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29_zb_2010 - Copy - Examiners commentaries 2010 Examiners...

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Examiners’ commentaries 2010 1 Examiners’ commentaries 2010 29 Financial intermediation – Zone B Important note This commentary reflects the examination and assessment arrangements for this unit in the academic year 2009–10. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE). Specific comments on questions – Zone B Candidates should answer FOUR of the following EIGHT questions. All questions carry equal marks. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given with your Admission notice. The make and type of machine must be clearly stated on the front cover of the answer book. Question 1 Discuss the primary functions of financial intermediaries, and critically analyse the theory of ‘delegated monitoring’. Reading for this question Please refer to Chapter 1 of the subject guide (pp.7–10 and 12–14). Within these pages, there are Activity boxes which direct you to study appropriate sections from Bhattacharya and Thakor (1993), Diamond (1996), Matthews and Thompson (2008) and Saunders and Cornett (2006). Approaching the question This question comprises two elements, with the latter requiring a more detailed and technical discussion. The first part of your answer should focus on the main activities of financial institutions in their provision of brokerage and asset transformation functions. In brokerage, financial institutions 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. The bulk of your answer should focus upon 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 of the answer could initially address information costs and monitoring costs, which would then serve as a foundation to proceed to a discussion of the Diamond (1984) model (which could draw on Diamond (1996)).
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29 Financial intermediation 2 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.
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