29_zb_2009 - Copy - Examiners commentaries 2009 Examiners...

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Examiners’ commentaries 2009 1 Examiners’ commentaries 2009 29 Financial intermediation – Zone B Specific comments on questions Question 1 Critically analyse how (i) transaction costs and (ii) delegated monitoring could lead to a preference for intermediation over direct financing. Reading for this question: Please refer to Chapter 1 of the 2008 subject guide (pp.8–14). Within these pages, 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). Approaching the question: This question requires a critical analysis of the preference for intermediation over direct financing, and specifically expects the focus to be on transaction costs and delegated monitoring. Despite 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 (a) and (d). Reason (b) forms part of the answer to Question 2 on this examination paper. In terms of transaction costs, coverage of the technical material and the discussion on p.10 of the subject guide is an essential component for a good answer. Aspect (ii) of the question relates to one of the key learning objectives of Chapter 1 of the 2008 subject guide (see p.8), 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
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29 Financial intermediation 2 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
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