Topic 4-1

Review Exercise 4
Role of Financial Intermediation
Topic 4
http://www.pcgwm.com/images/top/financial.jpg
Review Exercise 4 –Roles of Financial Intermediaries

1 Discuss the various theories proposed to explain the existence of financial2011-2-ZB
intermediaries.(25 marks)
2 Discuss the main theories to explain the existence of financial2013-3-ZA
intermediaries. (25 marks)
3 Outline the process of asset transformation undertaken by banks. Explain the20101c-ZB
techniques used by banks to enable them to undertake this process of asset
transformation. (13 marks)
4 Discuss the role of transaction costs in explaining why banks exist(13 marks) 2006-2a-ZA
5 Discuss the role of conflicting requirements of lenders and borrowers and2015-2a-ZA
transaction costs in explaining financial intermediation. (10 marks)
6 Explain the role of banks as liquidity insurers and explain how this role creates2012-3a-ZA
systemic risk problems for the banking system. (12 marks)
7 Examine the role of liquidity insurance provision (Diamond and Dybvig) in2015-2a-ZB
explaining financial intermediation. (10 marks)
Principles of Banking and Finance Ex4-pg1

Review Exercise 4
Review Exercise 4 –Roles of Financial Intermediaries

8 How does adverse selection influence the lending decisions of banks? (7m) 2007-2a-ZAB
9 Outline how adverse selection problems affect the functioning of20102a-ZB
lending/borrowing markets. (12 marks)
10 Discuss the role of asymmetric information in explaining why banks exist.(15m 2012-2a-ZB
11 Examine the role of asymmetric information in explaining financial2015-2a-ZB
intermediation. (15 marks)
12 Discuss how banks can reduce the adverse selection problem by asking the2007-2c-ZB
borrower to provide collateral against the loan. Try to use a example. (5m)
13 Discuss how to reduce/solve the problems arising from adverse selection.2007-2b-ZB
(13m)
14 Discuss the solutions to the adverse selection problem in debt markets(13m) 2010-2b-ZB
15 Discuss how asymmetric information can cause problems in debt markets. (12m)2014-2a-ZA
16 Discuss how asymmetric information can cause problems in financial2014-2a-ZB
markets(12m)
17 Examine the role of asymmetric information in explaining financial2015-2a-ZB
18 Examine the solutions aimed at reducing adverse selection in debt markets.2014-2b-ZA
(13m)
19 Discuss the solutions aimed at reducing moral hazard in debt markets.2014-2b-ZB

(13 marks)
20 Briefly outline the moral hazard problem as it affects financial2010-3a-ZA
contracts(3m
21 Compare the moral hazard problem in equity and debt contracts and 2010-3b-ZA
explain why moral hazard is generally lower for debt contracts. (10
marks)
22 2(a) Explain how to reduce/solve the problems arising from 2009-2a-ZB
moral hazard in debt markets. (12 marks)
23 Discuss how to reduce/solve the problems arising from moral hazard 2007-2b-ZA
(13m)
24 Explain adverse selection and moral hazard in debt markets and 2011-1a-ZA
discuss how the existence of such problems may explain the existence of
banks 15m
25 Explain the moral hazard problem in debt markets and 2012-3b-ZA
discuss suggested solutions to this problem. (13 marks)
26 Explain how to reduce/solve the problems arising from moral hazard in
equity markets. (12 marks) 4

Review Exercise 4
27 Explain the hypotheses, the framework, and the main findings of the2009-2b-ZB
delegated monitoring theory. (13 marks)
28 Discuss the contribution of the delegated monitoring theory of2011-1a-ZA
Diamond (1984) to our understanding of why banks exist. (10 marks)
29 Discuss the contribution of delegated monitoring theory to our2012-2b-ZB
understanding of why banks exist. (10 marks)
30 Explain the hypotheses, the framework, and the main findings of the2009-2b-ZA
delegated monitoring theory. (13 marks)
31 Examine the role of delegated monitoring (Diamond model) in2015-2b-ZA
explaining financial intermediation. (15 marks)
32 Explain and give examples of disintermediation. (5 marks) 2013-2d-ZAB

33 Explain what is meant by disintermediation and discuss to what extent2011-1a-ZA
disintermediation has lead to a decline in banks.(13m)
34 Explain disintermediation & discuss its consequences for banks.2006-2b-ZA
(12m)
35 What is meant by securitisation? Outline the process and identify the2009-1a-ZAB
advantages to a financial institution in securitising its assets. (5 marks)
36 What factors have caused the decline in the share of financial assets2007-1b-ZB
held by banks in recent years? What are the main consequences for
banks? (15 )
37 What has been the two main reactions of banks to the decline in their2008-1d-ZAB
traditional role? (5 marks)
38 Explain how banks have responded to the decline in their2011-3b-ZB
intermediation role and discuss to what extent this may have
contributed to the banking crisis of 2007/8. (12 marks)

Review Exercise 4
Sources of Funds for the Firms

main internal financing= r p
main external financing = b l (but declining recently)
important external financing: bond (bond: stock: US:32% vs 11%, Japan 9% vs 5%)
least important external financing: S (e.g. US: stocks 5 times < loan, Germany: 10 times, Japan: 20 times)
• Key buyers of marketable securities (stocks, bonds) are:

a) indirect finance- by non-bank financial intermediaries
(pension funds, m________ funds & i___________ companies)
b) indirect finance (more important) – by Households (buy small portion)
• S________ units lend funds (earn a return) directly to d________ units
Theory of financial intermediation Market perfection
1) A___________ transformation Differences in the presences of lenders & borrower
(e.g. size, maturity, liquidity risk)
2) t____________ costs reduction Presences of transaction costs
3) l_____________insurance Shocks in consumers’ consumption
4) informational e__________of s_______ Adverse selection
9
5) Delegated m_________________ Moral hazard
Existence of Financial Intermediaries- (1) Asset Transformation Theory

