Elmélet 10

Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.

Adverse selection is the asymmetric information problem that exists before the transaction occurs. For lenders, it is the difficulty in judging a good credit risk from a bad credit risk. Moral hazard is the asymmetric information problem that exists after the transaction occurs. For lenders, it is the difficulty in making sure the borrower uses the funds appropriately. Financial intermediaries can reduce adverse selection through intensive screening and can reduce moral hazard by monitoring the borrower.

The concept of diversification is captured by the statement

Don't put all your eggs in one basket

In the United States, loans from .... are far ..... important for corporate finance than are securities markets.

Financial intermediaries; more

The countries that have made the least use of securities markets are ...... and ....... : in these two countries finance from financial intermediaries has been almost ten times greater than that from securities markets

Germany; Japan

If bad credit risks are the ones who most actively seek loans, and, therefore, receive them from financial intermediaries, then financial intermediaries face the problem of

adverse selection

The problem created by asymmetric information before the transaction occurs is called ......., while the problem created after the transaction occurs is called ....

adverse selection; moral hazard

Typically, borrowers have superior information relative to lenders about the potential returns and risks associated with an investment project. The difference in information is called

asymmetric information

Reducing risk through the purchase of assets whose returns do not always move together is

diversification

Studies of the major developed countries show that when businesses go looking for funds to finance their activities they usually obtain these funds from

financial intermediaries

Although the dominance of ________ over ________ is clear in all countries, the relative importance of bond versus stock markets differs widely.

financial intermediaries; securities markets

The process of indirect finance using financial intermediaries is called

financial intermediation

Risk sharing is profitable for financial institutions due to

low transactions costs

Financial intermediaries provide customers with liquidity services. Liquidity services

make it easier for customers to conduct transactions

An example of the problem of ________ is when a corporation uses the funds raised from selling bonds to fund corporate expansion to pay for Caribbean cruises for all of its employees and their families.

moral hazard

Economies of scale enable financial institutions to

reduce transactions costs.

The process where financial intermediaries create and sell low-risk assets and use the proceeds to purchase riskier assets is known as

risk sharing

The process of asset transformation refers to the conversion of

risky assets into safer assets

An example of economies of scale in the provision of financial services is

spreading the cost of writing a standardized contract over many borrowers

Adverse selection is a problem associated with equity and debt contracts arising from

the lender's relative lack of information about the borrower's potential returns and risks of his investment activities.

The time and money spent in carrying out financial transactions are called

transaction costs