Topic E 2 banking and credit
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23 Terms
Why do banks exist?
To reduce transaction costs and solve info problems
Why does adverse selection make lending difficult?
Banks cannot easily identify good vs bad borrowers, bad borrowers seek more funds agressively.
Why are banks important for small firms?
Small firms struggle to access financial markets directly. Banks solve info gaps
How does screening reduce adverse selection?
Banks gather information before lending so better borower quality.
How does monitoring reduce moral hazard?
Banks observe borrower behaviour after lending. Limits excessive risk taking.
How does collateral reduce risk?
Borrowers lose assets if they default. Creates discipline
Why do banks hold reserves?
To meet withdrawals and legal requirements as liquidity protection
Why are excess reserves useful?
They protect against unexpected deposit outflows.
What happens if a bank has reserve shortages?
It must, borrow, sell securities and reduce loans
How do banks make a profit?
Borrow short term, lend long term
Why are loans profitable?
Higher returns than reserves or many securities. But higher risk
Why diversify assets?
To reduce risk concentration.
Why does higher bank capital improve safety?
It absorbs losses before insolvency
Why is high capital costly?
Lower return on equity. Safety return trade off.
Why do long term relationships matter?
Banks gain private info, improves screening.
Why do loan commitments help banks?
They strengthen relationships and improve info flow.
If IRs rise and liabilities are more rate sensitive than assets, what happens?
Profits fall, costs rise faster than income.
Why did securitisation grow?
To transform illiquid loans into tradeable assets.
Why has traditional banking declined?
Technology reduced info costs. Firms can borrow directly
Why did shadow banking grow?
Alternative lenders filled gaps left by traditional banks.
Why has bank consolidation increased?
economies of scale + deregulation + technology
Benefit of bank consolidation?
More efficiency and diversification
Cost of bank consolidation?
Less local lending and potentially more systematic risk.