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29_ za_2008 - Copy - Examiners commentaries 2008 Examiners...

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Examiners’ commentaries 2008 1 Examiner’s commentary 2008 29 Financial intermediation Specific comments on questions Zone A Question 1 Explain the brokerage and asset transformation functions of banks and their role as delegated monitors in overcoming imperfect information and ‘free rider’ problems. This question relates to the readings from Matthews and Thompson (2008), Diamond (1984, 1996) and Bhattacharya and Thakor (1993), which are referred to in Chapter 1 of the subject guide. The question comprises two elements, with the latter requiring a more detailed and technical discussion. The first part of the answer should focus on the main activities of financial institutions in their provision of brokerage and asset transformation functions (as discussed in the early part of Chapter 1 in the subject guide). In brokerage, they match surplus and deficit units, and thus reduce transaction costs and information costs. In asset transformation, they issue claims that are far more attractive to savers than the claims issued directly by corporations. The asset transformation function includes an asset diversification function and an asset evaluation function. The most important contribution of intermediaries is a steady flow of funds from surplus to deficit units. Important reading on this from Matthews and Thompson (2008) and Saunders and Cornett (2006) is identified in the subject guide. The second part of the question relates to one of the key learning objectives of Chapter 1 of the subject guide. The bulk of the answer should focus on this aspect, namely the theory of financial intermediation as delegated monitoring. Defined broadly, ‘monitoring’ of a borrower by a bank refers to information collection before and after a loan is granted, including screening of loan applications, examining the borrower’s ongoing creditworthiness and ensuring that the borrower adheres to the terms of the contract. This section should initially address information costs and monitoring costs, which then serves as a foundation to proceed to a discussion of the Diamond (1984) model. Delegated monitoring is one of the key reasons for the dominance of intermediation over direct financing. An important constraint on direct investment by households in the financial claims of corporations is the cost of information collection. Failure to monitor in a timely and complete manner exposes a supplier of funds to agency costs. Financial institutions provide a solution to these problems by pooling funds from suppliers (e.g. household savers) and investing in the financial claims of corporations. The financial institution has an incentive to collect information and monitor, which also alleviates potential ‘free rider’ problems with direct financing. The average cost
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29 Financial intermediation 2 of collecting information is also reduced. It is thus argued that suppliers of funds appoint banks as delegated monitors (to act on their behalf). Better answers should proceed to analyse the costs and benefits of monitoring.
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