Class 16 Financial Institutions Outline

Class 16 Financial Institutions Outline - b.i.3.b.iii...

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Class 16 Financial Institutions Outline: Intermediaries => indirect or ‘mediated’ finance 1) Why Intermediaries? (Examine Cecchetti Table 11:1) a. they are better at solving the Problems associated with asymmetric information b. They form a disconnect between primary borrowers and lenders => reduced risk 2) Functions of Intermediary a. Pooling funds b. Transactions services b.i. Fund Storage and tracking—digital money b.ii. Execute transactions c. Liquidity supply d. Risk shifting e. 3) Information Asymmetry a. Meaning: “I know more about me than you know about me” b. b.i. Adverse selection=> “bad choice” in contract b.i.1. i.e., ‘market for lemons’ b.i.2. financial market ‘lemons’ b.i.2.a. least credit worthy seek finance b.i.3. solutions: b.i.3.a. screening applicants b.i.3.b. performance bond b.i.3.b.i. collateral b.i.3.b.ii. net worth
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Unformatted text preview: b.i.3.b.iii. insurance (CDO’s & CDS’s) b.i.3.c. transparency b.i.3.c.i. free-rider problem b.ii. Moral Hazard: after fact ‘behavior change’ => take on more risk b.ii.1. Driving habit in rental car vs. own car; investing other’s money vs. own b.ii.2. Equity Funds used in higher risk activities or personal use b.ii.2.a. Principal/Agent problem b.ii.2.b. Solutions: Align incentives b.ii.2.b.i. Require mgr to ‘own’ significant shares with sale restrictions b.ii.2.b.ii. Avoid options b.ii.3. Debt Moral Hazard funds asymmetric risk borrowers keep gains; creditors eat losses b.ii.3.a. Solutions b.ii.3.a.i. Restrictive covenants b.ii.3.a.ii. Monitoring b.ii.3.a.iii. Net worth maintenance b.ii.3.a.iv. Bank with lender c. External monitoring ( limits to regulation) c.i. Expensive c.ii. Gains to cheating c.ii.1. Bernie Madoff c.ii.2. Allen Stanford c.ii.3. Bernie Ebbers – MCI World/Com c.ii.4. Enron...
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Class 16 Financial Institutions Outline - b.i.3.b.iii...

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