Financial intermediaries aims are:
a) to satisfy the needs of b_______ (need long-term capital) & l_______ (highly liquid asset)
b) To transform the primary securities (issued by firms) into the indirect securities (required by lenders).
(1) A_______ T____________ Theory
a) M_________ Bank liabilities (i.e. deposits) mature quicker than assets (i.e. loan).
Transformation banks make long-term loans & fund them by issuing short term deposits (i.e. ‘borrowing short and
lending long’). Financial intermediaries mismatch the maturity of the assets held with the
maturity of the liabilities issued.
b) S_________ The amount provided by lender are smaller than the amounts required by borrowers. Financial
intermediaries collect the small amounts from lenders & parcel them into the larger amounts to
Transformation
borrowers.
c) L_________ financial intermediaries provide secondary claims to depositors that have superior liquidity than
direct claims (e.g. bonds & stocks). Deposits are liquid & low risk. Loans are illiquid & with
Transformation
higher risk than deposits. Financial intermediaries can diversify their portfolio by hold liabilities &
assets with different liquidity.
Higher diversification, lower default risk.
d) R_________ financial intermediaries transform risks to reconcile the preferences of borrowers & lenders. The
lenders (who hold the liability of the financial intermediaries) are safe.
transformation
Banks bear default risk of its loans.

Review Exercise 4
Banks transform the risks by:

S_____________ Select good borrowers to minimize the risk of loss on loan
loan applications
D___________ risk lend to different types of borrowers, rather than concentrate in single branch
or single area of the country & to restrict the maximum size of any single loan.
E.g. The failure of 400 Texan banks over the period 1985–89 was due to the
heavy concentration of their loan portfolio in real estate dependent on the oil
business.
P__________ risks Have large number of loans to reduce the variability of losses.
Asset transformation highlights the existence of surplus units (lenders) & deficit units (borrowers) with
heterogeneous preferences. Lenders & borrowers are unable to diversify perfectly & optimize risk sharing.
Financial intermediaries need to reconcile the conflicting requirements of lenders & borrowers.
Asset transformation does not explain:

i) why borrowers do not undertake their own asset transformation
ii) why there are different types of financial intermediaries
iii) how different types of intermediaries perform their
monetary, credit & allocation functions.
2. Discuss the various theories proposed to explain the

existence of financial intermediaries.(25 marks)
• Covered throughout Chapter 4 of the subject guide. 20111a
• Answers should cover at least asset transformation, transaction costs and
asymmetric information. Better answers would also cover liquidity insurance,
informational economies of scale and delegated monitoring.
• The best answers would discuss the extent to which the different theories help us
explain why indirect finance is preferred over direct finance.

Review Exercise 4
3.Discuss the main theories to explain the existence of financial intermediaries.

(25 marks) ZA2013-3
• See the subject guide, most of Chapter 4.
Approaching the question
• Several theories have been developed to explain how financial intermediaries
reduce/solve market imperfections. They are the theories of:
• asset transformation- to reconcile conficting requirements of lenders and borrowers
• transaction costs reduction liquidity insurance - intermediaries provide liquidity in
response to shocks in consumers‘ consumption
• information asymmetries leading to adverse selection
• information asymmetries leading to moral hazard- leads to Diamond's model of
delegated monitoring.
• The main elements of these theories should be outlined with a discussion of how they
contribute to our understanding of why intermediaries exist.
23
1(c) Outline the process of asset transformation undertaken by banks. Explain the
techniques used by banks to enable them to undertake this process of asset
20101c
transformation. (13 marks)
• refer to pp.65–67 of the subject guide, and to pp.24– 27 (sixth edition) of Mishkin and Eakins Financial markets and
institutions.
• The process of indirect lending involves banks in a process of asset transformation. They satisfy borrowers’ needs for
long-term finance (by holding loans as assets) but fund this by borrowing short term (issuing deposit claims). They
effectively create liquidity for lenders. This satisfies the needs of many lenders for assets that they can liquidate
quickly.
• To enable institutions to reconcile the conflicting requirements of lenders and borrowers they undertake three main
asset transformations:
– i. Liquidity transformation – by lending long term and financing by issuing short term deposits. Hence there is a
mismatch of maturities of assets and liabilities of the bank.
– ii. Size transformation – by collecting in many small value deposits that are bundled together to create larger
value loans
– iii. Risk transformation – deposits are seen as relatively safe but bank loans have a higher degree of default risk.
• financial intermediaries such as banks, are able to undertake this process. Essentially they are able to undertake this
process because they have skills, structure and processes that enable them to manage the risks that asset
transformation exposes them to. They are able to undertake these transformations by:- a. managing liquidity risk
arising from liquidity transformation – using gap analysis, pooling and diversifying deposits
– b. managing credit risk arising from risk transformation – screening, pooling, diversifying loans etc
26

Review Exercise 4
2(a) Discuss the role of transaction costs in explaining why banks exist. (13 marks)
2006-2a-ZA
• a brief explanation of the four main costs in lending/borrowing: Search costs,

Verification costs, Monitoring costs, Enforcement costs.
• discuss the way in which financial intermediaries are able to reduce these costs by
internalising them due to: economies of scale, economies of scope, expertise, reduction
in costs as a result of technological and financial innovation.
• Also, costs do not provide a full explanation of why banks exist as they do not explain
why banks make better investment decisions.
2. (a) Discuss the role of conflicting requirements of lenders and borrowers and
transaction costs in explaining financial intermediation. (10 marks) 2015-2a-ZA
• See subject guide, Chapter 3, pp.68–73.
• This part requires a discussion of two of the explanations for financial intermediation.
• Conflicting requirements of lenders and borrowers requires intermediaries to hold the long
term/high risk claims of final borrowers but to fund these claims by issuing claims to
lenders which are short term/low risk. This exposes banks to credit and liquidity risk.
Banks are better able to manage these risks compared to individual lenders. This
can be demonstrated more clearly with a diagram.
• Transaction costs include search costs, verification costs, monitoring costs and
enforcement costs. Financial intermediaries have expertise and economies of scale that
enable them to reduce costs for both lenders and borrowers.
• Better answers will explain how transaction costs help to explain why most finance
is intermediated but does not explain why banks are better at selecting good risks. To
explain this requires an explanation based on asymmetric information.

