Topic 3: Finance in the Economy

Question 1

5 roles of external finance

Answer 1

1. reduce the need for self finance (self finance constrains investment)
2. evaluate & rank investment projects
3. management & diversification of risk
4. transformation of liquidity (savers vs investors)
5. price discovery

Question 2

Intermediation (4)

Answer 2

1. maturity transformation (borrow short, lend long)
2. liquidity transformation (borrow cash invest in less liquid loans/assets)
3. leverage (obtain funds to buy assets to magnify gains
4. credit risk transfer ( take risk of default of the borrower & transfer from originator to another party)

Question 3

Intermediation vs disintermediation (context - external financing)

Answer 3

Intermediation: bank / intermediary sits between depositor & borrower
Disintermediation: via capital markets, brokers, fund managers

Question 4

Shadow banking vs traditional banking

Answer 4

Shadow: does not take retail deposits, subject to little regulation, cannot borrow in emergency from CB, can’t be bailed out.
Shadow activities: securitisation, collateral services

Question 5

Moral hazard

Answer 5

moral hazard = problem created by information asymmetry AFTER the transaction occurs.
Borrowern may engage in activities after borrowing that make likelihood of paying back loan lower & shift costs to lender

Question 6

Financial crisis (procyclicality) - banks vs markets

Answer 6

procyclical banks tend to tighten lending standards and availability of credit; and markets tend to speed up the deleveraging paving way for sustained recovery

Question 7

Australian financial system - intermediation vs disintermediation

Answer 7

In Aus, intermediation (ie banks) dominates. But there are significant securities markets and superannuation

Question 8

Credit is procyclical and can exacerbate busts & booms

Describe procyclicality in banks and capital markets

Answer 8

Banking sector procyclical
- banks concerned about macroeconomic cycle & losses from customers
- increased provisions reduces capital & leverage / lending
Capital markets also procyclical
- investors become nervous - head for cash / safety
- demand higher yields / spreads & stronger covenants

Question 9

Excessive credit / leverage…

Answer 9

often leads crises and weak income / output growth

Question 10

Address procyclicality

Answer 10

1. new macroprudential regulations
2. build up (run down) capital buffers in ‘good’ (bad) times
   - procyclical regulatory capital
   - forward looking provisioning
   - raise LTVs in bad times
3. Address risks from systemically important FIs - G SIFIs