FMI- Theories of Financial Intermediation

What is the role of financial institutions?

To resolve the limitations caused by market imperfections, such as limited information regarding the creditworthiness of borrowers.

What are the main functions of financial institutions?

Brokerage, Asset transformation

What is the Brokerage Function

To match borrowers and lenders, and reduce the transaction costs and information costs

What is Asset transformation?

Issue claims that are attractive to savers, and to mismatch liquidity and maturity.

What subsections does Asset transformation also include?

Asset diversification and Asset evaluation.

What is Asset diversification?

The transformation of large assets into smaller units in order to diversify across a large number of lenders.

What is Asset evaluation?

Evaluate credit risk for lenders through having better information and skills around evaluation.

What costs are included in transaction cost theory

Search costs, Verification costs, Monitoring costs and Enforcement costs

How do financial intermediatries reduce transaction costs

Through being easy to find, economies of scale and their expertise.

Why do some firms prefer direct finance?

Because they are large and have high credit ratings

Information sharing coalitions: characteristics?

Full and complete information is not uniformly distributed amongst parties as the borrowe is likely to have more information than the lender.

What helps reduce information asymmetries?

Regulation however to a limited degree.

What is the importance of complete information?

High quality information is used to distinguish good borrowers from bad borrowers and to price loans accordingly.

What is the first fundamental problems assicated with asymmetric information

Adverse selection

What is adverse selection( before lending)

Not enough information to be able to distingish good borrowers from the bad ones, where market pruces reflect the average borrower

To resolve the problems of information asymmetry:

The individual lender must collect information on borrower, banks can help.

What are the problems with individual lenders collecting information

Costly and unkown quality, ‘ free rider’ problem

How do banks help resolve the problems of information asymmetry

Commit to long term relationships with customers, they have lost of resources and pooling of funds.

How can information sharing coalitions work

Through diversification- ‘ coalition of borrowers’ can provide information about its project to offer collaternal security.

What is another fundamental problem associated with asymmetric information:

Moral hazard after lending

What is a moral hazard after lending

Where there is not enough information on what the borrower is doing with funds, thus lenders are unable to monitor.

How to address morla hazards? Delegated monitoring

Information collection before and after the loan granted

What is the Free rider problem

Where other lenders may copy decisions if you do all the research

What does the theory on delegated monitoring require?

Scale economies in monitoring, small capacity of individual investors and low costs of delegation

What model is used for a single borrower and m lenders to justify the benefits of the delegated monitoring?

Diamond model

What is the function of the diamond model

Intermediation reducing model

What is the liquidity assurance theory

Relates to shcocks in consumers consumption patterns.

What is the portfolio theory

Total liquid reserved required by a FI are less than the aggregation of reserves required by individual customers.

What is delegated monitoring?

A theory by Douglas Diamond stating that Financial Institutions such as banks exist solely to efficienty monitor borrowers on behalf of depositors

What is the no monitoring case in delegated monitoring?

Where S is the cost of not monitoring at all, Bankrupcy of the borrower results in a cost measured as S

What is Direct monitoring?

Single borrower,m lenders, k is the cost of monitoring per lender, VERY EXPENSIVE

What is delegated monitoring in terms of EQUATION

K is the cost of monitoring, performed only once, total cost is less

What are search costs?

Expenses including time, money and effort to locate a borrower with creditworthiness

What are verification costs

Costs to do with confirming the terms of a contract are fulfilled

What are monitoring costs

Costs to do with supervising parties to fulfill their obligations

What are enforcement costs

Costs incurrend to ensure borrower follows terms of contract

Define what Transaction cost theory is:

A framework that explains why firms exist and how they decide whether to produce internally or source externally

Define Information sharing coalition theory:

A framework which analyses how seperate autonomous actors share data or knowledge to act as a cohesive group to reach a shared goal