The role of financial intermediaries

Lecture no 2 BANKING TECHNIQUES AND OPERATIONS

Objectives of the lecture

Understand the difference between internal and external sources of finance 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

Financial system

The importance of credit/bank loan and financial intermediarries

Eight Basic Facts

1. Stocks are not the most important sources of external financing for businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance is many times more important than direct finance 4. Financial intermediaries are the most important source of external funds

Eight Basic Facts (contd)

5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well-established corporations have easy access to securities markets to finance their activities 7. Collateral is a prevalent feature of debt contracts (secured and unsecured debt) 8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers

How to explain? Asymmetric Information

Agency 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

Moral Hazard in Debt Markets

Borrowers have incentives to take on projects that are riskier than the lenders would like

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 for average quality The buyer will decide not to buy at all because all that is left in the market is poor quality items

Adverse Selection: Solutions

Private production and sale of information
Free-rider problem

Government regulation to increase information Financial intermediation Collateral and net worth

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

Moral Hazard: Solutions

Net worth and collateral
Incentive compatible

Monitoring and Enforcement of Restrictive Covenants

Discourage undesirable behavior Encourage desirable behavior Keep collateral valuable Provide information

Financial Intermediation

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

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

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.

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 Financial Markets, Prentice Hall (Ch 2 and ch 8)