowers
Costs of purchasing diversified securities (e.g., high bond denominations)
Examples of Transaction Costs in Financial Markets
High Unit Prices:
Direct investments like stocks or corporate bonds require large sums (e.g., $1,000 per bond), limiting diversification for small investors.
Legal/Agreement Costs:
Drafting a private loan agreement may cost £700 or more—often too high to justify direct lending for small-scale investors.
How do Transaction Costs Affect Capital Allocattion
Impact:
They impede the efficient allocation of capital, preventing money from flowing directly from savers to the most productive investment opportunities. This discourages direct finance.
Result:
Entrepreneurs or firms with good ideas might not receive funding directly because the costs to arrange a deal are too high for individual savers.
How do Financial Intermediaries Reduce Transaction Costs?
- Economies of Scale:
Banks and mutual funds pool resources and spread fixed costs over many transactions (e.g., standardised loan contracts), making services cheaper per client. - Expertise:
Intermediaries have specialised knowledge and experience in financial transactions, letting them operate efficiently and cheaply compared to individual savers.
Why are Financial Intermediaries Useful for Indirect Finace
Core Reason:
They reduce transaction costs that would otherwise make direct lending/investing unfeasible or too expensive for individuals.
Real-World Benefit:
Intermediaries make it cost-effective for savers to fund borrowers without dealing with contract drafting, credit evaluation, or legal negotiations.
What is Adverse Selection
Definition:
Adverse selection is a problem of asymmetric information that occurs before a transaction, where parties with lower quality or higher risk are more likely to seek funding or be selected—leading to bad outcomes for lenders/investors.
Effect:
It hinders the efficient flow of capital by making bad borrowers more likely to get financing, while good borrowers may be overlooked or underfunded.
What is the Lemon Problem (Used Cars)
Concept (Akerlof, 1970):
When buyers can’t tell between good and bad quality, they only offer an average price.
Outcome:
Good sellers withdraw from the market (undervalued).
Bad sellers stay (overvalued).
Market breaks down as quality declines.
Example:
If the average buyer offers £10,000 for a car valued between £5k–£15k, only lower-value sellers accept, dragging expected value lower, leading to no trade at all.
What is the Lemon Problem in Relation to Securities Markets
Problem:
Investors can’t tell good securities from bad ones.
Impact:
Firms with good projects avoid issuing securities (undervalued).
Firms with bad projects rush to issue (overvalued).
Market suffers from low trust and underinvestment.
Connection to Facts:
Explains why:
Fact #1: Stocks are not the most important source of external financing.
Fact #2: Issuing marketable securities is not the primary way firms finance operations.
Fact #6: Only large firms with reputations (like Sainsbury’s) can raise funds directly.
What are the Four Tools to Solve Adverse Selection
Private Production and Sale of Information
Government Regulation to Increase Information
Financial Intermediaries
Collateral and Networth