Review Exercise 4
Existence of Financial Intermediaries - (2) Transaction Costs Theory

Types of transaction costs:
S___________ costs costs of searching out suitable counterpart (lenders & borrowers).
V___________ costs lenders incur costs to verify the accuracy of the information provided by borrowers.
M___________ & lenders incur costs to monitor the activities of borrowers & their adherence to the conditions
auditing costs of the contract.
E___________ costs lenders incur cost to ensure the borrower is able to meet the conditions of the contract.
Financial intermediaries can reduce the transaction costs by:

(i) internalising develop branch networks & information systems (which enable lenders & borrowers to avoid
t_________cost searching suitable counterpart). standardised products (cut the information costs of
scrutinising financial instruments). use tested procedures & routines.
(ii) E_________ reduce transaction costs per $ of output (as transaction size increases).
of scale If Q1> Q2 C(Q1)<C(Q2) [C: total costs, Q1 & Q3: outputs] A bank is able to use a standard loan
contract for a wide range of loans. The unit cost of the contract per loan is much smaller for the bank
than for an individual who has a loan contract drawn up when undertaking direct lending. important in
lowering the costs of fixed investments.
(iii) Economies = cost advantage to producing more than one product jointly rather than producing them
separately. C(Q1,Q2)<C(Q1) + C(Q2) E.g. deposit & payment services: deposits (banks both
of S________
collect funds) to satisfy the request of payment instruments .Expertise to lower transaction cost
E.g. financial intermediaries have expertise in information technology (e.g. ATM, or Point of sales-
POS) to provide low-cost liquidity services.
Existence of Financial Intermediaries –

(2) Transaction Costs Theory: Advantages & Limitations
Advantages of Transaction Costs Theory:
Transaction cost theory explains:
(i) The distribution of financial transactions between financial i_________ & financial m________.
Financial intermediaries able to internalise many transaction costs because they have developed expertise & take advantage of
economies of scale and/or economies of scope. The different level of internalisation of transaction costs explains why greater funds flow
through financial intermediaries than financial markets. Transaction costs explains why indirect finance is much more important than direct
finance.
(ii) The distribution of financial transactions among different types of inter____________.
Different financial intermediaries (i.e. broker to banks) charge different transaction costs.
(iii) Easier to conduct transaction with the presence of payment services (or liquidity services) provided by
financial intermediaries (especially by banks).
Limitations of Transaction Costs Theory:

Transaction cost theory does not explain:
i) why financial intermediary makes a better selection of investment opportunities.
ii) why recent technological innovations and new financial instruments have reduced transaction
costs. So, reduction in transaction costs cannot be the main reason for explaining the existence of
financial intermediaries and additional theories are needed: these include the liquidity insurance theory and the
asymmetric information theory .
37

Review Exercise 4
Existence of Financial Intermediaries –(3) Liquidity Insurance Theory

= C s_________ theory
• The theory says there is a demand for l________ assets as economic agents are unsure when they will
require funds to finance consumption. By the law of large numbers, a large coalition of investors (e.g. bank)
able to invest in illiquid but more profitable assets, while preserving liquidity need to satisfy the individual
investors. i.e. financial intermediaries provide l_______ insurance
• Depository institutions are ‘pools of l_______’ that provide households with insurance against
idiosyncratic shocks that affect their consumption needs.
• Depository institutions are ‘consumption s________’ that enable economic agents to smooth
consumption by offering insurance against shocks to a consumer consumption path.
• If the shocks in householder consumption needs are imperfectly correlated, the total cash reserve needed
by a bank of size N (a coalition of N depositors) increases less than proportionally with N (= Fractional
reserve system)
• Fractional reserve system says some fraction of the deposits can be used to finance profitable but
illiquid loans. but this is also the source of the potential fragility of banks (it is depositors withdraw funds
for not due to liquidity needs- e.g. loss of confidence in the bank)
• Note: The theory is valid for banks, depository institution & insurance companies.
41
Existence of Financial Intermediaries (4) Asymmetric Information Theory

A__________ information = one party to a transaction has more/ less information than
the other party, so unable to make an accurate decision.
Eg1.Potential investors have less information than the managers, as they do not know (i) how good the projects to be financed are
(ii) unable to evaluate the risks & returns of the projects.
Eg2 Life insurance companies do not know the precise health of the purchaser of a life insurance policy.
Eg3.Banks do not know how likely a borrower is to repay.
Consequences of asymmetric information:

A______ s_______ The potential borrowers likely to produce an undesirable (adverse)
(ex-ante) outcome are the ones who most actively seek out loans, so bad
(problem arise before transaction)
credit risks increase. So lenders may decide not to give loans,
even to good credit risks.
M______ h_______ risk (hazard) that the borrower will engage in undesirable (immoral)
(ex-post) activities, reduce the repayment probability, so the lenders may
problem arise after transaction. not provide loan. Investors may behave differently when using
borrowed funds rather than when using their own funds.
45

Review Exercise 4
Asymmetric Information Problems & Ways to Reduce them

Types of asymmetric information Adverse selection Moral hazard
corollaries Free-r________ problem P_______-a______ problem
Ways to reduce/solve P___________ production Monitoring of e______ contracts
the market imperfection
Government r___________ Government regulation

Financial intermediaries D________________ contracts
Monitoring & enforcement of
cov____________
Financial intermediaries
Theory of In________________ D_______________ monitoring
financial intermediation economies of scale (Diamond, 1984)
(Leland and Pyle, 1977)
49
2(a) How does adverse selection influence the lending decisions of banks? (7
marks) 20072a
• refer to page 55 of the subject guide.

