EC102: CLASS 10 LT
Christina Ammon
Financial Systems
 Financial systems: the institutions in the economy that
facilitate the flow of funds between and among households
and firm
 Financial markets vs. financial intermediaries
• Bond & Stock markets vs. banks
 What is the purpose of financial markets& intermediaries?
1. Financing investment
2. Sharing risk
 What is the purpose of intermediaries
• Overcoming asymmetric information
Quiz Question 1
Financial markets allow households to _____ provide resources
for investment, while financial intermediaries allow households
to _____ provide resources for investment.
 A. directly; indirectly
 B. indirectly; directly
 C. productively; unproductively
 D. unproductively; productively
Quiz Question 2
All of the following are examples of financial intermediaries except:
 A. commercial banks.
 B. stock exchanges.
 C. pension funds.
 D. insurance companies.
Essay 7
Basic setup:
 A farmer’s harvest will be worth £200 if she can borrow £100
worth of fertilizer, and £0 otherwise.
 The fertilizer needs to be applied now and harvest will take
place in six months’ time.
 There are N>100 other people in the village, each of whom has
saved £1.
Essay 7 Question a
Is there a role for a financial system in this economy? Briefly
describe a few types of financial arrangements that you might
observe in this economy.
 Without financial systems: Borrow (<)1$ from 100 (+)
villagers
 Possible, but costly
 Financial system allows farmer easier access to savings of
villagers
 If financial markets present: Could issue bonds or stocks
 If financial intermediaries present: villagers deposit savings
and bank gives loan to farmer
Essay 7 Question b
Suppose an enterprising villager starts a new bank (with 0
capital), collects all of the villagers’ savings, and lends the
£100 to the farmer. How will this bank’s balance sheet look
like?
 What does a balance sheet consist of?
 Assets = Liabilities (+equity)
Assets
Liabilities+ Equity
Loans 100$
Deposits: N$
Reserves N$-100$
Equity
Essay 7 Question c
Suppose now that each of the savers faces some chance that
there will be an emergency such as they will absolutely need
access to their £1 three months from now. Is there still a role
for a financial system?
 Without financial markets - will the farmer be able to finance
his investment?
 What about if we only have financial markets?
Essay 7 Question d
Suppose that the probability that any investor faces the
emergency is p. What is the minimum value of N such that
the financial system can viably allow the farmer to buy the
fertilizer?
 Pool of savings: N*1$
 But p*N*1$ will need to be withdrawn in expectation
 Hence the savings to reach the farmer will be (1-p)N$
 Needs to be >=100$
 => need N>100(1-p)
 Similar with financial intermediaries: need to keep p*N*1$ as
reserves
Essay 7 Question e
On the basis of this example, can you see what economists
mean when they say banks are engaged in maturity
transformation?
 Depositors willing to provide short term debt
 Banks take short term debt and issue long term debt for
investment
 Can be problematic!
Quiz Question 5
Falling house prices generate widespread insolvency of financial
institutions by:
 A. reducing the value of collateral assets.
 B.
reducing the value of liabilities.
 C. increasing the value of assets.
 D. increasing capital
Quiz Question 4
To the extent that mortgage defaults contributed to the financial
crisis of 2008–2009, blame for these actions lies with:
 A. homebuyers who borrowed more than they could afford to
repay.
 B. mortgage brokers who encouraged households to borrow
excessively.
 C. financial intermediaries who held large positions in
mortgage-related assets
 D. all of the above
Quiz Question 3
A credit crunch reduces aggregate demand by:
 A. increasing the exchange rate.
 B. increasing interest rates.
 C. reducing consumption and investment spending.
 D. reducing the money supply.
Financial Crisis - Causes
 Mistakes
• Relying on prices going up
• Over relying on diversification
• Rating agencies issues
 Bad incentives
• On the level of the worker: asymmetric rewards
• On the level of the bank: Originate and distribute
• On the level of the financial system: Implicit bailouts
 Bad “culture”?
Essay 8 Question a
Explain the meaning of the expression “originate and
distribute” and explain how this practice may have
contributed to the financial crisis.
 = lenders generate loans with the intention of selling them
immediately
 Why is that a problem?
 Normally: monitor loans closely
 Now: the institution that issues the loans has no incentive to
monitor the loan as carries no more risk
 Issue a large amount of loans
Essay 8 Question b
What are rating agencies and what role are they thought to
have played in the crisis?
 Rating agencies are institutions that evaluate the
creditworthiness of a bond
 i.e. how likely is the bond going to be repaid
 Problem:
• Bad ratings
• Moral hazard – paid by issuer of bonds
• Self-fulfilling prophecy?
Quiz Question 1
The Volcker rule restricts excessive risk taking by commercial banks
by:
prohibiting banks from making certain kinds of speculative
investments.
b. increasing the amount of capital banks must hold.
c. decreasing the deposit insurance coverage of depositors in
commercial banks.
d. limiting the compensation that bank executives can be paid.
a.
Quiz Question 2
What sort of changes to compensation in the financial sector is
more likely to discourage excessive risk taking?
a. Caps to the amounts that banks can pay in the form of
bonuses.
b. Caps to the amount of stock options given to bankers
c. Caps to overall banker’s pay
d. Make pay conditional on long-term performance