What do information asymmetries generate?
- Adverse selection
- Moral hazard
- Agency costs
What is an ex ante consequence of information asymmetry?
Adverse selection (hidden info)
What is an ex post consequence of information asymmetry?
Moral hazard (hidden actions)
What is another term for agency costs?
Monitoring costs
What can mitigate adverse selection?
- Screening
- Warranties / signalling
- Requiring informed agents to invest their own resources
What is market failure?
Inefficient distribution of goods & services in free market
What is credit rationing?
Market failure where lenders are unwilling to lend at prevailing rate
What can mitigate moral hazard?
- Monitoring
- Covenants limiting what borrowers can do with funds
What can mitigate agency costs?
- Aligning interests (risk-sharing, performance bonuses…)
- Cost economies for intermediaries
True or false: decreasing informational costs due to tech have reduced importance of banks
False – therefore banks must also fulfil other functions
What are the explanations for financial intermediation?
- Delegated monitoring
- Information production
- Liquidity transformation
- Consumption smoothing
- Commitment mechanisms
True or false: delegated monitoring comes with ‘delegation costs’ of monitoring the FI itself
True, therefore the delegation cost must be lower than the direct monitoring cost
What do banks create in their information production role?
Relational contracts / “soft” information
What do banks create in their liquidity transformation role?
Financial / secondary claims
What is the advantage of secondary claims over direct claims (equity & bonds)?
More liquid
Consumption smoothing is most relevant to which FIs?
Pension funds & insurers
How does ‘commitment mechanism’ work?
Disciplines management against excessive risk-taking – imprudent management lowers supply of deposits, raising cost of finance
Why are loans illiquid?
They are bilateral contracts
What are the benefits of financial intermediation to ultimate lenders?
- Liquidity
- Diversification
- Marketable securities (CDs)
- Lower transaction costs
- Simpler process
What are the benefits of financial intermediation to ultimate borrowers?
- Lower transaction costs = lower financing costs
- Larger funds available
- Long-term funds available
- Funds available when needed
