Week 1/2: The Modern Financial System/ Theories Of Financial Intermediation Flashcards
Describe why asymmetric information leads to adverse selection and moral hazard.
Adverse selection occurs at the search/verification stage(ex-ante) due to hidden information where borrowers have better insight into risk and returns of their project than lenders.
This then means that lenders may select borrowers that default
Moral hazard arises after agreement terms (ex-post) due to hidden actions where parties may not act in the best interest of the transaction after securing the loan
How can adverse selection be reduced?
Screen informed agents to gather as much information as possible
To require a warranty is available to signal the quality of the project
To require that informed agents invest some of their own resources
How can Moral Hazards be reduced?
Regularly monitor the performance of the borrowers and, when available, the credit ratings
Can impose covenants that’s restrict what borrowers can do with borrowed funds
What is the principle agent problem? And what is the solution?
A principle is someone who employs and agent to act in his own interests.However the agents can have incentives to act according to his own interests against the principles. The agent typically is more informed and can’t be easily monitored
The solution is to align the interest of the principle and agent by
Performance based compensation
Monitoring
Risk sharing
What do Lenders require before issuing a loan ?
Minimisation of risk(i.e. risk of default)
Minimisation of cost
Ease of converting the loan into cash without a loss in capital value and in a short amount of time ( liquidity)
What do borrowers usually require when looking for a loan?
Funds at a particular specified date
Funds for a specific period of time
Funds at the lowest possible cost
Why are financial markets not enough to bridge the gap between borrowers and lenders?
Incomplete information: financial markets may not provide all the information on a borrowers creditworthiness or quality of projects making it hard to assess risk.
Cost of information: finding and verifying information about borrowers is costly and time consuming
Asymmetric access: access to information may not be evenly distributed. Larger institutions or borrowers with good reputations will have better market data.
What are the functions of financial intermediaries ?
The brokerage function:They match transactors, provide transactions and other services. As a result they reduce transaction costs and remove information costs.
The asset transformation function: They issue claims more attractive to savers ( lower monitoring costs, liquidity costs and lower price risk) than claims issued by corporations
Name the roles of Financial Intermediaries.
- Pooling the resources of small savers
- Supplying liquidity by converting savers balances directly into a means of payment whenever needed
- Providing ways to diversify risk
- Collecting and processing information in ways that reduce information costs
What’s is meant by Pooling savings?
Accepting many small deposits. Done by attracting lots of savers and promising them soundness.
What is meant by Providing liquidity in relation to deposits?
FI allow people to transform assets into money at low cost by means of demand deposits and ATMs.
How? Banks structure their assets by keeping enough funds in the short term and having liquid financial instruments to satisfy people that may need them. They then lend out the rest.
How do banks diversify risk?
- Take deposits from thousands of people and make thousands of loans with them
- Each depositor has a stake in each of those loans
- This allows for a low cost way for people to diversify their investments.
How can banks collect and process information in ways that reduce costs?
Naturally there’s information asymmetry and borrowers know more about their project than lenders.
Banks collect standardised data and can banks can use their economies of scale to reduce information asymmetry at a lower average cost than it would be for individuals.
How do banks allow for consumption smoothing?
People uncertain about the future can save their money inside of banks.
This then increases the demand for liquid assets and banks can create this by lending out consumer deposits. (Asset transformation/liquidity transformation)
Explain Commitment mechanisms and why illiquid assets are financed by demand deposits.
Transformation is based on demand deposits because they can discipline bankers by controlling their risk taking:
Changes in the demand and supply of demand deposits will be reflected in the financing costs for the banks (i.e higher costs will be associated with the intention to punish the bank) it commits them to act prudentially.
