Chapter 14

What steps can the govt take to reduce asymmetric info probs and help the fin system fcn more smoothly and efficiently?

-produce information about borrowers and provide it to investors free of charge -require borrowers to report honest information about themselves to Investors and -set and enforce rules that govern the behavior of financial institutions -banning certain activities and asset categories considered too risky -establishing minimum capital requirements

What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?

-screen potential borrowers before making loans -Monitor borrowers financial conditions and how they're using borrowed funds -Insert restrictive clauses into debt contracts -Require collateral against the loans they make

Why do govt provide safety nets for bank depositors and what are their consequences?

They provide insurance on deposits. They make sure that funds are available to fin institutes that're having trouble on the fin market. This makes depositors more willing to provide funds.

Investment Banks

Trade sec and help corps issue sec by guaranteeing a price and for the sec and then selling them.

Adverse Selection

A problem that occurs when the party who is most eager to engage in a transaction is the one most likely to produce an undesirable outcome for the other.

Asymmetric Information

A situation in which one party in a transaction has much less accurate information than the other, impedes the direct movement of funds to those with the best investment opportunities.

What is asymmetric info? what two problems hinder the operation of the financial system?

A situation in which one party in a transaction has much less accurate information than the other, impedes the direct movement of funds to those with the best investment opportunities. Adverse selection and moral hazard hinders financial system.

Capital

A-liab. If assets fall while liab remain constant, capital falls.

Screening

Collecting info about potential borrowers before a transaction occurs in order to avoid adverse selection problems

FInancial Deepening

Financial development. Linked to economic growth.

Prudential supervision

Monitors banks by examining them on a regular basis.

Hedge Funds

Mutual funds that acquires funds by selling shares to very wealthy people. Less regulated than mutual funds. Use proceeds to purch sec and engage in complex fin transactions.

Banks

aka depository institutions. Acquire funds by issuing deposits and using the proceeds to make loans. Includes commercial banks, savings and loan associations, mutual savings banks, and credit unions.

How can asymmetric info probs lead to a bank panic?

bank depositors face an asymmetric information problem of their own: They do not know as much as bank managers do about how much risk banks are taking and are uncertain about the safety of their deposits and their banks' ability to pay them back in full. If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not.

Net Worth

capital

Equities

debt sec (bonds) and c/s

What are the benefits of financial deepening?

growth of financial assets that is faster than rate of economic growth. Reflected in growth of liquid financial assets to GDP. Provides an indication of the ability of financial system to finance investment. interest rate > inflation. Reduces poverty and child labor. Industries dependent on external sources of funds will grow faster. New firms created. Improves capital allocation.

Mutual Funds

Acquire funds by selling shares top individuals and use the proceeds to buy securities such as stocks and bonds.

Insurance Companies

Acquire funds from premiums paid by policyholders and insure against hazards.

Exchanges

Buyers and sellers of securities meet in one central location to conduct trades .

Moral Hazard

Created by asymmetric info, its the risk (hazard) that the other party will engage in activities that are undesirable (immoral) from your pov

Bonds

Debt securities that offer a stream of pmts for a fixed period of time.

Why are asymmetric information problems particularly challenging in developing countries? What does this imply about the importance of financial intermediation and the role of banks in these countries?

Developing countries likely have weaker accounting and reporting standards, so accurate information about private firms is more difficult to come by and also more difficult to analyze because of limited access to information technology. As a result, asymmetric information problems are greater in developing countries, and local firms, therefore, find it difficult to acquire funds through selling securities in financial markets. Because banks make private loans and have an incentive to gather information to solve asymmetric information problems, financial intermediation becomes even more important in developing countries' financial systems than it is in developed countries.

How does direct finance differ from indirect finance? Which form of finance is more important?

Direct finance does not require intermediaries because borrowers borrow directly from savers. Indirect is more important because it supplies about 60% of funds to nonfin businesses.

Pension funds

Include private and govt funds, acquire funds through contributions from employees and their employers and provide retirement income to the employees and their employers.

Financial Intermediary

Indirect fin, a financial institution stands between lenders and borrowers.

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

Investors in financial instruments who engage in information collection face a free-rider problem, which means other investors may be able to benefit from their information without paying for it. Individual investors, therefore, have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. Because they will reap all the benefits from the information they collect, their information collection activities will be more profitable. They, thus, have greater incentive to invest in information collection.

Balance Sheet

Lists assets and liabilities. A=Liab +OE

Microcredit

Offer very small loans

Free- rider problem

Private investors who don't spend their resources on collecting info taking advantage of info others collect.

Financial Intermediation

Process

Collateral

Property the borrower promises in the loan contract to hte lender if the borrower defaults on its debt.

Finance Company

Raise funds by selling commercial paper and by issuing stocks and bonds. They use funds to lend to consumers and businesses.

Prudential regulation

Rules set by the government to prevent banks from taking too much risk.

What role does the financial system play in promoting economic growth?

The financial system directs funds to where they can do the most good, promoting economic stability, and growth.

Financial Instruments

securities