• Adverse selection is a problem created by asymmetric information
• The existence of asymmetric information means that lenders will lend at a rate of
interest reflecting average risk
(as they cannot distinguish between good and bad risks)
• This drives many good risk borrowers out of the market leaving mainly poor risks .
• Hence the borrowers who are more likely to want to borrow are poor risks
• As a consequence lenders may decide not to lend.
55

Review Exercise 4
2. (a) How does adverse selection influence the lending decisions of banks?
(7 marks) ZA-2007-2a-ZAB
• refer to page 55 of the subject guide. A very good answer to this question would be
structured as an essay-style answer which covered the following points:
– Adverse selection is a problem created by asymmetric information (1 mark).
– The existence of asymmetric information means that lenders will lend at a rate
of interest reflecting average risk (as they cannot distinguish between good and
bad risks) (2 marks).
– This drives many good risk borrowers out of the market leaving mainly poor risks
(2 marks).
– Hence the borrowers who are more likely to want to borrow are poor risks (1
mark).
– As a consequence lenders may decide not to lend (1 mark).
2(a) Outline how adverse selection problems affect

the functioning of lending/borrowing markets. (12 marks) 20102a
• refer to pp.69–70 of the subject guide, and to pp.370–72 (sixth edition) of Mishkin and
Eakins Financial markets and institutions.
• Adverse selection is a problem created by asymmetric information. It arises when the
potential borrowers who are most likely to default are the ones who are most likely to
seek a loan. This arises because in a market characterised by asymmetric information
lenders will lend at an interest rate reflecting average quality. This is likely to drive some
of the better quality (lower risk) borrowers out of the market leaving a greater proportion
of poor quality (higher risk) borrows remaining in the market. In the case of debt security
markets the good quality borrowers will find their securities are undervalued (higher
cost). And will be unwilling to sell them.
• why the existence of asymmetric information, and hence adverse selection can lead to
less lending/ borrowing and hence less investment/lower economic growth.
60

Review Exercise 4
2. (a) Discuss the role of asymmetric information in explaining why banks exist. (15
marks)
• See subject guide, pp.73–76. 20122a

• Asymmetric information causes adverse selection and moral hazard.
• Need to examine what these two problems are and how they can be solved.
• Better answers would explain why banks are better at solving these problems
compared to capital markets – no free-rider problem.
Existence of Financial Intermediaries (4) Asymmetric Information Theory

Adverse selection explains:
① why bank loans are the most important source of e_____________ funds.
② why i______ finance is more important than direct finance.
Others:
i. Banks are more important in d_______________ than developed countries
because harder to get firms’ information in developed countries.
ii. Large & well-known corporations have easier access to securities markets as the investors have more
information about them.
iii. Information technology makes it easier to acquire firms’ information firms, & reduces the lending role of
financial institutions.
Problems of asymmetric information (affect lending & borrowing, it leads to:
(i) select the borrowers with the higher risk (a________________ s_____________);
(ii) increase the risks of offering a loan due to opportunistic behaviours of the borrowers (m___ h_____).
How Adverse Selection Influences Financial Structure?

• Issuers have more information than potential investors in the stocks & bonds market due to adverse
selection. Market is inefficient when the borrowers (i.e. issuing firms) have private information on the projects
they wish to finance. Investor is unable to distinguish good & bad firms, investor tends to pay an average
price (reflecting the average quality). Good firms are unwilling to sell (undervalued securities) Bad firms are
willing to sell (overvalued securities). Investor has problems in selecting firms to invest in & decide not to
buy any security. Asymmetric information obstruct the transactions(& cause the market to collapse) or
influence the level (& quality) of production activities. So, marketable securities are not the primary source of
66
external financing

Review Exercise 4
Solutions for Adverse Selection Problem

(1) Governments (e.g. SEC) can regulate firms to disclose full information & adherence to
standard accounting principles to investors. (Note: financial markets are heavily regulated)
Government
But the recent collapse of the Enron Corporation shows that disclosure requirements do not
r__________ solve the adverse selection problem.
(2) Private companies (e.g. S______& P____, M_______, Value Line) can produce & sell the
information (e.g. financial statements, investment activities) to investors to distinguish firms
P__________
& to select their securities. S&P classify 7 quality ratings (e.g. AAA, AA, A, BBB) based on the
production & perceived credit quality of the bond issuers.But free-rider problem exists when people who do
sale of not pay for information take advantage of information acquired by other people. Investor can
information buy the information & use it to purchase undervalued securities. But free-rider investors (who
do not purchase the information) may observe your behaviour & buy the same security, so the
demand & price for the undervalued securities will increase. This reduces the value of
information. This causes the investors reluctant to buy information & as a result the adverse
selection problem remains.
(3) Financial intermediaries (e.g. banks) produce accurate valuations of firms & are able to select
good credit risks. Banks have information about borrowers from their bank accounts & know
Financial
their creditability (& loan repay ability). Banks can avoid the free-rider problem because bank
in__________
loans are private securities and not traded in the open financial market. Investors are unable
to observe the bank & bid up the price of the loan, Banks ask the borrower to provide
collateral (i.e. property promised to the lender if the borrower defaults) to reduce the losses
due to loan default.
2(b) Discuss how to reduce/solve the problems arising from adverse selection. (13 marks)
20072b
• refer to page 57 of the subject guide.
① Private production and sale of information. Explanation of the economic concept of
free-rider. Impossibility for this mechanism to solve adverse selection because of the
free-rider problem.
② Government regulation through disclosure requirements. Impossibility for this
mechanism to solve the adverse selection problem.
③ Financial intermediaries. They are a better solution than private production of
information (credit rating agencies) because they do not face the free-rider problem.
74

Review Exercise 4
2(c) Discuss how banks can reduce the adverse selection problem by asking the
borrower to provide collateral against the loan. Try to use a example. (5 marks)
20072c
• banks reduce the adverse selection problem by asking the borrower to provide
collateral against the loan. Collateral is property promised to the lender if the borrower
defaults. Therefore it reduces the losses of the lender in the event of a default.
77
2(b) Discuss the solutions to the adverse selection problem in debt markets. (13 marks)
20102b
The three solutions are:

