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The role of financial intermediaries

Lecture no 2

BANKING TECHNIQUES

AND OPERATIONS

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Objectives of the lecture

Understand the difference between internal andexternal sources offinance

Explain the main types of financing (equity and debt) Understand the difference between direct and indirect

finance Understand the difference between primary and

secondary market Analyse the importance of financial intermediaries

Explain the functions of financial intermediaries Identify types of financial intermediaries

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Financial system

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The importance of credit/bank loan and

financial intermediarries

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Eight Basic Facts

1. Stocks are not the most important sources ofexternal financing for businesses

2. Issuing marketable debt and equity

securities is not the primary way in whichbusinesses finance their operations

3. Indirect finance is many times more importantthan direct finance

4. Financial intermediaries are the mostimportant source of external funds

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Eight Basic Facts (contd)

5. The financial system is among the mostheavily regulated sectors of the economy

6. Only large, well-established corporations

have easy access to securities markets tofinance their activities

7. Collateral is a prevalent feature of debtcontracts (secured and unsecured debt)

8. Debt contracts are extremely complicated legaldocuments that place substantial restrictivecovenants on borrowers

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How to explain?

Asymmetric InformationAgency theory analyses how asymmetric information

problems affect economic behavior

Adverse Selection (before the transaction)more likely

to select risky borrower

Moral Hazard (after the transaction)less likely borrower

will repay loan

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Moral Hazard in Debt Markets

Borrowers have incentives to take on

projects that are riskier than the lenders

would like

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Adverse Selection:

The Lemons Problem

If quality cannot be assessed, the buyer is

willing to pay at most a price that reflects

the average quality

Sellers of good quality items will not want

to sell at the price foraverage quality

The buyer will decide not to buy at allbecause all that is left in the market is

poor quality items

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Adverse Selection: Solutions

Private production and sale of information

Free-rider problem

Government regulation to increaseinformation

Financial intermediation

Collateral and net worth

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Function of Financial Intermediaries:

Indirect Finance

Lower transaction costs

Expertise

Economies of scale

Liquidity services

Reduce Risk

Risk Sharing (Asset Transformation< maturity

transformation)Diversification: You shoudnt put all the eggs in a

basket

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Moral Hazard: Solutions

Net worth and collateral

Incentive compatible

Monitoring and Enforcement of Restrictive

Covenants

Discourage undesirable behavior

Encourage desirable behavior

Keep collateral valuableProvide information

Financial Intermediation

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Types

Depository institutions

Commercial banks

Savings and loan associations

Credit unions

Contractual savings institutions

Insurance companies

Pension funds

Investment intermediaries

Finance companies

Mutual funds

Investment banks

others

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Questions

1. Financial institutions that accept deposits and make loans are called

________ institutions.

a. Depository institutions;

b. Investment institutions;

c. Contractual savings;d. underwriting.

2. When an investment bank ________ securities, it guarantees a price

for a corporation's securities and then sells them to the public.

a. underwrites;

b. undertakes;

c. overwrites;

d. overtakes

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Questions

3. An important financial institution that assists in the initial sale of securities in

the primary market is the:

a. investment bank;

b. commercial bank;

c. stock exchange

d. brokerage house.

4. . The process of asset transformation refers to the conversion of

a. safer assets into risky assets;

b. safer assets into safer liabilities;

c. risky assets into safer assets

d. risky assets into risky liabilities.

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References

Dima.M. A, Agapie, A., Orzea, I., Moroianu, M. (2010). Banking. Theory,

cases and applications, Ed ASE

Dima, M.A., (2010), Credit Analysis. Case studies, Ed. Business Excellence

Casu, B., Giraradone, C., Molyneux (2006). Introduction to Banking,

Prentice Hall

Mishkin, F. (2007). The Economics of Money, Banking and FinancialMarkets, Prentice Hall (Ch 2 and ch 8)