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1
Lecture 3: Financial Intermediaries
Mishkin chapter 2 – part B
Page 35-42
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Review
Financial markets
1. Money markets and capital markets
2. Debt markets and equity markets
3. Primary markets and secondary markets
4. Exchanges and Over-the-Counter (OTC) markets
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Financial system – revisited
Financial Intermediaries(e.g. bank)
Financial markets
Money
MoneyMoney
Indirect finance
Direct finance
Lender BorrowerRegulation
Financial instrument B(e.g. student loans)
Financial instrument A
(e.g. saving account)
Financial instruments (e.g. bond, stock)
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Financial intermediaries
Financial intermediaries are institutions that borrow funds from people who have saved and make loans to other people.
Financial asset transformation More important source of finance than
financial markets, engage in process of indirect finance.
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Direct and indirect finance
Direct finance: through trading securities (financial
instruments) in financial markets. only happen in primary market
Indirect finance: transfer funds via financial intermediaries. involves financial asset transformation
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Function of financial intermediaries Indirect finance
facilitate borrowing and lending
Lower transaction costs Economies of scale, develop expertise Liquidity services ( but bank charges premium)
Reduce risk Risk Sharing (e.g. insurance companies) Diversification
Alleviate ‘asymmetric information problem’
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Asymmetric information
Adverse selection Adverse selection is a problem that arises for
a buyer of a good, service, or asset when the buyer has difficulty assessing the quality of this item before purchase.
‘lemon car’loan market:
risky borrower are more likely to be ‘selected’
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Asymmetric information – Cont’d
Moral hazard Moral hazard is said to exist in a market if,
after the signing of a contract or transaction:
1. one party changes behavior which might have undesirable results;
2. only imperfectly able to monitor/control insurance, stock market: engage in
undesirable (risky) activities
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FIs come to the rescue FIs can reduce adverse selection by:
Check up on borrowers/do credit research.Develop reputation (keep credit report) for
repaying. reduce moral hazard by:
develop monitoring expertise. joint ownership
FIs make profits from producing information.
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Financial asset transformation Financial asset transformation (FAT)
means to purchase one kind of financial asset from borrowers (long-term loan contract, e.g., a mortgage) -- and sell a different kind of financial asset to savers (generally relatively liquid contract, e.g., a deposit account).
Financial intermediaries make profits from financial asset transformation.
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Recap
Direct vs. indirect finance Functions of financial intermediaries Adverse selection and moral hazard in
financial markets. How can financial intermediaries solve
these asymmetric information problems?