• i. private production and sale of information. For example ratings agencies collect and publish such
information. However this solution is sub-optimal because of the free rider problem. Investors who have
not purchased the information can free ride on the actions of others who have, thus negating the benefits
to the purchaser. This may lead investors not to purchase information and the adverse selection problem
is not solved.
• ii. government regulation – force disclosure of information (e.g. accounts to be published, information
relevant to the pricing of securities has to be published). However, accounting information can be
manipulated.
• iii. Financial intermediaries such as banks can provide a more optima solution to this problem as they are
skilled at producing information and have access to information that other investors do not have
(transaction accounts). Also banks do not face the free rider problem as their securities are not traded and
so they have the incentive to spend resources to produce the optimal amount of information to reduce the
adverse selection problem as they are the only party that will benefit from this.
80

Review Exercise 4
2(a) Discuss how asymmetric information can cause problems in debt markets. (12m)
2014-2a-ZA
Ch4, section headed ‘Asymmetric information: Adverse selection&moral hazard’.
Asymmetric information occurs when one party to a transaction has more information than
the other party. In debt markets borrowers will generally have more information than
lenders. This can cause adverse selection and moral hazard problems for the lender. Each
of these needs to be explained along with why they cause problems.
Adverse selection – borrowers with a greater risk of default are the ones who are most
likely to seek out lenders. Better answers will explain the insights from Akerlof’s 1970
paper ‘The market for lemons’ – although the discussion should be in the context of
lending/borrowing rather than used cars. Knowledge of this problem is likely to cause
lenders to reduce lending or not engage in lending thus reducing credit and hence funds
for investment by companies.
Moral hazard – borrowers may behave more recklessly than promised/ expected after the
funds are lent. Hence lenders need to monitor borrowers after loan is made. This increases
costs of lending leading to potentially less lending taking place.
82
2(a) Discuss how asymmetric information can cause problems in financial

markets(12m) 2014-2a-ZB
Ch4, section headed ‘Asymmetric information:Adverse selection &moral hazard’.
Asymmetric information occurs when one party to a transaction has more information than
the other party. In debt markets borrowers will generally have more information than
lenders. This can cause adverse selection and moral hazard problems for the lender. Each
of these needs to be explained along with why they cause problems.
Adverse selection – borrowers with a greater risk of default are the ones who are most
likely to seek out lenders. Better answers will explain the insights from Akerlof’s 1970
paper ‘The market for lemons’ – although the discussion should be in the context of
lending/borrowing rather than used cars. Knowledge of this problem is likely to cause
lenders to reduce lending or not engage in lending thus reducing credit and hence funds
for investment by companies.
Moral hazard – borrowers may behave more recklessly than promised/ expected after the
funds are lent. Hence lenders need to monitor borrowers after loan is made. This increases
costs of lending leading to potentially less lending taking place.
84

Review Exercise 4
2. (a) Examine the role of asymmetric information in explaining financial

2015-2a-ZB
Approaching the question [See subject guide, Chapter 4, pp.73–74 and 75–80.]
Asymmetric information gives rise to two problems:
i. Adverse selection – a problem created before a loan is made. This is the risk of lending
to a borrower who is likely to default. This risk increases in markets characterised by
asymmetric information. The Akerlof analysis can be used to illustrate this risk.
ii. Moral hazard – a problem created after the loan is made. This is the risk created by a
borrower using the borrowed funds in a reckless way, thus increasing the risk of default.
The solution to these problems by financial intermediaries is more efficient as banks do not
face a free rider problem in acquiring information (to solve adverse selection) or monitoring
(to solve moral hazard). This is because their loans are not traded so no one can front-run
the bank and extract some of the benefits from information acquisition or monitoring by
trading the same loans.
Better answers would explain why financial intermediaries such as banks are better able to
select projects generating a higher return due to their ability to mitigate the problems
created by asymmetric information.
2(b) Examine the solutions aimed at reducing adverse selection in debt markets. (13m)
2014-2b-ZA
See subject guide, Chapter 4, section headed ‘Asymmetric information:
Adverse selection and moral hazard’.
Lenders having more information about the circumstances of borrowers can help reduce
adverse selection.
This information can be produced by:
i. private production
ii. government regulation
iii. financial intermediaries.
Better answers would look at the effectiveness of each solution and explain why financial
intermediaries provide the most effective solution; that is, they do not face the free rider
problem therefore they have more incentive to commit sufficient funds to produce enough
information to overcome the adverse selection problem.
87

Review Exercise 4
2(b) Discuss the solutions aimed at reducing moral hazard in debt markets. (13 marks)
2014-2b-ZB
See subject guide, Chapter 4, section headed ‘Asymmetric information:
Adverse selection and moral hazard’.
Main solutions include:
i. making debt contracts incentive compatible
ii. monitoring and enforcement of restrictive covenants
iii. financial intermediaries.
Better answers would examine the effectiveness of each solution and explain why financial
intermediaries provide the most effective solution; namely, they do not face the free rider
problem therefore they have more incentive to commit sufficient funds to monitor effectively
to overcome the moral hazard problem.
89
2009-2a-ZA
2. (a) Explain how to reduce/solve the problems arising from
moral hazard in equity markets. (12 marks)
• refer to pp.73–74 of the subject guide, and to pp.383–86 (fifth edition) pp.376–79
(sixth edition) of Mishkin and Eakins, Financial markets and institutions.
• Candidates are required to discuss the solutions to the moral hazard problem in
equity markets.
• The Examiners were then looking for the list of the four main tools used to
reduce/solve moral hazard in the equity market:
1. Monitoring
2. government regulation to increase information
3. financial intermediaries active in the equity market
4. debt contracts.
(1 mark for listing the four tools.)

