29_za_2009 - Copy

29_za_2009 - Copy - Examiners commentaries 2009 Examiners...

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Examiners’ commentaries 2009 1 Examiners’ commentaries 2009 29 Financial intermediation – Zone A Specific comments on questions Question 1 Explain how the presence of imperfect information and asymmetric information provides theoretical reasons for financial intermediaries to exist. Reading for this question: Please refer to Chapter 1 of the 2008 subject guide, in particular pp.8–10, 12–14. Within this chapter, there are ‘Activity’ boxes which direct you to study appropriate sections from Matthews and Thompson (2008), Saunders and Cornett (2006), Bhattacharya and Thakor (1993) and Diamond (1996). Good answers must cite Diamond (1984, 1996) and Leland and Pyle (1977). Approaching the question: This question relates to both learning objectives of Chapter 1 of the 2008 subject guide. A good answer would begin with a concise discussion of the characteristics of financial intermediaries and the functions that they perform. Your answer should proceed to explain in detail how imperfect information and asymmetric information can impinge on the efficient flow of funds from surplus units to deficit units. Despite the different requirements of lenders and borrowers, one could still envisage that the shorter chain of transactions involved in direct financing would be less costly than intermediated financing. In a situation of perfect knowledge, no transaction costs and no indivisibilities, financial intermediaries would be unnecessary, but these conditions are not present in the real world. There are four further reasons for the dominance of intermediation over direct financing: a) transaction costs (e.g. Benston and Smith, 1976) b) liquidity insurance (e.g. Diamond and Dybvig, 1983) c) information-sharing coalitions (Leland and Pyle, 1977) d) delegated monitoring (Diamond, 1984, 1996). This question relates to reasons (c) and (d). The bulk of the answer should be structured around the following three elements whereby banks help to overcome problems of moral hazard and adverse selection: i) providing commitment to long-term relationships with customers
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29 Financial intermediation 2 ii) economies of scale, and the view of banks as information-sharing coalitions iii) delegated monitoring of borrowers. Under point (i), your answer should emphasise the merits and benefits arising from a close relationship between the intermediary and its customers. Under point (ii), you should discuss Leland and Pyle’s (1977) ideas that information is a private good within a bank, thus providing an incentive for the gathering of information. More depth is expected for point (iii) since this attracts greater coverage in the subject guide and the suggested readings. 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. An important constraint on direct investment by households in the
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This note was uploaded on 03/29/2011 for the course FIN 29 taught by Professor Oap.gwilym during the Spring '11 term at University of London.

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29_za_2009 - Copy - Examiners commentaries 2009 Examiners...

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