Financial Intermediaries/Moral Hazard/Adverse Selection/Theories of FIs Flashcards
General statement
Financial intermediaries provide a mechanism by which funds are transferred and allocated to their most productive opportunities.
Banks are financial intermediaries who collect surplus funds from savers in the form of depositors and allocate them to borrowers in the form of loans.
What is direct finance?
Direct finance is where borrowers obtain funds directly from lenders in financial markets.
What is the problem with direct finance?
Difficultly and expense of matching the complex needs of lenders and borrowers.
Incompatibility of the financial needs of lenders and borrowers.
What do lenders require vs borrowers requirements?
Lenders require: minimisation of risk, minimisation of cost and liquidity.
Borrowers require: funds for a specific time period (long term), funds at a specified date and funds at the lowest possible cost.
Why do banks exist general statement?
Intermediaries bridge the gap between borrowers and lenders. They help reduced the costs associated with direct lending - particularly transaction costs and those derived from information asymmetries.
Why do banks exist? Delegated Monitoring & Information Production
Delegated Monitoring: Monitoring borrowers and their likelihood of paying back a loan is costly and time consuming. Therefore lenders delegate this task to FI’s who have economies of scale, therefore reducing the costs of monitoring.
Information production: Gathering information on borrowers is also costly and time consuming. Banks build up information over time and become experts in gathering information. Depositors thus leave their money with banks knowing they will be directed to the appropriate borrowers.
Why do banks exist? Liquidity Transformation, Consumption Smoothing & Commitment Mechanisms
Liquidity Transformation: Banks deposits’ offer high liquidity and low risk are the liabilities of a bank. They are financed by illiquid high risk assets such as loans. All due to diversification of portfolios.
Consumption Smoothing: Consumers have uncertain preferences about their expenditure and thus demand liquid assets. Banks provide these assets via lending.
Commitment Mechanisms: Demand deposits have evolved as a necessary device to discipline bankers. Changes in supply and demand of these instruments will be reflected in financing costs and so ensures banks have sufficient liquidity and capital resources.
What are transaction costs and how are they reduced?
Transaction costs refer to the costs associated with the buying and selling of a financial instrument (search costs, information costs).
They are reduced due to economies of scale, increased volume of transactions = reduced cost per unit of transactions.
What is asymmetric information and how does it arise?
Not everyone has the same information, everyone has less than perfect information and some parties to a transaction have “inside” information that is not available to both sides of the transaction.
It arises due to the fact that information is not a free good and acquiring information is not a costless activity.
It leads to moral hazard and adverse selection.
What is adverse selection and how can it be solved?
Adverse selection occurs at the search/verification stage of a transaction. The better informed party has an incentive to exploit his informational advantage. E.g. Second hand car market.
Solution: Offer a warranty as it would signal quality. Informed party should signal and the uninformed party should screen (insurance companies, banks before a loan is granted).
What is moral hazard and how can it be solved?
Occurs after a loan has been granted and is associated with the monitoring and enforcement stages. E.g. Funds borrowed for a safe investment which are then used for a high risk project. Deposit insurance and LOLR resort.
Solution: Monitoring the performance of borrowers as well as screening. Regulation of banks.