Review Exercise 4
1. Stockholders can engage in the monitoring (auditing) of firms’ activities to reduce moral
hazard. There are several reasons why monitoring is needed: to ensure that information
asymmetry is not exploited by one party at the expenses of the other; the value of equity
contracts cannot be ascertained with certainty when the contract is made; the value of many
financial contracts (i.e. future return on a stock) cannot be observed or verified at the
moment of purchase, and the post-contract behaviour of a counterparty determines the
ultimate value of the contract; the long-term nature of many financial contracts implies that
information acquired before the contract is agreed may become irrelevant at maturity due to
changes in conditions. (Up to 2 marks were awarded.)
• Outstanding candidates would explain that monitoring is expensive in terms of money and
time, or rather it is a costly state verification. In addition, if you know that other stockholders
are paying to monitor the activities of the firm you hold stocks in, you can free ride on the
activities of the others. As every stockholder can free ride on others, the free-rider problem
reduces the amount of monitoring that would reduce the moral hazard (principal-agent)
problem. This is the same as with adverse selection and makes equity contracts less
desirable. (Up to 2 marks were awarded.)
2. Governments have incentives to reduce the moral hazard problem (same as with
adverse selection). Several measures are used by governments: laws to force firms to
adhere to standard accounting principles (i.e. to make profit verification easier); laws to
impose stiff criminal penalties on people who commit the fraud of hiding/stealing profits.
However these measures are only partially effective as these frauds are difficult to
discover. (1 mark.)
3. Financial intermediaries operating in the equity market are able to avoid the free-rider
problem in the face of moral hazard. Venture capital firms are an example of an
intermediary that is able to avoid the free-rider problem in the face of moral hazard.
They use the funds of their partner to help entrepreneurs to start new business; in
exchange for the use of the venture capital the firm receives an equity share in the new
business. Venture capital firms have their representatives participating in the
management of the firm (i.e. easier profit verification and thus lower moral hazard).
Moreover, the equity in the firm is not marketable to anyone but the venture capital firm
(i.e. elimination of the free-riding of other investors on the venture capital’s verification
activities). (Up to 3 marks were awarded.)

Review Exercise 4
4. Debt contracts are a way to reduce moral hazard. Moral hazard affects equity contracts
because they are claims on profits in all situations, whether the firm makes or loses
money. Consequently, there is the need to structure a contract that confines moral
hazard to certain situations, and thus reduces the need to monitor managers. This is a
debt contract, a contractual agreement to pay the lender a fixed amount of money
independently from the profits of the firm. Therefore debt contracts are preferred to
equity contract. The presence of moral hazard in equity markets explains why stocks
are not the most important external source of financing for firms. (Up to 3 marks were
awarded.)
3. (a) Briefly outline the moral hazard problem as it affects financial contracts. (3 marks)
2010-3a-ZA
• refer to p.69 of the subject guide, and to p.371 (sixth edition) of Mishkin and Eakins
Financial markets and institutions.
• Moral hazard is a problem that occurs after the transaction has occurred. It is the risk
that borrowers/those insured will behave in an undesirable way after the
loan/insurance product is provided, so increasing the risk of default/claim on
insurance.
• As a consequence lenders/insurers may refuse to make loans/provide insurance. A
satisfactory answer would outline the moral hazard problem in relation to loans.
Better answers would recognise that it applies to insurance products as well.

Review Exercise 4
I_____________ Economies Of Scale

• Adverse selection causes informational economies of scale in the lending-borrowing activity.
• Leland & Pyle (1977) said financial intermediaries are ‘information sharing coalitions’
• Entrepreneurs can ‘signal’ the quality of their projects by investing more or less of their wealth in the firm. Good firms
can be separated from bad firms by the level of self-financing,
reduces the adverse selection problem. But ‘signalling’ is costly as entrepreneurs are risk-averse. Information
(not publicly available) on the quality of the projects can be obtained with an expenditure of resources. This
information can benefit potential lenders. If there are economies of scale in the production of this information, specific
organisations may exist to gather this information.
Problems in selling information to investors
Q___________ of buyers may not unable to ascertain the quality of the information. as a
the information consequence the price of the information will reflect average quality so that firms that
seek out high quality information will lose money.
Appropriability (= f_____-r______ problem): Firm that originally collected the information may be
of returns unable to recoup the value of the information.
Financial intermediary (e.g. bank) can solve the above problems. Information embodied in portfolio & non-transferable. This
provides an incentive for gathering information. For organization which can better in sorting risk (than other lenders), borrowers
of good risk wish to be identified & to deal with an informationally efficient intermediary rather than with a set of lenders offering
the value of the average risk. With the best risk ‘peeled off’, the average risk is less valuable, inducing borrowers of the next best
risk to deal with the intermediary. Finally, borrowers of all types of risk will deal with intermediaries, except the bottom class.
101
How Moral Hazard Influences Financial Markets

Moral hazard in Equity Contracts
= p_______-a_____ problem (Jensen & Meckling, 1976). S_________ (i.e. principals) own the firm’s equity, are
different from the m________ (agent) of the firm. Managers have more information about their activities than stockholders
so asymmetric information problem exists. Both (i) separation of ownership & control and (ii) asymmetric information
induce managers to act in their own interest rather than in the interest of stockholder-owners. Equity contracts are
claims on profits in all profits or loses situation. are preferred as they require less monitoring.
Moral hazard problem in equity markets causes stocks are not the most important external source of financing.
Solution to reduce moral hazard problem in equity markets
a) M____________ Monitor (auditing) firms’ activities to: ensure that information asymmetry is not exploited by one party at
the expense of the other determines the value of contract which is determined by the post-contract
behaviour of a counterparty. (information acquired before the contract is agreed may become irrelevant
at the maturity due to changes in conditions.) Monitoring is expensive. Investor may free-ride on the
activities that other stockholders are paying to monitor the activities of the firm you hold stocks in. Free-
ride problem reduces monitoring (which will reduce the moral hazard principal-agent problem). This
is similar to adverse selection & makes equity contracts less desirable.
b) govn r_______ to Government can impose regulation to adhere to standard accounting principles (i.e. easier
increase information profit verification); impose stiff criminal penalties if fraud of hiding/stealing profits. But these
measures are not effective as difficult to discover frauds.
c) Financial Venture capitalists provide funds to help entrepreneurs to start new businesses in exchange for
intermediaries active in equity share in the new business. Venture capitalists participate in the mgt of the firm (i.e. easier profit
the equity market verification & lower moral hazard). Equity in the firm is not marketable to anyone but the venture capital
firm (i.e. eliminates free-riding problem).

