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7/31/2019 Curs 2 TOB 24 Feb 2012
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The role of financial intermediaries
Lecture no 2
BANKING TECHNIQUES
AND OPERATIONS
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Objectives of the lecture
Understand the difference between internal andexternal sources offinance
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
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Financial system
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The importance of credit/bank loan and
financial intermediarries
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Eight Basic Facts
1. Stocks are not the most important sources ofexternal financing for businesses
2. Issuing marketable debt and equity
securities is not the primary way in whichbusinesses finance their operations
3. Indirect finance is many times more importantthan direct finance
4. Financial intermediaries are the mostimportant source of external funds
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Eight Basic Facts (contd)
5. The financial system is among the mostheavily regulated sectors of the economy
6. Only large, well-established corporations
have easy access to securities markets tofinance their activities
7. Collateral is a prevalent feature of debtcontracts (secured and unsecured debt)
8. Debt contracts are extremely complicated legaldocuments that place substantial restrictivecovenants on borrowers
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How to explain?
Asymmetric InformationAgency 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
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Moral Hazard in Debt Markets
Borrowers have incentives to take on
projects that are riskier than the lenders
would like
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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 foraverage quality
The buyer will decide not to buy at allbecause all that is left in the market is
poor quality items
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Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increaseinformation
Financial intermediation
Collateral and net worth
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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
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Moral Hazard: Solutions
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive
Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuableProvide information
Financial Intermediation
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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
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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
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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.
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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 FinancialMarkets, Prentice Hall (Ch 2 and ch 8)