Financial Intermediation

Question 1

What is the four types of external finance and what is the composition of these in major economies?

Answer 1

• BANK LOANS: Japan (78%), Germany (75%), US (18%), Canada (56%)
• NON-BANK LOANS: Japan (8%), Germany (9%), US (37%), Canada (11%)
• BONDS: Japan (9%), Germany (7%), US (32%), Canada (15%)
• EQUITY: Japan (5%), Germany (9%), US (13%), Canada (11%)

Question 2

How can the sources of external finance be categorised?

Answer 2

• DIRECT: Bonds + Equity; direct interactions with savers
• INDIRECT: Bank Loans + Non-Bank Loans; FIs used to channel funds
• Data suggests that direct finance is not the primary way of raising external finance

Question 3

What are the eight basic facts on financial structure?

Answer 3

• Stocks are not the most important source of external finance
• Nor marketable debt or stocks are the primary financing
• Indirect finance is generally preferred to debt
• FIs are important for external financing
• Financial system is heavily regulated
• Only large, well-established firms have access to securities
• Collateral is a big feature of debt contracts
• Debt contracts are complicated and place restriction on FIs

Question 4

What is asymmetric information? What does this lead to?

Answer 4

• Asymmetric infomtation gives parties incentives to lie, especially borrowers- creating market distortions
• Moral Hazard and Adverse Selection can all follow soon after

Question 5

Why are FIs used?

Answer 5

• FIs reduce transaction costs
• FIs can take advantage of EoS and bundle funds to reduce per $ transaction cost
• Accumulation of expertise allow for lower risk. Better screening and monitoring cause greater allocation of resources
• FIs can increase economies of scope and be offered related/complementary services, reducing costs as a biproduct of information

Question 6

What is Adverse Selection? How does the Akerlof example explain how adverse selection can happen?

Answer 6

• Borrowers find adverse outcomes to seek loans and be selected
• This occurs before the transaction
• Example in 2001 from Akerlof of car market- lemons and cherries
• If quality can’t be assessed, the buyer will pay the aveage quality level of price [best guess]
• Good sellers will not want to sell; UNDERvalued, but bad seller will happily sell
• This can be applied to the equity market, where quality will fall as well as withdrawal of funds

Question 7

How can issues of adverse selection be solved?

Answer 7

• Private production and sale of information like Credit Ratings (Moody’s, S&P)
• BUT; information is a public good- so free-riding is encouraged, reducing fee-paying consumers and information
• Government regulation like compulsory audits and disclosure through regulation. Although this is tough, this would increase information
• Financial Intermediaries reduces free-riders. Private loans are not traded within the open market, therefore bank keeps monitisation
• Collateral and Networth guarantees a form of repayment if the firm is bad

Question 8

What is Moral Hazard? What is the example that can illustrate how Moral Hazard works?

Answer 8

• Borrowers are incentivised to engage in undesirable activities
• This occurs after the purchase
• Agency theory studies how asymmetric information affects behaviour
• The result of a separation of onwership by stockholders (P) from control of the firm by their managers (A) is that managers pursue their own benefits

Question 9

How can issues of moral hazard be solved?

Answer 9

• Monitoring through costly state verification, however, this provides a free-rider issue
• Government regulation can increase information via prosecuting fraudulent behaviour- although this is tough
• Financial Intermediaries can pool capital in exchange for equity (VC firms)
• Debt Contracts are fixed amounts of repayment that are not tied to performance

Question 10

How does moral hazard in debt contracts work?

Answer 10

• Borrowers now have incentives to take along riskier projects
• Upside risk for borrowers, thus default increases and lending decreases
• The solution is to have collateral

Question 11

What are Covenants? Why are they used?

Answer 11

• List of restrictions on debt contracts
• This discourages undesirable behaviour, keeps collateral valuable and provide information
• But, they are costly and free-riding is common. This encourages using FIs to reduce free-riding

Question 12

What is the conflict on interest that occur with FIs?

Answer 12

• FIs have reduced transactional costs via economies of scale and scope
• HOWEVER; scope might be conflicting with each other- providing misleading information and reducing the quality of information
• This is usually common with Investment Banks

Question 13

What is the key regulation in the UK Financial System?

Answer 13

• Increased informayion for investors through the FCA in an attempt to reduce AS and MH
• Ensuring soundness within financial markets such as chartering, restricting entry, disclosing information, asset restriction, deposit insurance avoids bank runs in FSCS