Review Exercise 4

Moral hazard in Equity Contracts
= p_______-a_____ problem (Jensen & Meckling, 1976). S_________ (i.e. principals) own the firm’s equity, are
different from the m________ (agent) of the firm. Managers have more information about their activities than stockholders
so asymmetric information problem exists. Both (i) separation of ownership & control and (ii) asymmetric information
induce managers to act in their own interest rather than in the interest of stockholder-owners. Equity contracts are
claims on profits in all profits or loses situation. are preferred as they require less monitoring.
Moral hazard problem in equity markets causes stocks are not the most important external source of financing.
Solution to reduce moral hazard problem in equity markets
a) M____________ Monitor (auditing) firms’ activities to: ensure that information asymmetry is not exploited by one party at
the expense of the other determines the value of contract which is determined by the post-contract
behaviour of a counterparty. (information acquired before the contract is agreed may become irrelevant
at the maturity due to changes in conditions.) Monitoring is expensive. Investor may free-ride on the
activities that other stockholders are paying to monitor the activities of the firm you hold stocks in. Free-
ride problem reduces monitoring (which will reduce the moral hazard principal-agent problem). This
is similar to adverse selection & makes equity contracts less desirable.
b) govn r_______ to Government can impose regulation to adhere to standard accounting principles (i.e. easier
increase information profit verification); impose stiff criminal penalties if fraud of hiding/stealing profits. But these
measures are not effective as difficult to discover frauds.
c) Financial Venture capitalists provide funds to help entrepreneurs to start new businesses in exchange for
intermediaries active in equity share in the new business. Venture capitalists participate in the mgt of the firm (i.e. easier profit
the equity market verification & lower moral hazard). Equity in the firm is not marketable to anyone but the venture capital
firm (i.e. eliminates free-riding problem).

Moral hazard in Debt contracts
= agreement to pay the lender a fixed amount of money independently from the profits of the firm.
lower lower) than in equity contracts.
Moral hazard in debt contracts exists but is (higher/
Debt contracts require borrowers to pay fixed amounts & let them keep any profit above this
amount. Borrowers have incentives to take investments riskier than lenders would like.
Moral hazard arise when borrowers tends to take r_____risky investments to gain higher returns
(but this may cause lenders to lose most if the project failed).
Solution to reduce moral hazard in debt markets?

a) making borrowers tends to undertake risky investment when using borrowed funds. Can reduce
debt contracts moral hazard problem by increasing the stake of borrowers own personal net worth
incentive- in the investment project. Borrowers could lose their wealth if the project fails. So borrowers
have an incentive to make the project less risky.
Compatible
b) covenants monitoring & enforcing restrictive c______________
covenants
Restrictive covenant = covenant which restrict the borrower’s activity.
c) financial Banks do not face the same free-rider problem, as loans are not traded on the market. Banks
intermediaries gain the full benefits of their monitoring & enforcement activities. Banks devote sufficient 109
resources (e.g. screening & monitoring) to overcome moral hazard.

Review Exercise 4
2(a) Explain how to reduce/solve the problems arising from

moral hazard in debt markets. (12 marks) 20092a
• refer to pp.74–75 of the subject guide and to pp.386–89 (fifth edition) or pp.379–82 (sixth edition) of
Mishkin and Eakins, Financial markets and institutions.
• Borrowers have incentives to take investments riskier than lenders would like: borrowers get all the gains
from a risky investment if they succeed, but lenders lose most, if not all, of their loan if borrowers do not
succeed.
3 main solutions:
1. making debt contract incentive-compatible (i.e. aligning the incentives of borrowers & lenders)
2. monitoring and enforcement of restrictive covenants
3. financial intermediaries.
investors are more likely to take on riskier investment projects when using borrowed funds than
when using their own funds. Thus the moral hazard problem can be reduced by increasing the
stake of personal net worth (the difference between personal assets and liabilities). One way to
reduce the moral hazard problem is to make debt contract incentive-compatible, or rather to align
the incentives of the borrowers and lenders
115
• the moral hazard problem can be reduced is by introducing restrictive covenants into debt contracts. A
restrictive covenant is a provision aimed at restricting the borrower’s activity.
• although covenants reduce moral hazard problems, they do not eliminate them: it is not possible to rule
out every risky activity. Moreover, in order to make covenants effective, they must be monitored and
enforced. Monitoring typically involves increasing returns to scale, which implies that it is more efficiently
performed by specialised financial institutions. Individual lenders tend to delegate the monitoring activities
instead of performing them directly. Thus the monitor has to be given an incentive to do its job properly.
• However, because monitoring and enforcement are costly activities, investors can freeride on the
monitoring and enforcement undertaken by other investors. Thus in the bond market (as well as in the
stock market) the free-rider problem arises. The consequence will be that insufficient resources will be
devoted to these activities.
• financial intermediaries, and especially banks, can be seen to provide solutions both to the incentive
problem and to the free-rider problem. They solve the incentive problem using several mechanisms, such
as reputation effects, and the option for depositors to withdraw their money should the bank managers
prove incompetent. They do not face the same free-rider problem, as they primarily make private loans
not traded on the market. Banks therefore gain the full benefits of their monitoring and enforcement
activities and have an incentive to devote sufficient resources to them. The possibility of overcoming
moral hazard with adequate instruments (such as screening and monitoring), favoured by the existence of
established long-term relationships, enables this theory to emphasise the peculiar nature and role of
banks in the allocation process.
116

