Lecture 3

Why Financial Intermediaries?Why financial intermediaries exist?To reduce transaction costs and information costsTransaction costsWhich means the time and money spent on carrying out financial transactionsTC are major problem for people who have excess funds to lendIn absence of FIs, every lender will need a lawyer to write a contract for him which will be very costlyInstitutions pay lower commissions like mutual funds Institutions can take advantage of latest technology

Transaction and Information costsFinancial intermediaries can reduce these costs as they have developed expertise in lowering them and their large size allow them to have economies of scaleFor example, once a bank pays a lawyer for one loan contract, the same contract can be used in many other loan contracts

Asymmetric Information: Adverse selection and Moral HazardAnother reason for the presence of financial intermediaries is that one party often does not know enough about the other party to make accurate decision of lending Asymmetric information means the inequality in the level of information between two partiesFor example, a borrower usually have better information about the potential returns and risks of the project for which funds borrowed than the lender doesThe analysis of how asymmetric information affect economic behavior is called agency theory

Information Problems: Adverse Selection and Moral HazardsInformation asymmetry creates two problems in the financial system:A. Before the transaction is entered intoB. After the transactionAdverse Selection: Borrowers that can create undesirable outcome will actively seek out a loan and are thus most likely to be selected. Adverse selection means making a mistake by giving away loans to undesirable borrowers

Moral HazardsMoral hazard is the risk that the borrower might engage in activities that are undesirable from lenders perspective. Moral hazards needs frequent monitoring of the borrowers activitiesIt is also referred to as conflict of interestFinancial intermediaries have better earnings to pay for information and screen out bad borrowers from good borrowers (solving adverse selection problem)

Financial intermediaries also have better resources and can monitor and force borrowers to act in accordance with the provisions of the contract and reduce the chances of misconduct of borrowers

Types of Intermediaries

Regulation of Financial intermediariesIt is one of the highly regulated sectors. There are three reasons why it is so:A. Increase information available to investorsB. To ensure soundness of financial systemC. To improve control of monetary policy

A. Increase information available to investorsIncomplete information leads to adverse selection and moral hazard problems which reduce efficiency of the financial system, this is why govt tries to increase information available to investorsSECP requires corporations issuing securities to disclose certain information about their sales, assets, earningsSimilarly, SECP prohibits insider trading

B. To ensure soundness of financial systemAsymmetric information can also lead to widespread collapse of financial intermediaries, called financial panicWhen geneal public lose trust in financial institutions, they will withdraw funds from both good and bad institutionsTo protect public and economy from financial panic, govt implements six types of regulations

To avoid Financial Panic1. Restriction to entryOnly citizens with good credentials and large amount of initial funds get approval from SECP2. DisclosureStringent reporting requirement for FIs 3. Restrictions on assets and activities4. Deposit insurance5. Limits on competition6. Restriction on interest rates

C. Improving control n monetary policyBecause banks play a very important role in determining the supply of money, much of regulations are intended to improve control over monetary supplyOne such regulation is reserve requirements

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