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TOPIC 1
Introduction
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What is finance?
What is finance?
They may be .
Lender-Savers Borrower-Spenders
1. Households 1. Households
2. Business firms 2. Business firms
3. Government 3. Government
4. Foreigners 4. Foreigners
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Direct Financing
Flow of fund
Flow of financial securities
2. Secondary Market
Securities previously issued are bought
and sold
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Indirect Financing
In indirect financing, instead of
savers lending / investing directly
with borrowers, a financial
intermediary (usually an
institution, e.g. a bank) plays a
role as the middleman:
the intermediary obtains funds
from savers
the intermediary then makes
loans/investments with
borrowers
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Indirect Financing
This process is called financial
intermediation.
It is actually the primary means of moving
funds from lenders to borrowers.
More important source of finance than
securities markets, whether it is money
market or capital market.
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Indirect Financing
Functions of financial intermediaries / financial
institutions
a. Dealing with transaction cost
b. Facilitating risk sharing
c. Dealing with the problem of asymmetric
information
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Indirect Financing:
Functions of Financial Intermediaries
(A) Transaction Costs
1. Financial intermediaries make profits by
reducing transaction costs (e.g. The costs to
find the other party, to negotiate, to draw a
contract, etc.)
2. by developing expertise and taking
advantage of economies of scale (e.g. the
same contract can be used in many cases)
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Indirect Financing:
Functions of Financial Intermediaries
(A) Transaction Costs
3. A financial intermediarys low transaction costs
mean that it can provide its customers with liquidity
services, services that make it easier for customers to
conduct transactions
(i) Banks provide depositors with checking
accounts that enable them to pay their bills
easily
(ii) Depositors can earn interest on savings
accounts and yet still convert them into goods
and services whenever necessary
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Indirect Financing:
Functions of Financial Intermediaries
(B) Risk sharing
Financial intermediarires can help reduce the
exposure of investors to risk
FIs create and sell assets with lesser risk to
one party in order to buy assets with greater
risk from another party
This process is referred to as asset
transformation, because in a sense risky
assets are turned into safer assets for
investors (savers). (e.g. commercial banking)
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Indirect Financing:
Functions of Financial Intermediaries
(B) Risk sharing
Financial intermediaries (e.g. mutual fund) also
help by providing the means for individuals and
businesses to diversify their asset holdings.
Why diversify?
Indirect Financing:
Functions of Financial Intermediaries
(C) Problems of asymmetric information
It means one party lacks crucial information
about another party in a transaction, seriously
affect decision-making.
We usually discuss this problem along two
fronts: adverse selection and moral hazard.
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Indirect Financing:
Functions of Financial Intermediaries
Indirect Financing:
Functions of Financial Intermediaries
C) Problems of asymmetric information
Moral Hazard
1. Occurs after a transaction
2. Hazard (bad consequence) that borrower
has incentives to engage in undesirable
(immoral) activities making it more likely that
wont pay loan back
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Indirect Financing:
Functions of Financial Intermediaries
Adverse selection and moral hazard are challenges to any
human organization.
Success or failure to deal with them determines survival
or extinction.
Think of your group projects.
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Indirect Financing:
Functions of Financial Intermediaries
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Indirect Financing:
Functions of Financial Intermediaries
Financial intermediaries reduce
asymmetric information problems,
enabling them to make profits.
Because they are better equipped than
individuals to screen out bad credit risks
from good ones, thus reducing losses
due to adverse selection.
Besides, they develop expertise in
monitoring the parties they lend to, thus
reducing losses due to moral hazard.
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Types of Financial Intermediaries
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Types of Financial Intermediaries
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Required Reading
M&E Ch.1 - 2
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END