Money, Banking and
Financial Markets
Section 1
Introduction
2. Nature and Variety of Financial
Intermediaries (FIs) -
1
Objectives 1
• Understand the motivation of this
course.
• Explain why Financial Intermediaries
(FIs) exist ?
•Explain how Adverse Selection can
cause a market failure
•Find how FIs can save on screening
costs.
2
Introduction to the Course
• Finance and Economics – focus
difference.
•Example : options
-Finance
-Economics
3
An exchange with two people
• Person 1:
•Person 2:
•The exchange
4
Advantages of financial exchange
1. Completing Projects
2. Smoothing over Time
3. Smoothing over Space
5
FINANCIAL INTERMEDIARIES
•DEFINITION:
•FINANCIAL INTERMEDIARY (F.I)
•Contemporary Financial Intermediation
“WHY” IS MORE POWERFUL KNOWLEDGE
Main FI:
But still keep it general:
6
Why do FIs exist ?
1. Advantage in producing
information “Brokerage”
2. Transforming Assets
”Qualitative Asset Transformation”
Financial Intermediation Services
Brokerage
QAT
7
Information Contracts
•Financial Contract
•Key:
•Asymmetric Information
•Pre-contract information
•Post contract information
8
Key Informational Problems
Pre-contract
Informational
Asymmetry
Adverse
Selection
Post-contract
Informational
Asymmetry
Moral
Hazard
9
Adverse Selection (AS) : “Hidden
Information”
•“Lemons” Story and Intuition
•”Evaluation Costs” to overcome AS
•Applying ”Lemons” to Credit Markets
10
Adverse Selection (AS) Example
•Akerlof (1970), used car example. For
now we will use the used car example
return to finance later.
•We will show that AS can lead to a
market failure:
•Example: I am willing to sell for $
2000., a ”good car.” Buyer willing to
pay $ 2500. If there was no problem,
an exchange would occur, i.e. if the
buyer could evaluate the proper value:
11
Adverse Selection (AS) Example
•But suppose the buyer knows there
are lemons out there worth $1000 and
the buyer cannot differentiate
between lemons and the $2500 car.
Assume buyers know chance is 50/50
good car/lemons. “bad cars” = lemons
•What will happen now ?
•But then a market failure would exist !
12
Adverse Selection & Market Failure
(cont)
•Now there will be a market failure
because…
13
Adverse Selection with Screening
•Suppose to overcome the adverse
selection, buyers can overcome with
an evaluation cost ? What are some
examples of this in the used car
market ?
•In the previous example, if there
were an evaluation cost option,
what is the largest amount a
borrower would pay for evaluation ?
14
Answers
1.
2.
15
Application of “lemons” market
Apply to credit markets and explain
how the market could fail in this case,
e.g. instead of good and bad cars we
have… (just in words) – meaning of
adverse selection.
Explain what evaluation costs are now
?
16
THIS COURSE
Section 1: FIs and Financial System
•Motivation of FIs
•Varieties of FIs
•Sources of Financing
•Types of Risks
Section 2: Lending and Credit Risk and Other
Financial Instruments
•Writing Loan Contracts
•Different Types of Off-Balance Sheet Banking
and Contingent Claims Products
Section 3: Securitization and Deposits
•Creating Securities
•Deposits and Bank Runs
SYLLABUS
•Textbook
-available directly as e-book from library
-hardcover copies on Reserve
• Three Exams (in class, on paper)
• True False
• Fill in the Blank
• Matching
• Multiple Choice
•Problems
•Exam 3 not cumulative, before
Thanksgiving
•Weighting
• 30 % two highest exams, 20 % lowest
exam
• 20 % quizzess
QUIZZES: 2 Types
1. Quizzes on Reading of that Day – 5 points
– Not all days, random. On Canvas
2. Quizzes on Canvas – 10 points
- Based on Homeworks mostly
Extra Credit (points added to exams)
1.Random group work in class.
2. Paper on a banking/finance topic with
given choices.
Makeup Policy: Read syllabus.
