Theories of FI

Question 1

What are the ways of funding?

Answer 1

2 ways namely direct financing and intermediated financing.

Question 2

What is direct financing?

Answer 2

It is defined as the flow of funds directly from savers to borrowers through the financial system. Mainly via the financial markets.

Question 3

What is intermediated financing/financial intermediation?

Answer 3

It is defined as the flow of funds through a financial intermediary like a bank between savers and borrowers.

Question 4

What causes inefficient flow of funds between savers and borrowers?

Answer 4

Market imperfections such as high transaction costs, information asymmetry and differences in preferences of savers and borrowers.

Question 5

Why is intermediated financing preferred over direct financing?

Answer 5

Asset transformation function of the bank reduces liquidity cost and other transaction costs. Also reduces monitoring costs (centralised using delegated monitoring) and reduces information asymmetry problems.

Question 6

What are the differences in preferences of savers and borrowers?

Answer 6

Savers prefer higher liquidity, shorter maturity, lower risk and smaller denominations while borrowers prefer the exact opposite

Question 7

What are the functions of Financial Intermediaries?

Answer 7

Brokerage function and Asset transformation function. Subfunctions are asset evaluation and asset diversification.

Question 8

Explain the asset transformation function of FIs?

Answer 8

Different types of transformation such as maturity, size, liquidity and risk.

Maturity + Liquidity + Size: Issue short-term high liquidity small deposit claims for savers to fund long term low liquidity large loans for borrowers.

Risk: Banks regarded as having good risk management mechanisms and have safeguards. People put $$ into banks and expect almost risk free. Bank manage risk and can take on higher risk investments and loans.

Question 9

Explain the subfunction of Asset Diversification of FIs?

Answer 9

FIs can break down large denomination assets into smaller portfolios for depositors. Can diversify by lending to various different types of borrowers and reduce risk. Use law of large numbers to reduce variability of losses.

Question 10

Explain the subfunction of Asset Evaluation?

Answer 10

FIs have expertise in collecting info from past banking clients. Can better evaluate credit risk in asymmetric info environment. Do screening to determine default probability of borrower and reduce risk of loss on each loan.

Question 11

What are the 4 criterias to distinguish FIs?

Answer 11

1. Deposits (Liabilities) are normally short term while assets (loans) are longer term
2. High proportion of deposits are withdrawable on demand . Highly liquid for depositors.
3. Liabilities (Deposits) and Assets (Loans) are mostly not transferable.
4. Deposits (Liabilities) are specified as fixed sum but doesnt affect portfolio performance.

Question 12

What are the types of transaction costs?

Answer 12

Search cost, verification cost, monitoring cost and enforcement cost.

Question 13

How does FIs reduce transaction costs?

Answer 13

3Es.
Economies of Scale: Reduction of cost per dollar output as transaction size increases. E.g. Pay $$ to lawyer draft 1 loan contract with covenants, can use this template for all the other borrowers. Pass reduced cost benefit to borrowers and increase amount financial transactions in economy

Economies of Scope: Cost advantage to produce 1 product jointly than doing it separately.

Expertise: Have special info and tech to reduce transaction cost

Question 14

Why is it better for some larger corporate borrowers to use direct financing?

Answer 14

They have reputation and higher credit ratings. More information available on them. Can issue debt in the financial markets and have high take up rate. Able to raise funds in this way which would be cheaper than having to pay fees through intermediated financing.

Question 15

Why smaller firms cannot use direct financing?

Answer 15

Lack reputation and have lower credit ratings. If direct financing, will have large bid-ask spread on securities prices so will high transaction cost.

Cheaper to use intermediated financing.

Question 16

Explain the liquidity insurance theory.

Answer 16

By Diamond & Dybvig 1983

Usage of law of large numbers to invest in illiquid but profitable assets and uses the fractional reserve system to preserve sufficient liquidity for emergency if consumer need to withdraw $$ urgently.

