Week 01: Economic Role and Specialness of Financial Intermediaries

Question 1

What is direct finance and indirect finance?

Answer 1

Direct finance: is when borrowers borrow directly from lenders by selling them securities.

Indirect finance: is when a financial intermediary stands between the lender-savers and the borrower-spender

Question 2

What are the first 4 basic facts about financial structure?

Answer 2

1. Stocks are not the most important source of external financing for business.
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.
3. Indirect finance is many times more important than direct finance.
4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

Question 3

What are the last 4 (5-8) basic facts about financial structure?

Answer 3

5. The financial system is among the most heavily regulated sectors of the economy.
6. Only large, well established corporations have easy access to securities markets to finance their activities.
7. Collateral is a prevalent feature of debt contracts for both households and businesses.
8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower.

Question 4

Explain what transaction costs are and how to solve them?

Answer 4

• The time and money spent in carry out financial
transactions.

• It limits the investment selection as well as
diversification.

• Tools to solve this problem: financial intermediaries,
e.g. mutual funds

– Economies of scales: the reduction in transaction costs per dollar of transactions as the size of transactions increases.

– Expertise in technology.

– It can also provide liquidity services.

Question 5

What is asymmetric information?

Answer 5

• A situation that arises when one party’s insufficient
knowledge about the other party involved in a
transaction makes it impossible to make accurate
decision when conducting the transaction.

• Two problems:
  
  • Adverse selection
  • Moral hazard

Question 6

Explain Adverse selection and moral hazards in equity contracts?

Answer 6

– Adverse selection: the problem created by asymmetric information before the transaction occurs
- the
interaction between the inclination of the informed to strategically manipulate and the anticipation of such
manipulation by the uninformed will result in a dysfunctional market

– Moral hazard: the problem created by asymmetric
information after the transaction occurs.
• Principal-agent problem: the separation of
ownership (principal) and management
(agent).

• Managers in control (the agents), who has more information about their activities than the shareholders do, may act in their own interest rather than in the interest of the owners (principals).

Question 7

How do you solve the problems of adverse selection?

Answer 7

Adverse selection:
• Private production and sale of information
– Can’t solve adverse selection problem completely
because of free rider problem

• Government regulation
– To encourage or enforce firms to reveal honest
information

– disclosure requirement doesn’t always work well, nor eliminates adverse selection problem

• Collateral and net worth

• Financial intermediation
– Specialised in producing information and
distinguishing good firms
– The severer the asymmetric information problems, the more important the FIs.

Question 8

How do you solve the problem of moral hazard in equity contracts?

Answer 8

• Principal-agent problem can be solved by:
– Aligning the incentives of agent with those of
principal

• Production of information: monitoring

• Debt contracts
– Debt contract holders receive contractual fixed payments
instead of residual claim - monitoring is less frequent
needed

• Government regulation
– To increase reliable information, e.g. standard accounting
principles.
– To impose criminal penalties for fraud and/or misconduct

• Financial intermediation, e.g. venture capital firms
– Pool resources of its partners and use the funds to help
entrepreneurs starting up new businesses.

Question 9

Explain moral hazard in debt contracts

Answer 9

• The conflict between shareholders and
debtholders.

• Management may choose investments that maximise the value of equity at the expense of the debt holders.

Question 10

how do you solve the problem of moral hazard in debt contracts?

Answer 10

• Net worth and collateral
- align the incentives of borrowers with
those of lenders; risk-shifting activities are
less likely

• Monitoring and enforcement of restrictive covenants
– To discourage undesirable behaviour, e.g. prohibit or limit
the dividends paid
- negative/restrictive covenants
– To encourage desirable behaviour, e.g. maintain minimum
holdings of assets
- positive/affirmative covenants

• Financial intermediation
– Solve free-rider problems existing in traded debt market (e.g. bonds) by making nontraded private loans.

Question 11

3 reasons why households might find investments in

corporate securities unattractive?

Answer 11

– Information costs (e.g. screening and monitoring):
expensive, plus free-rider problems.

– Liquidity costs: long-term nature of corporate equity
and debt, plus the lack of a deep, active secondary
market.

– Price risk: the risk that the sale price of an asset will
be lower than the purchase price of that asset, plus
transaction costs

Question 12

Name and explain the 2 main functions of financial institutions

Answer 12

1) Brokerage function
– Provide economies of scales and specialised
skill/technology in information collection as well as in transaction costs.
2) Asset transformation function
– Purchase financial claims issued by corporations (primary
securities) and finance these purchase in the form of secondary securities (e.g. deposits, insurance policy).

Question 13

Name and explain the other functions of financial institutions

Answer 13

• Time intermediation
– Wealth transfer between generations.

• Denomination intermediation
– Give individuals indirect access to large
denomination markets.

• Credit allocation
– Major source of finance in particular sector of
an economy.

• Transmission of monetary policy
– Liabilities of depository institutions are a
significant component of the money supply that
impacts the inflation rate. Actions include setting
discount rate, open market operations, and/or
setting reserve requirement

• Payment service
– RBNZ:
• NZClear: for high-value debt securities and equitie

• Failure or inefficiency to provide above services can
cause costly negative externality. FIs are therefore
highly regulated

Question 14

explain the exchange settlement Account system

Answer 14

• Balance of the settlement account can’t be negative. When banks run out of settlement cash, they can borrow cash for
a short time from Reserve Bank, or from inter
‐bank cash market.

• Banks can also borrow from/lend to each other in the inter‐bank
cash market.

• The overnight loan is usually for only a very short period as the
banking day runs from 9am to 830am the next day