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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 22
ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED)
Role of Financial Intermediaries (cont)
Liquidity;
Risk diversification
Information Services
Information Asymmetry and Information Costs
Adverse Selection
Moral Hazards
Providing Liquidity
Liquidity is a measure of the ease and cost with which an asset can be turned into a means of
payment
Financial intermediaries offer us the ability to transform assets into money at relatively low cost
(ATMs are an example)
Financial intermediaries provide liquidity in a way that is efficient and beneficial to all of us
By collecting funds from a large number of small investors, a bank can reduce the cost of their
combined investment, offering the individual investor both liquidity and high rates of return
Financial intermediaries offer depositors something they can't get from financial markets on
their own
Financial intermediaries offer both individuals and businesses lines of credit, which are pre-
approved loans that can be drawn on whenever a customer needs funds
Diversifying Risk
Financial intermediaries enable us to diversify our investments and reduce risk
While investing, don't put all your eggs in one basket
Putting $1 in 100 stocks is better than investing $100 in just one stock
Financial institutions enable us to diversify our investment and reduce risk.
Banks mitigate risk by taking deposits from a large number of individuals and make thousands
of loans with them, thus giving each depositor a small stake in each of the loans
Bank may collect $1,000 from each of one million depositors and then use $1 billion to make
10,000 loans of $100,000 each
Thus each has a 1/1,000,000 share in each of the 10,000 loans. This is diversification!
And since bank are expert at this game, it can minimize the cost of all such transactions
All financial intermediaries provide a low-cost way for individuals to diversify their
investments
Mutual funds
Information Services
One of the biggest problems individual savers face is figuring out which potential borrowers are
trustworthy and which are not
There is an information asymmetry because the borrower knows whether or not he or she is
trustworthy, but the lender faces substantial costs to obtain the same information
Financial intermediaries reduce the problems created by information asymmetries by collecting
and processing standardized information
Screen loan applications to guarantee the creditworthiness
Monitor loan recipients to ensure proper usage of funds
Information Asymmetries and Information Costs
Information plays a central role in the structure of financial markets and financial institutions
Markets require sophisticated information in order to work well, and when the cost of obtaining
information is too high, markets cease to function
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Money & Banking ­ MGT411
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Asymmetric information
Issuers of financial instruments ­ borrowers who want to issue bonds and firms that want to
issue stock ­ know much more about their business prospects and their willingness to work than
potential lenders or investors
Solving this problem is one key to making our financial system work as well as it does
Lets take up our online store example
Buyers must believe that item has been described accurately and they must be sure that the
seller will send the item in exchange for their payment
Here sellers have much more information than buyers have, creating an information asymmetry
To resolve this issue,
Induct an insurance system
Devise an information system collecting data of purchases and delivery
Asymmetric information poses two obstacles to the smooth flow of funds from savers to
investors:
Adverse selection, - involves being able to distinguish good credit risks from bad before the
transaction;
Moral hazard, - arises after the transaction and involves finding out whether borrowers will use
the proceeds of a loan as they claim they will.
Adverse Selection
Potential borrowers know more about the projects they wish to finance than prospective lenders
Used Cars and the Market for Lemons:
In a market in which there are good cars ("peaches") and bad cars ("lemons") for sale, buyers
are willing to pay only the average value of all the cars in the market.
This is less than the sellers of the "peaches" want, so those cars disappear from the markets and
only the "lemons" are left
To solve this problem caused by asymmetric information, companies like Consumer Reports
provide information about the reliability and safety of different models, and car dealers will
certify the used cars they sell
Adverse Selection in Financial Markets:
Information asymmetries can drive good stocks and bonds out of the financial market
If you can't tell the difference between a firm with a good prospects and a firm with bad
prospects, you will be willing to pay a price based only on their average qualities
The stocks of the good company will be undervalued so the mangers of these companies will
keep the stocks away from the market
This leaves only the firms with bad prospects in the market
The same happens in the bond market
If a lender can not tell whether a borrower is a good or a bad credit risk, the demand for a risk
premium will be based on the average risk
Borrowers having good credit risk will not pay higher risk premiums and would withdraw from
the market
Only bad credit risk bonds are left in the market
Solving the Adverse Selection Problem:
The adverse selection problem resulting in good investments not to be undertaken, the economy
will not grow as rapidly as it could.
So there must be some way of distinguishing good firms from the bad ones
Disclosure of Information
Collateral and Net Worth
Disclosure of Information:
Generating more information is one obvious way to solve the problem created by asymmetric
information
This can be done through government required disclosure and the private collection and
production of information
E.g. Securities and Exchange Commission regulations
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Money & Banking ­ MGT411
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Reports from private sources such as rating agencies, brokerage companies and financial
analysts
The cost and credibility of such information are to be kept in mind
Collateral and Net Worth:
Collateral is something of a value pledged by a borrower to the lender in the event of
borrower's default
Lenders can be compensated even if borrowers default, and if the loan is so insured then the
borrower is not a bad credit risk
Net worth is the owner's stake in the firm, the value of the firm minus the vale of its liabilities
If a firm defaults on loan, the lender can make a claim against the firm's net worth
The same is true for home loans
The importance of net worth in reducing adverse selection is the reason owners of new
businesses have so much difficulty borrowing money
Moral Hazards
Moral hazard arises when we cannot observe people's actions, and so cannot judge whether a
poor outcome was intentional or just a result of bad luck
Moral Hazard in Equity Finance
While purchasing stocks of a company, are you sure that it will use the funds in a way that is
best for you?
Principal-agent problem
The separation of ownership from control
When the managers of a company are the owners, the problem of moral hazard in equity
financing disappears.
Moral Hazard in Debt Finance
Because debt contracts allow owners to keep all the profits in excess of the loan payments, they
encourage risk taking
A good legal contract can solve the moral hazard problem that is inherent in debt finance.
Bonds and loans often carry restrictive covenants
The Negative Consequences of Information Costs
1. Adverse Selection:
Lenders can't distinguish good from bad credit risks, which discourages transactions from
taking place.
Solutions include
Government-required information disclosure
Private collection of information
The pledging of collateral to insure lenders against the borrower's default
Requiring borrowers to invest substantial resources of their own
2. Moral Hazard:
Lenders can't tell whether borrowers will do what they claim they will do with the borrowed
resources; borrowers may take too many risks.
Solutions include
Forced reporting of managers to owners
Requiring managers to invest substantial resources of their own
Covenants that restrict what borrowers can do with borrowed funds
Financial Intermediaries and Information Costs
The problems of adverse selection and moral hazard make direct finance expensive and difficult
to get.
These drawbacks lead us immediately to indirect finance and the role of financial institutions.
Much of the information that financial intermediaries collect is used to reduce information costs
and minimize the effects of adverse selection and moral hazard
Screening and Certifying to Reduce Adverse Selection
Monitoring to Reduce Moral Hazard
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY