Chapter 7 - Financial Institutions

Question 1

Why do financial institutions exist? (2)

Answer 1

1. Lower transaction costs

2. reduce asymmetric information

Question 2

Why are FI better equipped than financial markets to solve transaction costs and asymmetric info?

Answer 2

By lowering transaction costs and reducing asymmetric information FI engage in risk sharing asset transformation/diversification

Question 3

Transaction costs

Answer 3

Influence the financial structure. Certain types of investments only available in large denominations. For small transactions, commissions and fees represent a high percentage of investments. As a result, small individual investments are not well diversified

Question 4

How do FI reduce transaction costs? (2)

Answer 4

1. Economies of scale: AC go down and Q goes up

2. Economies of scope: AC go down and nr. of products go up

Question 5

What are the sources of external finance for non-financial businesses?

Answer 5

non-financial businesses mostly use indirect finance as a source of external funds

Question 6

Why do non-financial businesses use indirect finance as an external source of funds? (3)

Answer 6

1. small firms do not issue bonds + stocks
2. there is more debt than equity
3. Bank loans often require collateral because of asymmetric information

Question 7

Asymmetric Information

Answer 7

there is asymmetric information when one counter party lacks crucial information about another party, impacting decision making. - market failure-

Question 8

Adverse selection (2)

Answer 8

Before agreeing to a transaction, one party has more info.

1. before the transaction occurs (ex-ante)
2. the party that knows more about the transaction most likely produce the adverse outcome

Question 9

Solutions to Adverse Selection (4)

Answer 9

1. Private collection of Information (health exam before selling insurance, credit rating agencies, credit score to get credit card)
2. government regulations (reduce asymmetrical info by having true company’s info revealed. auditors check financial statements)
3. screening ex-ante from FI (especially banks) (like private collection of information, but rather than selling it, FI makes private loans that other investors can’t observe. They also repeatedly sell to the same businesses.
4. Collateral and Net Worth (ask ex-ante to borrowers to have some ‘skin in the game’)

Question 10

Moral Hazard

Answer 10

situation where one party has the incentive to engage in immoral activities after the transaction has occured (ex-post).

Question 11

Principal Agent Problem

Answer 11

Result of separation of ownership by stockholders (principal) from control by managers (agents).
Problem: agents act in own interest rather than principal’s. Agents know more about the company than principals. Principals could monitor agent’s activity but its costly. Moral hazard arises especially with equity contracts.

Question 12

Solutions fo Principal Agent Problem (3)

Answer 12

1. Monitoring (Ex-post screening: shareholders can observe effort levels of managers, but its costly)
2. Govt. Intervention (enforces the law on fraudulent behavior)
3. Debt Contracts (equity is a claim on all profits of a firm = problem. Principal needs to make sure agent doesn’t divert profits. A debt contract can reduce monitoring costs)

Question 13

Why is debt more prevalent than equity?

Answer 13

debt itself is not immune from moral hazard e.g. the entrepreneur can take on riskier projects one the funds are obtained, as he only needs to pay a fixed interest and keep the rest if he makes more

Question 14

to overcome moral hazard, debt contracts often have: (2)

Answer 14

1. collateral
2. covenants (to prevent undesirable behavior)
   FI require and enforce both