Fractional reserve based off portfolio theory that total liquid reserves required by bank is less than aggregation of reserves required by individuals acting independently as shocks are not perfectly correlated across individuals.

Question 17

Using the fractional reserve system, how does bank provide liquidity insurance?

Answer 17

Bank accept deposit from various uncorrelated individuals while keeping fraction of $$ for withdrawals. Use remaining money to invest and diversify across asset classes and industries to ensure uncorrelated shocks. Pooling of funds as bank deposits create insurance arrangement whereby depositors share risk of liquidating asset early at a loss.

Quoted from subj guide: Bank offering fixed money claim overcome liquidity problem by pooling resources and making smaller payments to early withdrawal consumers and larger payments to late withdrawal consumers.

Improve liquidity since offer deposits that are more liquid than primary securities. Lower price risk as loss from early liquidation less than holding illiquid asset.

Question 18

What is information asymmetry? What problems does it cause?

Answer 18

Information asymmetry occurs when borrowers possess more information than lenders which causes lenders to be unable to make accurate decisions.

It could lead to problems like adverse selection and moral hazard.

Question 19

Define adverse selection and explain it.

Answer 19

Adverse selection occurs before the transaction takes place. It occurs when borrowers have more information than lenders and the risky borrowers are the most active in seeking loans. The chances of lending to a risky borrower greatly increases which leads to lender not lending at all.

Explained best with Lemons Problem by George Akerlof. Taking loans as an example, the market would be filled with good and bad borrowers. Lender lack info to distinguish between them and therefore only lend out at average rate. This rate is higher than what good borrower willing to accept but lower than bad borrower. Good borrower leave market, leaving behind only bad borrowers. Lender realises and decides to not lend at all since all are risky borrowers.

Question 20

Define moral hazard and explain it.

Answer 20

Moral hazard occurs after the transaction takes place. It is also commonly known as the Principal-Agent problem. It occurs when one party has greater incentive to take on higher risk after the agreement is made. One example is debt contracts. When the borrower borrows money from the lender, they are only required to pay the fixed monthly amounts plus the interest regardless of the profits they earn from using the funding. They are therefore incentivized to take on higher risky investments to generate higher returns since they get to keep all the profits if the investment succeeds and the lenders would lose the most if the investment fails.

This requires some solutions to reduce moral hazard like collection of info on borrowers and monitoring of borrowers. However, this could lead to the free-rider problem.

Question 21

Explain delegated monitoring diamond model

Answer 21

There is existence of n identical firms that seek to finance projects and each firm requires investment of 1 unit. The cashflow y that firm gets from the investment is priori unobservable to lenders and this leads to moral hazard, as explained above due to information asymmetry. In order to solve moral hazard, it is required to monitor the firm and the cost is k. Alternatively, we can reduce moral hazard by drafting debt contracts at Cost c. Assuming k<c, lenders choose to monitor since it is cheaper.

Assuming each investor can only lend 1/m, where m is the required number of investors to finance one project. Also assume that total numbers of investors is m x n so that all projects can be financed.

Under direct lending, each investor would have to undergo monitoring and so the total cost is n x m x k. Under FI lending, cost = n x k. This is as banks can pool the funds to reduce duplication of efforts in monitoring and have the expertise in doing so. Since FI lending is less costly, it makes sense to delegate monitoring to FIs.

FIs will also dominate direct lending as soon as n is large enough as diversification and pooling is possible. When n is large, banks can hold larger amounts of loans and can reduce risk through diversification. This increases the probability that banks have enough loan proceeds to repay deposit claims which makes banks trustable to be an intermediary and lower risk of bank failings.

Question 22

What are the market imperfections that explain the existence of financial intermediaries?

Answer 22

1. Differences in preferences of lenders & borrowers.
2. Shocks in Consumers consumption
3. Information asymmetry
4. Presence of transaction cost