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CHAPTER 3 WHY ARE FINANCIAL INTERMEDIARIES SPECIAL? Chapter outline Financial Intermediaries' Specialness Information Costs Liquidity and Price Risk Other Special Services Reduced Transaction Cost Maturity Intermediation Other Aspects of Specialness The Transmission of Monetary Policy Credit Allocation Intergenerational Wealth Transfers or Time Intermediation Payment Services Denomination Intermediation Specialness and Regulation Safety and Soundness Regulation Monetary Policy Regulation Credit Allocation Regulation Consumer Protection Regulation Investor Protection Entry Regulation The Changing Dynamics of Specialness Trends in Australia Future Trends Global Issues Instructors Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 15 Answers to end-of-chapter questions: QUESTIONS AND PROBLEMS 1. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial intermediaries (FIs). In a world without FIs the users of corporate funds in the economy would have to approach the household savers of funds directly in order to satisfy their borrowing needs. This process would be extremely costly because of the up-front information costs faced by potential lenders. Cost inefficiencies would arise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan's life span. The net result would be an imperfect allocation of resources in an economy. 2. Identify and explain three economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial intermediaries. Investors generally are averse to purchasing securities directly because of (a) monitoring costs, (b) liquidity costs, and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense and expertise. As a result, households would prefer to leave this activity to others and, by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns that may be available. Third, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.... View Full Document

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