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Week 4
March 13 2014

Economy with Money and


Deficit, surplus and balanced budget


If each and every household either

consumed its entire income or spent its
consumption and investment goods, all
households would be balanced budget units :
no scope for credit or finance to play a role.
For finance to play a role some economic
units must choose not to be balanced budget

Financial Intermediation

Transfer of funds from surplus to deficit


Direct financing borrowing directly from


Auction market credit/debt

Only accessible to government and other large

Indirect financing going through financial


Intermediaries negotiate between borrowers and


Financial Institutions and

Financial Intermediaries

Financial Institution:

A business whose primary activity is

buying, selling or holding financial

Financial Intermediary:

A business that connects savers with


Types of financial

1. Depository institutions (banks, credit unions, etc)

2. Financial brokers

Investment banks : They sell new securities for companies. They

dont hold deposits or make loans.
Brokerage Houses: Buy/sell old securities on behalf of individuals.

3. Investment institutions

Their main liabilities are deposits and main assets are loans.

Mutual funds: get money from small savers (individuals), who buy
shares in the fund; they in turn invest in variety of stocks, bonds,
etc.; allow individuals to pool their savings, diversify (avoid risk).
Finance companies: like banks, they use peoples savings to make
loans to businesses, but instead of holding deposits, they sell
bonds and commercial paper.

4. Contractual intermediaries

They hold and store individuals savings over long term PENSION

Financial Intermediation

The process of borrowing and

lending through intermediaries like
banks, mutual funds, etc. is called
Financial Intermediation or Indirect
All the above types of FIs except
for financial brokers are financial

Asset Transformation

Savers need

Some put money away for long time

and accept some degree of risk
Majority are most concerned with the
safety of their savings and put a
premium on liquidity
Overall, there is a strong preference
for safety and liquidity

Asset transformation

Investors requirements

Some require long-term capital or

Others require funds only for a short
period and can be repaid with a high
degree of certainty
Principal need is for long-term highrisk finance

Asset transformer

A FI issues financial claims that are

more attractive to household
savers than the claims directly
issued by the corporations

Financial Intermediaries

Asset transformer

Provision of liquidity

Reducing transaction costs

Provision of Liquidity

Main providers of liquidity

deposit-taking institutions

Issue liabilities (deposits) with a

maturity shorter than their assets
Rely on law of averages with respect
to deposit-making activities
Institutions must be able to remain
competitive in market for deposits

Variable rates of interest on deposits

Liquidity and Price risk

Liquidity refers to the ease of converting an

asset into cash
Price risk refers to the risk that the sale price of
an asset will be lower than the purchase price of
that asset.

FIs offers highly liquid and low price-risk contracts

to savers (liabilities) while investing in relatively
illiquid and higher price-risk securities (assets).
Why is it possible for the FIs to do so?
ANSWER: Diversification of risk.

Transaction costs

Transaction costs are non-price costs of

assessing and carrying out a transaction.

Examples are

Search costs
Credit risk assessment

Reducing transaction costs

Provide places to conduct business

Provide standardised prodicts

Branch networks
Information networks e.g. ATM
Reduce cost of information collection

Economies of scale

Minimise costs

Transaction costs

..the essential feature of financial intermediation

reduction of the transaction costs of effecting inter- and
intra-temporal consumption decisions.
(page 216)

Financial intermediaries create financial commodities

because they have a comparative advantage in
processing documents, in acquiring information about
borrowers ability to repay debts, and in monitoring
instruments that can be easily converted into
generalised purchasing power. (page 222)
Benston and Smith (1976)

How the FIs affect savings

and investment?

Saving increases at each given

interest rate
Risk and maturity transformation
probably encourage both saving
and investment and raise the level
of investment in economy

Increase borrowers demands for

funds; increase investment

Saving probably increases

Precautionary needs reduced (less savings)

Improvement in characteristics of financial
instruments makes saving more attractive
(more saving)
In absence of suitable saving instruments
individuals may have used alternative
methods such as family and friends (more
Net effects may rise or fall?


Modern Theory of

Why do intermediaries exists?

Lesser emphasis on transaction costs

Crucial in explaining trusts

Could explain intermediation, but in many
cases their magnitude does not appear
sufficient to be sole cause

Greater emphasis on incomplete

financial markets and informational

Imperfect market

In an imperfect market, FIs exist

not only due to transaction costs
but also because there is not full

A lack of information overall and

Asymmetric information

Asymmetric information

Asymmetric information (AI) exists

when one party to a transaction
has more information about that
transaction than the other party.

Asymmetric information

Asymmetric information leads to

Adverse selection

Moral Hazard

Adverse selection

Occurs when the potential borrowers

who are most likely to produce an
undesirable (adverse) outcome the bad credit risks are the ones
most likely to be selected

lemons problems refer to Reading

# 2, Akerlof (1970).

Adverse selection

Akerlofs lemons principle in a

market with quality uncertainty the
better quality items will tend to be
withdrawn from the market leaving
only the lemons for sale. Over
time the market may disappear.
In debt markets the lemons are
borrowers with high risk.

Lemon Problem

Occurs in the debt and equity

market when lenders have trouble
determining whether a borrower is
a good risk (he has good
investment opportunities with low
risk) or, alternatively, is a bad risk
(he has poor investment
opportunities with high risk)

Lemon problem

High quality firms will issue few


Credit markets will not work well

Many profitable projects will not be


Here financial intermediaries

Produce information
Correctly sort borrowers
Signal their findings to other

Financial intermediaries are

Specialists in risk assessment insider

knowledge due to broad customer

Moral hazard

In the financial markets:

The principal = the lender

The agent = the borrower

The lender would like the borrower

to use the funds on low risk
investment projects which would
minimise the risk of default.

Moral Hazard

Occurs after a loan is extended,

when the lender is subjected to the
hazard that the borrower might
engage in activities that are
undesirable (immoral) from the
lenders point of view, because
they increase the probability of

Moral hazard

Occurs because the borrower has

incentives to invest in projects with
high risk in which the borrower
does well if the project succeeds
but the lender bears most of the
loss if the project fails.

Principal-Agent Problem
Another form of moral hazard

Managers = agents

Owners = equity holders =


Principal Agent Problem

When managers own only a small

percentage of the equity in a firm,
they have an incentive to commit
moral hazard against equity
holders by either hiding profits or
by engaging in activities that
increase their well-being but do not
benefit the equity holders.


Agency costs are incurred by the

principal when his agent does not act in
the interests of the principal.

Costs relating to the risk that the

owners and managers of firms that
receive savers funds will take actions
with those funds contrary to the best
interests of the savers.

Banking Regulation

Banking regulation = prudential


Some features of banking

regulation explained by adverse
selection and moral hazard

Bank Panics and Deposit


In a panic, depositors withdraw

funds from the banking system

Due to asymmetric information

Deposit insurance

Consequences of deposit

Adverse selection

Moral hazard

Because people who are most likely to produce the

adverse outcome insured against (e.g. bank failure)
are those who most want to take advantage of the
because insurance provides increased incentives for
taking risks that might result in an insurance payoff


Regulation to prevent
moral hazard

Chartering of banks = bank licenses

Bank regulations that restrict asset

holdings and bank capital

Regular bank examinations