19
Other Information
On Canvas
• Powerpoint Slides
• Penwritten Powerpoint Slides (after week
is over)
• Readings
• Quizzes
People
• Professor Adel Varghese, Zoom Office
Hours, Wednesdays at 4 pm
• Teaching Assistant Elise Rodriguez, Zoom
Office hours, Tuesdays and Thursdays at
4 pm
Review
•The role of finance
•Why do FIs exist ?
• Adverse Selection
• Lemons Problem
21
Today
•Overcoming duplicated screening
•Moral Hazard
22
Screening in Financial Markets:
The Advantage of FIs
23
Adverse Selection with Screening
:Numerical Example for Finance
•2 Borrowers and 2 Lenders are
evaluating each other to see
whether the other is ”good” enough.
Note: evaluation goes both way
•Each evaluation costs = $ 25.
•Find the total evaluation cost in an
economy without FIs
•Find the total evaluation cost in an
economy with FIs
24
Adverse Selection with Screening
:Numerical Example for Finance
•100 Borrowers and 100 Lenders
are
•Each evaluation costs = $ 25.
•Find the total evaluation cost in
an economy without FIs
•Find the total evaluation cost in
an economy with FIs
•Find the savings.
25
Adverse Selection with Screening
:Numerical, No FIs
•Evaluation Costs
Cost for 1
Cost for
100
Borrower
Lender
Both
26
Adverse Selection with Screening
:Numerical, with FIs
•Exercise: Suppose we are in the same
situation but an FI evaluates the
borrowers and lenders.
•1.What is the total evaluation cost
now ?
•2.What are the savings ?
•3.Why are there savings?
27
Answers
•1. What is the total evaluation cost
now ?
•2.What are the savings ?
•3.Why are there savings?
28
Lessons Learned with Adverse
Selection
1. Adverse Selection can lead to
market failure
2. Adverse Selection can be
overcome with screening
3. Screening is costly though – and
FIs can help overcome costs
Try Homework 1
29
Is there a further advantage of
banks we have overlooked ?
•Denote bank’s monitoring cost as CB
•Previously we assumed the “C” with
individuals monitoring was the same
as “CB” of banks monitoring, i.e. C= CB •Is there any reason to believe
that C > CB ? Why ?
30
Review
•1. What this course is about
•2. The two roles of FIs
•3. Pre-contract Adverse Selection
A.Market Failure
B. Duplicated Screeing
31
Objectives
•How moral hazard can create a
problem
•Understand the Idea of Q.A.T.
32
Moral Hazard: Post contractual
Principal – Agent analysis
Example:
Manager
Shareholder
Financial Contract
Lender
Borrower
Limited Liability
33
MORAL HAZARD, pp. 13-15
34
ASSUMPTIONS OF THIS MODEL
•A firm has the following options with
its retained earnings of $100
•1.No investment : Project 1
•2. Make $30 Investment: Project 2
Which is safe, which is risky above ?
Also:
The firm has to take out a bond of $100
and has to repay the bondholders.
35
SHOW WHAT IS IN INTEREST OF
SHAREHOLDERS not IN INTEREST
OF BONDHOLDERS
Shareholder will choose:
Bondholders will choose:
36
How can we align incentives ?
37
QUALITATIVE ASSET
TRANSFORMATION (Q.A.T)
Reason independent of information on the existence of
FIs
38
Example : Mortgages
Why is a mortgage unattractive
instrument for common people to issue
?
39
Qualitative Asset Transformation
•Banks issue mortgages, how do they
finance them ?
•How are those instruments different ?
40
Qualitative Asset Transformatio
Problem !
•Risks arise !
•How can bank deal with risk ?
41
Lessons
Moral Hazard can provide
misalignment of incentives
•Methods are created to align
incentives
•Principal-Agent Framework
•FIs transform assets individuals
cannot: Q.A.T. = qualitative asset
transformation
•Q.A.T creates risks
•Methods arise to cover risks
42
Lessons
Adverse Selection creates possibility of
non-completion of projects
•Screening Costs greatly reduce AS
costs
•FIs arise as ”a method” invented by
society to reduce these frictions
•NEXT: What are the types of Fis – what
is the difference among them ?
43