ch11 - TheNatureofFinancial Intermediation Chapter11...

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    The Nature of Financial  Intermediation Chapter 11
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    The Economics of Financial  Intermediation In a world of perfect financial markets  there would be no need for financial  intermediaries (middlemen) in the  process of lending and/or borrowing Costless transactions Securities can be purchased in any  denomination Perfect information about the quality of  financial instruments
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    Reasons for Financial  Intermediation Transaction costs Cost of bringing lender/borrower together Reduced when financial intermediation is used Relevant to smaller lenders/borrowers Portfolio Diversification Spread investments over larger number of securities and  reduce risk exposure Option not available to small investors with limited funds Mutual Funds —pooling of funds from many investors and  purchase a portfolio of many different securities
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    Reasons for Financial  Intermediation Gathering of Information Intermediaries are efficient at obtaining  information, evaluating credit risks, and are  specialists in production of information Asymmetric Information Adverse Selection Moral Hazard
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    Asymmetric Information Buyers/sellers  not  equally informed about  product Can be difficult to determine credit worthiness,  mainly for consumers and small businesses Borrower knows more than lender about  borrower’s future performance Borrowers may understate risk Asymmetric information is much less of a  problem for large businesses—more publicly  available information
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    Adverse Selection Related to information about a business  before  a  bank makes a loan Small businesses tend to represent themselves as  high quality Banks know some are good and some are bad,  how to decide Charge too high an interest, good credit companies look  elsewhere—leaves just bad credit risk companies Charge too low interest, have more losses to bad companies  than profits on good companies Market failure —Banker may decide not to lend money to  any small businesses
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    Moral Hazard Occurs  after  the loan is made Taking risks works to owners  advantage, prompting owners to make  riskier decisions than normal Owner may “hit the jackpot”, however,  bank is not better off From owner’s perspective, a moderate loss  is same as huge loss—limited liability 
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  The Evolution of Financial  Intermediaries in the US The institutions are very dynamic and  have changed significantly over the years The relative importance of different types of  institutions and has changed from 1952 to  2002 Winners —Pension funds and mutual fund
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ch11 - TheNatureofFinancial Intermediation Chapter11...

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