PaolaFerretti_B&FMs_2021-2022

BANKING AND FINANCIAL

MARKETS

PAOLA FERRETTI
PAOLA.FERRETTI@UNIPI.IT

1
THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (2/9)

 Ex ante information asymmetry arises

because borrowers generally know more
about their investment projects than
lenders
 The borrowers that are most eager to engage
in a transaction are the most likely ones to
produce an undesiderable outcome for the
lender (adverse selection).
 It is difficult and costly to evaluate potential
borrowers

PaolaFerretti_B&FMs_2021-2022 2
THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (3/9)

 Individual savers may not have the time,

capacity or means to collect and process
information on a wide array of potential
borrowers
 Hence, high information costs may prevent funds
from flowing to the highest productive use
 On the contrary, financial intermediaries may
reduce the costs of gathering and processing
information (economies of scale and cost
savings from the use of digital technology) and
thereby improve resource allocation

PaolaFerretti_B&FMs_2021-2022 3
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (4/9)

 Additionally, there can be information asymmetry

problems ex post when borrowers can observe a
different behaviour.
 Once a loan has been granted, there is the risk that
the borrower will engage in indesiderable activities
from the perspective of the lender (moral hazard)
 In other terms, problems can occur if borrowers
engage in activities that increase the probability of
default; that is the loan’s default risk is much higher
than the lender was led to believe at the time the loan
was made.
PaolaFerretti_B&FMs_2021-2022 4
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (5/9)

Financial markets and intermediaries

mitigate the information acquisition and
costs of monitoring borrowers
For example, equity holders and banks will
create arrangements that force managers
to manage the firm in the best interest

PaolaFerretti_B&FMs_2021-2022 5
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (6/9)

 Besides, to mitigate information costs, the financial

system reduces the time and money required to carry
out financial transactions (transaction costs) by
pooling the funds from various savers for
investment….
 …In this way, large investment projects can be
financed.
 Mobilising savings allows to overcome
 The transaction cost of collecting savings from different
individuals
 The information asymmetries associated with making savers
feel comfortable about the control of their savings
PaolaFerretti_B&FMs_2021-2022 6
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (7/9)

Pooling can occur via either

1) financial markets or
2) financial intermediaries
1) Firms can raise funds to finance large-scale projects
by issuing securities (bonds and stocks) on public
markets (e.g. stock exchanges). Savers generally prefer
to invest in liquid instruments (it means that
instruments are easy to be converted into purchasing
power quickly and inexepnesively to ensure easy access
to funds)
PaolaFerretti_B&FMs_2021-2022 7
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (8/9)

2) Financial intermediaries (especially banks) offer

an alternative way of pooling.
They transform the funds collected from savers into
short-term (liquid) bank deposits and invest these
funds in portfolios of more profitable long-term
(illiquid) risky projects by granting loans to firms

PaolaFerretti_B&FMs_2021-2022 8
 THE REDUCTION OF INFORMATION AND
TRANSACTION COSTS (9/9)

To sum up
 By reducing information and transaction costs, financial
systems lower the cost of channelling funds between
borrowers and lenders, which frees up resources for other
uses: particularly investments, economic growth and
innovation
 Besides, financial intermediation affects capital allocation
by channelling funds to most productive uses (allocative
efficiency)

PaolaFerretti_B&FMs_2021-2022 9
 THE FACILITATION OF THE TRADING,
DIVERSIFICATION AND MANAGEMENT OF
RISKS (1/5)

 Additionally to the reduction of information

asymmetry, an important function of the financial
system is the facilitation of the trading,
diversification and management of risks
 Financial system may mitigate the risks
associated with individual investment projects by
providing opportunities for trading and
diversifying risk

PaolaFerretti_B&FMs_2021-2022 10
 THE FACILITATION OF THE TRADING,
DIVERSIFICATION AND MANAGEMENT OF
RISKS (2/5)

 In general, high-return projects tend to be riskier than

low-return projects. The financial system, that make it
easier for people to diversify risk by offering a broad
range of high-risk (e.g. equity) and low-risk (e.g.
government bonds) investment opportunities, tend to
induce a portfolio shift towards projects with a higher
expected returns
 The ability to manage a diversified portfolio of innovative
projects reduces risk, increases returns and promotes
investment in growth-enhancing innovative activities
PaolaFerretti_B&FMs_2021-2022 11
 THE FACILITATION OF THE TRADING,
DIVERSIFICATION AND MANAGEMENT OF
RISKS (3/5)

 Besides, financial intermediaries and markets can reduce

risk by providing liquidity, which refers to the ease and
speed with which agents can convert assets into
purchasing power at agreed prices
 Savers are generally unwilling to delegate control over
their savings to investors for long periods, so less
investment is likely to occur in high-return projects
requiring a long-term commitmment of capital
 However, the financial system makes it possible for savers
to hold liquid assets (e.g. equity, bonds, deposit) that they
can sell quickly and easily if they need funds
PaolaFerretti_B&FMs_2021-2022 12