Tutorial 2
Multiple Choice Questions
1. Intermediation can be defined as
a) Brokerage.
b) Facilitating asset transformation.
c) Acting as an agent to bring buyers and sellers.
d) Settling disputes among financial institutions.
e) B & C
f) All of the above
2. An institution which facilitates indirect lending is called
a) The financial system.
b) A stock exchange.
c) A financial intermediary.
d) A financial market.
3. Which of following is incorrect about the financial system?
a) Financial institutions and financial markets are part of the financial system.
b) Savers and borrowers are part of the financial system.
c) Both domestic and foreign borrowers are part of the financial system.
d) The financial system and the economic system are the same.
4. The cost savings that arise from engaging in complementary activities by financial firms are
called
a) Economies of scale.
b) Securitization.
c) Externalities.
5. A surplus spending unit is one who(se):
a) Income and expenditures for the period are equal.
b) Income for the period exceeds consumption and real investment expenditure.
c) Expenditure for the period exceeds receipts.
d) Uses credit cards for all consumer purchase.
6. Credit unions are classified as ______________ institutions, while pension funds are
classified as _______________ financial institutions:
a) Deposit-type, non-deposit type
b) Contractual savings; deposit-type
c) Federal agency; contractual savings
d) Deposit-type; mutual fund
7. The risk of financial institutions associated with varying returns caused by fluctuating
yields and corresponding costs of funds is called:
a) credit risk
b) liquidity risk
c) foreign exchange risk
d) interest rate risk
8. Economies of scale associated with financial intermediaries says:
a)
The total cost of handling transactions falls as more transactions are handled.
b)
The cost per transactions falls as more transactions are handled.
c)
The cost per transaction increases as more transactions are handled.
d)
a and b
e)
a and c
9. One reason financial intermediaries earn profits is because:
a) Individuals are not aware of the true cost of using an intermediary.
b) Financial intermediaries are charging for services people do not value.
c) Individuals are willing to pay for the reduction in transaction costs financial
intermediaries provide.
d) They raise the cost of transactions and pass these higher costs on to customers.
10. The reduction in transaction costs provided by financial intermediaries benefit:
a) Small borrowers and small savers.
b) Large borrowers but not small savers.
c) Society in the net, but small savers bear much of the cost.
d) Small borrowers but not small savers.
Questions
1. Briefly explain what is meant by disintermediation. Do you feel that it is
possible that this trend will eventually eliminate the need for banks?
Disintermediation is elimination of financial intermediaries or we can say it is the
removing the middleman or intermediary from future transaction.
No, because financial intermediation is still playing a crucial role in our daily
basis. Without financial intermediaries, people will find it difficult to find a
counterparty who need fund or willing to borrow fund. Transaction cost is higher
and monitoring cost, verification and enforcement cost will incurred by the
lenders without indirect finance.
2. Explain what is meant by the asymmetric information problem and how
financial intermediaries help to eliminate it.
a) Asymmetric information problem occur when both party do not have the perfect
information.
b) Full or complete information is not made uniformly available to all interested
parties.
c) Not all parties have the same ability to utilise the information that is available to
them.
d) Some parties have more information than others do.
e) The asymmetric information problem arise because information is not a free
good and acquisition of information is indeed a costly activity.
 Financial intermediaries eliminate asymmetric information problem by
collecting undiscovered information and screening on the borrowers.
 They also establish trust by providing a form of guarantee of investment
performance to the buyers of securities and a fair price to the sellers of
securities.
 They put their best foot forward to ensure perceived information
transparency and optimize the market function.
 They even gather and communicate information of various aspects of
financial assets and their market performance to buyers and sellers of
financial assets.
3. What is a portfolio? Can financial intermediaries help investors reduce risk
through portfolio creation? Explain how.
Portfolio is a collection of different type of financial asset.
Financial intermediaries can help investor to reduce risk through portfolio
creation. For instance, bank able to minimize the risk of individual loan by
diversifying their portfolio, pooling risk, screening and monitoring
borrowers and holding capital and reserves as a buffer for unexpected
losses.
4. Describe the theory of financial intermediation.
There are five theory of the existence of financial intermediation which are:
1. Delegated monitoring which means the surplus unit delegate the task
of
monitoring
the
borrowers
(deficit
units)
to
financial
intermediation. The financial intermediation build up better
relationship with the borrowers because they are the one who
constantly deal with borrowers and thus they can communicate better
and monitor the borrowers action become easier.
The financial intermediation will diversify the asset to reduce the risk
of loan (avoid putting all eggs in one basket. Diversification can
increase the number of loan, larger delegated intermediaries will
generate higher economies of scales and this will allow for greater
diversification than any individual lender could achieve.
2. Information processing/ production
The existence of bank has prevent duplication of information
production costs where surplus unit can thus avoid production cost
/considerable expense in seeking out the relevant information before
they committed funds to a borrowers.
3. Liquidity transformation
Bank provide financial or secondary claim to the surplus unit that
often have superior liquidity features as compared to direct claims
(such as bond or equity).
Loans are high risk and illiquid asset.
Bank can indeed hold liabilities and asset of different liquidity
features on both side of the balance sheet through diversification of
their portfolios.
The better the bank diversified their balance sheet, the less likely they
will default on meeting deposit obligation i.e. they can convert the
asset into cash if depositors demand for it.
(loan= asset for bank, deposit= liability of bank)
4. Consumption smoothing
The economic agent are able to smooth consumption by providing or
offering insurance against shock to a consumers’ expenditure.
Bank perform a major function as a consumption smoothers.
Economic agent have uncertain preference about their expenditure
and this create a demand for liquid assets thus bank provide liquid
asset via lending to help smooth consumption patterns of individuals.
5. Commitment mechanism
The deposit in the bank has evolve to become a discipline tool to lead
the bank become more prudent before giving out loan. The supply of
demand for deposit in the bank will reflected in financing cost and thus
discipline or commit bank to behave or act prudently in order to ensure
bank hold sufficient liquidity and capital resources.
6. Explain in detail the transformational role of banks in the system?
1. Size transformation- Bank collect fund from savers in the form of small size
deposit and repackage them into a larger size of loans. Bank perform this size
transformation function exploiting economies of scale associated with the
lending or borrowing function because they have access a larger number of
depositor than any individual borrower.
2. Maturity transaction- Bank transform fund lent for a short period of time into a
medium or long term loans.
Banks are said to be lending long and borrowing short and in this process they are
said to mismatch their asset and liabilities. The mismatch can create problem in
term of liquidity risk which is the risk of not having enough liquid cash or fund to
meet one’s liabilities when depositor want to withdraw their money.
3.Risk transformation- Bank minimize the risk of asset (loan) by diversifying their
investment, pooling risk, screening and monitoring borrowers as well as holding
capital or reserve as a buffer in case of unexpected losses.