Lecture 1 - Financial Intermediation Flashcards
What are the main points of Gurley and Shaw’s conventional theory of Financial Intermediation?
Banks “go between” surplus and deficit units - they collect deposits from savers and channel them to borrowers
Banks exist because they transform capital to be put to more efficient use, lending to the enterprise sector and the government, this increases the social value of capital. They are “PRODUCTIVE”
What are the key points of the New Theory of Financial Intermediation?
Banks are intermediaries which can solve specific information and incentive problems in the relationships with savers and investors
They solve these problems in a way better than the way that these problems could be solved either by direct financing or by financing in the capital market
- solving the problems of asymmetric information: adverse selection and moral hazard
What is the definition of “Asymmetric Information”?
Asymmetric Information is a situation where one party to a financial transaction has better information than the other about factors relevant to the transaction
Leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets
What is meant by “Adverse Selection”?
Adverse selection is a risk BEFORE the financial transaction occurs
The situation where those most likely to produce an adverse outcome are the ones who are seeking a loan
What is meant by “Moral Hazard”?
Moral hazard is a risk AFTER the financial transaction occurs
The risk that the borrower may engage in undesirable activities making it less likely that the loan will be repaid
What are the 2 ways that financial intermediaries can resolve the risk of adverse selection?
- Require more information from the borrower when requesting to borrow funds via an application from
- Source credit history reports from third parties to assess the promptness of repayment of previous loans
Financial intermediaries are better equip than individuals to identify good and bad risks
How do banks achieve Risk Transformation?
- Diversification of lending
2. Screening of borrowers
How do banks achieve Maturity Transformation?
Savers and borrowers have different incentives (savers want liquidity, lenders want to borrow long-term)
Banks act as “middle-men” going between surplus and deficit units, solving the conflict of interest
How do borrowers benefit from using financial intermediaries rather than directly borrowing?
- Saved the cost of searching for a lender
- Savers will lend at a modest interest rate due to the security provided by the nature of FI’s, therefore lowering the cost of borrowing
How do savers benefit from using financial intermediaries rather than directly lending?
- Saved the cost of searching for a borrower
- High security means that lenders don’t need to demand such high interest rates to compensate for the risk and inconvenience involved in lending long-term to unknown borrowers
What is the function of a Financial Institution?
To act as “intermediaries”
Dealing with borrowers and lenders separately
Creating more attractive assets and liabilities than would be the case if the two groups dealt with each other directly
How do bank’s provide liquidity to their clients (savers)?
Reserve requirements
Financial intermediaries are required to keep some deposits as a reserve, therefore the individual savers know that they can get their deposits back at short notice
Means they can repay their clients even under adverse conditions
Implications
How do banks lose their importance as intermediaries?
Disintermediation - a reduction in the use of intermediaries between producers and consumers
A lack of security on bank deposits and bank loans
Implications
Transforming deposits into loans requires what action?
Monitoring of the borrowers
Implications
What is the main indication that banks play an important role?
They transform capital to be used more efficiently, by the enterprise sector or the government
