V. Function of Financial Intermediaries

Question 1

The process of indirect finance using financial intermediaries, called ____________ is the primary route for moving funds from lenders to borrowers.

Answer 1

financial intermediation

Question 2

T or F. Securities markets are a far more important source of financing for corporations than financial intermediaries are. This is evident not only in the United States but in other industrialized countries as well.

Answer 2

False. Financial intermediaries are a far more important source of financing for
corporations than securities markets are.

Question 2

The time and money spent in carrying out financial transactions are a major problem for people who have excess funds to lend.

Answer 2

Transaction costs

Question 2

Studies of the major developed countries show that when businesses go looking for funds to finance their activities, they usually obtain them indirectly through ____________ and not directly from ______________.

Answer 2

financial intermediaries; securities markets.

Question 3

T or F. Financing from financial
intermediaries have been almost ten times greater than that of securities
markets.

Answer 3

True

Question 3

T or F. Although the dominance of financial intermediaries over securities markets is
clear in all countries, the relative importance of bond versus stock markets
differs widely across countries.

Answer 3

True

Question 4

Why do the financial intermediaries substantially reduce transaction costs?

Answer 4

because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale.

Question 5

What are economies of scale?

Answer 5

the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases.

Question 6

What benefits are there when financial intermediaries are able to reduce transaction costs substantially?

Answer 6

• they make it possible for people to provide funds indirectly to those who need productive investment opportunities.
• it can provide its customers with liquidity services, services that make it easier
  for customers to conduct transactions.

Question 6

Why are financial intermediaries and indirect finance so important in financial markets?

Answer 6

to address the presence of transaction costs and information costs.

Question 6

Describe asymmetric function in the financial market.

Answer 6

In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information.

Question 7

T or F. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into and during the transaction itself.

Answer 7

False. before the transaction is entered into and after.

Question 7

T or F. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.

Answer 7

True

Question 8

Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad
credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected.

Answer 8

Adverse selection

Question 9

The risk (hazard) that the borrower might
engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back.

Answer 9

Moral Hazard

Question 10

Differentiate adverse selection and moral hazard.

Answer 10

adverse selection is a problem of asymmetric information before entering into a transaction, whereas moral hazard is a problem of asymmetric information after the transaction has occurred.

Question 10

Why do lenders decide that they would rather not make a loan considering the moral hazard?

Answer 10

Because moral hazard lowers the
the probability that the loan will be repaid,

Question 10

Why are the problems created by adverse selection and moral hazard an important impediment to well-functioning financial markets?

Answer 10

Financial intermediaries can alleviate these problems.

Question 11

How do financial intermediaries gain higher earnings and lower losses from adverse selection?

Answer 11

Successful financial intermediaries have higher earnings on their investments than small savers because they are better equipped than individuals to screen out good from bad credit risks, thereby reducing losses due to adverse selection.

Question 12

T or F. Financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.

Answer 12

True