ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity

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Money & Banking MGT411

Lesson 22

ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED)

Role of Financial Intermediaries (cont)

Liquidity;

Risk diversification

Information Services

Information Asymmetry and Information Costs

Adverse Selection

Moral Hazards

Providing Liquidity

Liquidity is a measure of the ease and cost with which an asset can be turned into a means of

payment

Financial intermediaries offer us the ability to transform assets into money at relatively low cost

(ATMs are an example)

Financial intermediaries provide liquidity in a way that is efficient and beneficial to all of us

By collecting funds from a large number of small investors, a bank can reduce the cost of their

combined investment, offering the individual investor both liquidity and high rates of return

Financial intermediaries offer depositors something they can't get from financial markets on

their own

Financial intermediaries offer both individuals and businesses lines of credit, which are pre-

approved loans that can be drawn on whenever a customer needs funds

Diversifying Risk

Financial intermediaries enable us to diversify our investments and reduce risk

While investing, don't put all your eggs in one basket

Putting $1 in 100 stocks is better than investing $100 in just one stock

Financial institutions enable us to diversify our investment and reduce risk.

Banks mitigate risk by taking deposits from a large number of individuals and make thousands

of loans with them, thus giving each depositor a small stake in each of the loans

Bank may collect $1,000 from each of one million depositors and then use $1 billion to make

10,000 loans of $100,000 each

Thus each has a 1/1,000,000 share in each of the 10,000 loans. This is diversification!

And since bank are expert at this game, it can minimize the cost of all such transactions

All financial intermediaries provide a low-cost way for individuals to diversify their

investments

Mutual funds

Information Services

One of the biggest problems individual savers face is figuring out which potential borrowers are

trustworthy and which are not

There is an information asymmetry because the borrower knows whether or not he or she is

trustworthy, but the lender faces substantial costs to obtain the same information

Financial intermediaries reduce the problems created by information asymmetries by collecting

and processing standardized information

Screen loan applications to guarantee the creditworthiness

Monitor loan recipients to ensure proper usage of funds

Information Asymmetries and Information Costs

Information plays a central role in the structure of financial markets and financial institutions

Markets require sophisticated information in order to work well, and when the cost of obtaining

information is too high, markets cease to function

Money & Banking MGT411

Asymmetric information

Issuers of financial instruments borrowers who want to issue bonds and firms that want to

issue stock know much more about their business prospects and their willingness to work than

potential lenders or investors

Solving this problem is one key to making our financial system work as well as it does

Lets take up our online store example

Buyers must believe that item has been described accurately and they must be sure that the

seller will send the item in exchange for their payment

Here sellers have much more information than buyers have, creating an information asymmetry

To resolve this issue,

Induct an insurance system

Devise an information system collecting data of purchases and delivery

Asymmetric information poses two obstacles to the smooth flow of funds from savers to

investors:

Adverse selection, - involves being able to distinguish good credit risks from bad before the

transaction;

Moral hazard, - arises after the transaction and involves finding out whether borrowers will use

the proceeds of a loan as they claim they will.

Adverse Selection

Potential borrowers know more about the projects they wish to finance than prospective lenders

Used Cars and the Market for Lemons:

In a market in which there are good cars ("peaches") and bad cars ("lemons") for sale, buyers

are willing to pay only the average value of all the cars in the market.

This is less than the sellers of the "peaches" want, so those cars disappear from the markets and

only the "lemons" are left

To solve this problem caused by asymmetric information, companies like Consumer Reports

provide information about the reliability and safety of different models, and car dealers will

certify the used cars they sell

Adverse Selection in Financial Markets:

Information asymmetries can drive good stocks and bonds out of the financial market

If you can't tell the difference between a firm with a good prospects and a firm with bad

prospects, you will be willing to pay a price based only on their average qualities

The stocks of the good company will be undervalued so the mangers of these companies will

keep the stocks away from the market

This leaves only the firms with bad prospects in the market

The same happens in the bond market

If a lender can not tell whether a borrower is a good or a bad credit risk, the demand for a risk

premium will be based on the average risk

Borrowers having good credit risk will not pay higher risk premiums and would withdraw from

the market

Only bad credit risk bonds are left in the market

Solving the Adverse Selection Problem:

The adverse selection problem resulting in good investments not to be undertaken, the economy

will not grow as rapidly as it could.

So there must be some way of distinguishing good firms from the bad ones

Disclosure of Information

Collateral and Net Worth

Disclosure of Information:

Generating more information is one obvious way to solve the problem created by asymmetric

information

This can be done through government required disclosure and the private collection and

production of information

E.g. Securities and Exchange Commission regulations

Money & Banking MGT411

Reports from private sources such as rating agencies, brokerage companies and financial

analysts

The cost and credibility of such information are to be kept in mind

Collateral and Net Worth:

Collateral is something of a value pledged by a borrower to the lender in the event of

borrower's default

Lenders can be compensated even if borrowers default, and if the loan is so insured then the

borrower is not a bad credit risk

Net worth is the owner's stake in the firm, the value of the firm minus the vale of its liabilities

If a firm defaults on loan, the lender can make a claim against the firm's net worth

The same is true for home loans

The importance of net worth in reducing adverse selection is the reason owners of new

businesses have so much difficulty borrowing money

Moral Hazards

Moral hazard arises when we cannot observe people's actions, and so cannot judge whether a

poor outcome was intentional or just a result of bad luck

Moral Hazard in Equity Finance

While purchasing stocks of a company, are you sure that it will use the funds in a way that is

best for you?

Principal-agent problem

The separation of ownership from control

When the managers of a company are the owners, the problem of moral hazard in equity

financing disappears.

Moral Hazard in Debt Finance

Because debt contracts allow owners to keep all the profits in excess of the loan payments, they

encourage risk taking

A good legal contract can solve the moral hazard problem that is inherent in debt finance.

Bonds and loans often carry restrictive covenants

The Negative Consequences of Information Costs

1. Adverse Selection:

Lenders can't distinguish good from bad credit risks, which discourages transactions from

taking place.

Solutions include

Government-required information disclosure

Private collection of information

The pledging of collateral to insure lenders against the borrower's default

Requiring borrowers to invest substantial resources of their own

2. Moral Hazard:

Lenders can't tell whether borrowers will do what they claim they will do with the borrowed

resources; borrowers may take too many risks.

Solutions include

Forced reporting of managers to owners

Requiring managers to invest substantial resources of their own

Covenants that restrict what borrowers can do with borrowed funds

Financial Intermediaries and Information Costs

The problems of adverse selection and moral hazard make direct finance expensive and difficult

to get.

These drawbacks lead us immediately to indirect finance and the role of financial institutions.

Much of the information that financial intermediaries collect is used to reduce information costs

and minimize the effects of adverse selection and moral hazard

Screening and Certifying to Reduce Adverse Selection

Monitoring to Reduce Moral Hazard

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