Econ 412 - Chapter 11 & 12

The importance of intermediaries:

-Banks are critical providers of financing around the world. -Banks decide the size of a loan and interest rate to be charged. -Markets determine which firms can access the stock and bond markets. -Reflecting these markets, securities firms set the volume and price of new stocks and bond issues when they purchase them for sale to investors.

Diversifying Risk

-Banks take deposits from thousands of individuals and make thousands of loans with them. This allows for diversification & risk reduction -All financial intermediaries provide a low-cost way for individuals to diversify their investments.

Additional Solutions to Adverse Selection:

-Collateral - .... -Net Worth - the owner's stake in a firm. It's the value of the firm's assets minus the value of its liabilities.

Providing Liquidity

-Financial intermediaries offer us the ability to transform assets into money at relatively low cost -Banks can structure their assets accordingly -Intermediaries offer both individuals and businesses lines of credit, which provides customers with access to liquidity.

Solving the Moral Hazard problem in debt finance:

-Legal contracts can solve the moral hazard problem inherent in debt finance. -For new companies, in some cases a financial intermediary called a venture capital firm does the monitoring. -For example: home mortgages require home insurance, fire insurance, etc.

Financial Intermediaries and Information Costs:

-Much of the information that financial intermediaries collect is used to: --Reduce information costs. --Minimize the effects of adverse selection and moral hazard. To do this, intermediaries: --Screen loan applicants. --Monitor borrowers. --Penalize borrowers by enforcing contracts.

Social perspective problems of adverse selection are damaging to the economy:

-Some companies will pass up good investments. -The economy will not grow as rapidly as it would otherwise. -Useful products are either not developed or are delayed in introduction to the marketplace. -Solve this by disclosure of information: producing public financial statements

Collecting and Processing Information

-The fact borrowers know whether they are trustworthy, while the lender faces substantial costs to obtain information, results in an information asymmetry. - By collecting and processing standardized information they reduce the problems that information asymmetries create.

Role of Financial intermediaries and financial institutions - perform five functions:

1. Pooling the resources of small savers. 2. Providing safekeeping and accounting services, as well as access to payments system. 3. Supplying liquidity by converting savers' balances directly into a means of payment whenever needed. 4. Providing ways to diversify risk. 5. Collecting and processing information in ways that reduce information costs.

How Companies Finance Growth and Investment:

Two important sources of funds for firms that want to expand their operations: -Issue bonds. -Seek loans at financial intermediaries.

Information Asymmetries and Information Costs

- Asymmetric information is a serious hindrance to the operation of financial markets Poses two important obstacles: 1. Adverse selection arises before the transaction occurs. (bad car vs good car example) *Lenders need to know how to distinguish good credit risks from bad before making resources available.* 2. Moral hazard occurs after the transaction. *How do we give borrowers incentives to use borrowed money as claim it will be used?*

Safekeeping, Payments System Access, and Accounting

Banks: -Are a safe place for safekeeping. -Provide easy access to the payment system. -Specialize in handling payment transactions. -Facilitate the exchange of goods and services. -Provide us with bookkeeping and accounting services, noting all our transactions

Sources of funds for borrowers:

Direct finance: -The bond market. -The equity market. Indirect finance: -Financial intermediaries such as banks, insurance companies, pension funds, etc.

Unsecured loans:

Like credit cards, are loans made without collateral

Pooling Savings

The most straightforward economic function of a financial intermediary is to pool the resources of many small savers.