1301923333985_Chapter11_Instructor_Notes - CHAPTER 11: THE...

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______________________________________________________________________________________ 211 CHAPTER 11: THE ECONOMICS OF FINANCIAL INTERMEDIATION A. T HE B ASICS Core Principles 3 and 4 are on primary display in chapter 11. Core Principle 3 states that information is the basis for making decisions, while Core Principle 4 says that markets determine prices and allocate resources. Chapter 11 applies these principles to the manner in which lenders, directly or through financial intermediaries, collect and evaluate information on borrowers. An important point of the chapter is that obtaining and processing information is costly. Is the borrower is creditworthy; that is, will the borrower have the income needed to repay the loan in a timely manner? Only if the lender can collect enough information confirming a high likelihood of returns appropriate to the risk will funds be committed directly. Alternatively, a saver without the time or expertise to collect and process information may deposit funds into a bank, let a loan officer at a bank evaluate the information, and lend indirectly through the intermediary. As an indication of the difficulty and cost of collecting and evaluating information in order to provide funds to borrowers, look at Figure 11.3 on text page 280 and note that in the U.S., businesses finance less than 20% of their activities through the stock and bond markets and financial intermediaries combined, so-called external finance. So despite the attention paid to stock and bond markets, more than 80% of business financing comes from internal sources (mainly, retained earnings, or profits less dividends). And as also indicated in Figure 11.3, the pattern is much the same for other advanced economies. The main problem with external finance is asymmetric information, which means that one party to a transaction has more information than the counterparty. An established company expanding into a line of products related to its existing business probably knows more about the chances for success than even a sophisticated loan officer at a bank, not to mention an elderly grandmother considering buying the company‟s bonds for the coupon payments. Or, suppose you are looking for a used car and respond to a newspaper ad. Almost surely, the owner/seller knows whether the car is a “lemon” but you do not. Or, suppose you work at a credit union and there is a line of loan applicants waiting to see you about their financing needs. Can you tell “good” borrowers from “bad” ones? It is common to divide asymmetric information into two categories. First, there is “adverse selection.” For example, the applicants waiting for the loan officer typically are worse than the average credit risk. A household that is prudent with its finances saves until it can buy a car with cash, essentially making “car payments” to itself in advance of the purchase. Then after it buys the car, draining the “car payment” account, it starts paying for the next car while taking delivery of the new one. The loan officer at the bank
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This note was uploaded on 09/07/2011 for the course ECO 412 taught by Professor Staff during the Spring '05 term at Kentucky.

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1301923333985_Chapter11_Instructor_Notes - CHAPTER 11: THE...

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