Lecture 3:
Financial Intermediaries
Mishkin chapter 2 – part B
Page 35-42
1
Review

Financial markets
1.
Money markets and capital markets
2.
Debt markets and equity markets
3.
Primary markets and secondary markets
4.
Exchanges and Over-the-Counter (OTC)
markets
2
Financial system – revisited
Indirect finance
Money
Financial Intermediaries
(e.g. bank)
Financial instrument A
(e.g. saving account)
Lender
Regulation
Money
Financial instrument B
(e.g. student loans)
Borrower
Financial instruments (e.g. bond, stock)
Financial markets
Money
Direct finance
3
Financial intermediaries



Financial intermediaries are institutions
that borrow funds from people who have
saved and make loans to other people.
Financial asset transformation
More important source of finance than
financial markets, engage in process of
indirect finance.
4
back
5
Direct and indirect finance

Direct finance:
 through
trading securities (financial
instruments) in financial markets.
 only happen in primary market

Indirect finance:
 transfer
funds via financial intermediaries.
 involves financial asset transformation
6
7
Function of financial
intermediaries

Indirect finance


Lower transaction costs



Economies of scale, develop expertise
Liquidity services ( but bank charges premium)
Reduce risk



facilitate borrowing and lending
Risk Sharing (e.g. insurance companies)
Diversification
Alleviate ‘asymmetric information problem’
8
Asymmetric information
 Adverse selection
 Adverse selection is a problem that arises for
a buyer of a good, service, or asset when the
buyer has difficulty assessing the quality of
this item before purchase.
‘lemon
car’
loan market:
risky borrower are more likely to be
‘selected’
9
Asymmetric information – Cont’d

Moral hazard

Moral hazard is said to exist in a market if,
after the signing of a contract or transaction:
1. one party changes behavior which might
have undesirable results;
2. only imperfectly able to monitor/control

insurance, stock market: engage in
undesirable (risky) activities
10
FIs come to the rescue

FIs can reduce adverse selection by:
 Check
up on borrowers/do credit research.
 Develop reputation (keep credit report) for
repaying.

reduce moral hazard by:

develop monitoring expertise.
 joint ownership

FIs make profits from producing
information.
11
12
back
13
Financial asset transformation
Financial asset transformation (FAT)
means to purchase one kind of financial
asset from borrowers (long-term loan
contract, e.g., a mortgage) -- and sell a
different kind of financial asset to savers
(generally relatively liquid contract, e.g., a
deposit account).
 Financial intermediaries make profits from
financial asset transformation.

back
14
Recap
Direct vs. indirect finance
 Functions of financial intermediaries
 Adverse selection and moral hazard in
financial markets.
 How can financial intermediaries solve
these asymmetric information problems?

15