Adverse selection means this isnt really true the

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Adverse selection means this isn’t really true - the borrower will always know more about his/her risks than the lender, so the realized return will always be lower than expected. Raising contractual rates means that the problem will worsen, so doesn’t help. This means lenders must monitor borrowers and refuse loans when the risk is too hard to access or the borrower too hard to monitor. Further, usury ceilings (caps on loan rates) mean lenders may be unable to price risk accurately. Because of adverse selections, realized returns on loans are lower than expected (raising contractual rates does not help bc creates more adverse selection) usury ceiling is another obstacle to proper pricing. - ceiling is legal limit on rate lender can charge. prevents banks from lending to most risky borrowers (so when interest rates rise a lot, can force banks to restrict credit card lending to risky people). 4. How does the correspondent relationship affect the risk and liquidity of the banks involved? For small banks, correspondent relationships can diversify their lending. Fed funds sold to a correspondent bank are liquid but provide a return; they are uninsured though and earn less than other assets. The failure of the large bank can bring them down. Buying loans from a correspondent bank is another way to use funds, but they rely on the originating bank to assess the credit risk of the loan so may know little about it. Since these banks are usually deposit rich, the correspondent relationship provides an opportunity to put their funds to good use. For large banks, relationships with smaller banks provide them with an ability to get loans off their balance sheets and diversify. Banks keep the informational advantage of originating loans in an industry or area they know well (specialization) but avoid the lack of diversification by selling the loans. Since these banks are usually deposit poor, the relationship allows them access to funds of other banks with fed funds purchased. Risk:
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Interbank lending is a source of credit risk Because so many respondent small banks and thrifts lend large amounts to regional and money- center correspondent banks, if one large correspondent bank fails, many respondent banks can also fail Fed Funds sold and Eurodollar deposits are not covered by deposit insurance, so higher risk to the lender that they might lose everything in case of borrower default Money center correspondent banks can reduce the risk of very large loans that would make their assets undiversified, by sharing the risk with their respondents through syndications and participations (and securitization) Liquidity: Fed Funds sold (loans from respondent banks, Ledyard, to correspondent banks) are mostly overnight so they are a source of liquidity for small banks can be turned into cash by not rolling over Disadvantages: Lower yield than securities, unsecured and uninsured so credit risk if correspondent defaults Correspondent money center banks use Fed Funds bought (borrowed from respondent banks) to increase their liquidity, allowing them to fund more assets than they could otherwise fund 5.
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