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Chapter 11. The Economics of Financial Intermediation. The role of financial intermediaries Asymmetric Information. The role of financial intermediaries. Depository institutions Banks, S&Ls, credit unions Nondepository institutions

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Chapter 11. The Economics of Financial Intermediation

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Chapter 11 the economics of financial intermediation l.jpg

Chapter 11. The Economics of Financial Intermediation

  • The role of financial intermediaries

  • Asymmetric Information


The role of financial intermediaries l.jpg

The role of financial intermediaries

  • Depository institutions

    • Banks, S&Ls, credit unions

  • Nondepository institutions

    • Mutual funds, pension funds, insurance companies, finance companies


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  • Indirect finance (through intermediary) is most important source of funds

    • Larger than stocks/bonds combined

  • Why?

    • Intermediaries perform important functions


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5 functions

  • Pooling savings

  • Payments services

  • Liquidity

  • Diversification

  • Information


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Pooling savings

  • Many small savers…

  • Pooled together to make large loans or investments

    • 100 savers with $1000 becomes a

      • $100,000 loan by a bank OR

      • $100,000 stock portfolio with a mutual fund


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Payments system

  • Funds are kept safe

  • Funds are easily accessed for payments

    • Checks, ATM, debit cards, online banking

  • Tracks our finances


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  • This function has large economies of scale

    • As output rises, per unit cost falls

    • Very true for financial services


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Liquidity

  • Ease/cost of converting assets to cash

  • ATMs, checks, etc. to depositors

  • Lines of credit to borrowers


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Diversification of risk

  • Small savers cannot diversify on their own

  • Pooled savings mean large, diversified investment portfolios

    • Loan portfolios

    • Stock/bond portfolios

    • Money market accounts


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Information

  • Collecting it and using it

    • Info about borrowers

    • Info about investments

  • By doing this on a large scale

    • become experts at it

    • Do it for a lower per unit cost


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Asymmetric Information

  • 2 parties in a transaction

  • one has better info than the other

    • could exploit this for advantage

  • if not controlled, this leads to markets breaking down


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  • Asym. info affects

    • buy/sell goods

      • eBay, used cars

    • insurance market

    • lending market


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2 problems:

  • adverse selection

    • occurs before the transaction

  • moral hazard

    • occurs after the transaction


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Adverse selection

  • people most who are most risky are more likely to

    • seek insurance

    • borrow money

    • sell their crappy stuff

  • the adverse are more likely to be selected


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  • why a problem?

    • uninformed party may leave market

    • beneficial transactions do not occur


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Solutions to adverse selection

  • Screening (banks, insurance)

  • Disclosure of info

    • Public companies required by SEC to produce public financial statements

  • Collateral & Net Worth

    • Bad borrowers less likely to have collateral


Example 1 life insurance l.jpg

example 1: life insurance

  • adverse selection:

    • sick/dying people more likely to want life insurance

  • solution

    • health history, blood work, etc.

    • or group membership


Example 2 bank loan l.jpg

example 2: bank loan

  • adverse selection:

    • riskier people more likely to need money

  • solution

    • credit history, references, collateral….


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Moral Hazard

  • after transaction, people likely to engage in risky behavior or not “do the right thing.”

  • hazard of lack of moral conduct


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  • why a problem?

    • uninformed party may leave market

    • beneficial transactions do not occur


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Solutions to moral hazard

  • Monitoring behavior

  • Restrictive convenants on behavior

  • Aligning incentives to both parties

    • Collateral

    • Stock options


Example 1 auto insurance l.jpg

example 1: auto insurance

  • moral hazard

    • given coverage, drive less carefully or do not lock up

  • solution

    • monitor for tickets

    • discount for anti-theft device


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example 2: bank loan

  • moral hazard

    • get the loan and “blow the money” so cannot pay it back

  • solution

    • collateral

    • insurance to protect collateral

    • consequences on credit report

    • Restrictions on how money is used


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Example 3: equity financing

  • How will funds be used?

    • Better equipment?

    • Corporate jet?

    • Principal-agent problem

      • Do corporate officers act in shareholders’ best interest?

  • Solution: stock options


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Costs of Information

  • Screening/monitoring is costly

    • But financial intermediaries minimize costs

      • Specialization/expertise

      • Economies of scale


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