Review Exercise 4
2(b) Discuss how to reduce/solve the problems arising from moral hazard. (13 marks)
ZA-2007-2b
• refer to page 58–59 of the subject guide. The question asks for a discussion of the
solutions to the moral hazard problem. The Examiners were looking first for a brief
explanation of the four main solutions:
① Making debt contract incentive-compatible (i.e. align the incentives of borrowers
and lenders). Up to 3 marks awarded.
② Monitoring and enforcement of restrictive covenants. Discussion of the four
types of possible covenants and relevant examples. Up to 4 marks awarded.
③ Financial intermediaries. Problems arising from the use of covenants.
Mechanisms used by financial intermediaries to solve the incentive problem
and the free-rider problem. Use of screening and monitoring – favoured by
the existence of established long-term relationships – to overcome moral
hazard. Up to 6 marks awarded.
2(c) Explain why loan contracts do not suffer from free-riding problems compared to
bonds or other public financing. (5 marks) ZA-2007-2c
• refer to the fact that bank loans are private securities, not traded in the open financial
market (2 marks). Therefore, investors are not able to observe the bank and bid up
the price of the loan to the point where the bank makes no profit on the production of
information (3 marks).

Review Exercise 4
2. (a) Explain adverse selection and moral hazard in debt markets and discuss
how the existence of such problems may explain the existence of banks. (15
marks)
• See pp.73–82 of the subject guide. ZA-20111a
• The two problems need to be defined in the context of asymmetric information.
• It is the solution to these problems that helps to explain the existence of banks.
• The main solutions to these problems should be outlined.
• One solution is the involvement of banks providing non-traded debt.
• As this solution is not subject to the free rider problem then it is a more efficient
solution to the two problems.
D_________ M_________ Theory by Diamond (1984)

As monitoring borrowers is costly so it is efficient for lenders to delegate the monitoring task to specialised
agents (e.g. banks). Banks have a comparative advantage relative to direct lending in monitoring activities
in the context of costly state verification. Banks can reduce monitoring costs by diversifying loans.
Conditions for delegated monitoring:
scale economies in monitoring i.e. bank finances many projects
small capacity of investors as compared to the size of investments (i.e. each project
needs the funds of several investors)
low cost of delegation cost of monitoring the financial intermediary is less than the benefit gained from
exploiting scale economies in monitoring investment projects
Framework of Delegated Monitoring Theory
• the existence of n identical firms that seek to finance projects & the requirement by each firm of an
investment of one unit.The cash flow y that the firm obtains from its investment is unobservable to lenders.
This is where moral hazard arises.
Moral hazard can be solved by:
a) ‘m____________’ the firm (at cost K) or
b) ‘d____________’ a debt contract characterised by a non-pecuniary cost C
(i.e. unmonitored direct lending) 130

Review Exercise 4
2(b) Explain the hypotheses, the framework, and the main findings of the delegated
monitoring theory. (13 marks) 20092b
• refer to pp.76–77 of the subject guide.

• Hypotheses required for delegated monitoring to work:
– 1. existence of scale economies in monitoring, that means that a typical bank finances many projects
– 2. small capacity of investors as compared to the size of investments, that means that each project
needs the funds of several investors
– 3. low cost of delegation, that means that the cost of monitoring the financial intermediary itself has to
be less than the surplus gained from exploiting scale economies in monitoring investment projects.
Framework of the delegated monitoring theory: It is based on the existence of n identical firms that seek to
finance projects and the requirement by each firm of an investment of one unit.
• The cash flow y that the firm obtains from its investment is a priori unobservable to lenders. This is where
moral hazard arises.
137
• Moral hazard can be solved by:

– either ‘monitoring’ the firm (at cost K)
– or ‘designing’ a debt contract characterised by a non-pecuniary cost C.
• Main findings: Assume that K<C. If the firm has a unique financier, it would be efficient
to choose the monitoring option. However, assume that each investor owns only 1/m,
so that m of them are needed for financing the project. Assume also that the total
number of investors is m*n, so that all the projects can be financed. Direct lending
implies that each of the m investors monitors the financed firm: the total cost is n*m*K.
• If a bank (financial intermediary) emerges, it can choose to monitor each firm (total cost
n*K) or to sign a debt contract with each of them (total cost n*C). Since K<C, the first
solution is preferable: the bank is a delegated monitor, which monitors borrowers on
behalf of lenders (note that the banks is not monitored by its lenders – the depositors).
Financial intermediation (delegated monitor) dominates direct lending as soon as n is
large enough: this means that diversification exists (i.e. a large number of loans is held
by the intermediary). Diversification is important because it increases the probability that
the intermediary has sufficient loan proceeds to repay a fixed debt claim to depositors.
138

Review Exercise 4
2(b) Discuss the contribution of the delegated monitoring theory of Diamond

(1984) to our understanding of why banks exist. (10 marks)
• See pp.81–82 of the subject guide. ZA-20111a

• An answer to this question should cover the basic framework of delegated
monitoring and thus show that under certain reasonable conditions it becomes
preferable for lenders to delegate lending to a specialist lender such as a bank.
• The cost of doing so for the lender (the delegation cost) is virtually zero due to the
low risk of default of the bank due to diversification.
• This explanation provides another justification for the existence of banks.
2(b) Discuss the contribution of delegated monitoring theory to our understanding of

why banks exist. (10 marks) 20122b
• See subject guide, p.81.

• Since monitoring borrowers is costly, it is efficient for surplus units
• (lenders) to delegate the task of monitoring to specialised agents such
• as banks. This is the idea underlying the Diamond model of delegated
• monitoring.
• Banks are more efficient at monitoring as they are able to obtain the
• benefits of diversification in lending so reducing risk.

Review Exercise 4
2(b) Explain the hypotheses, the framework, and the main findings of the delegated
monitoring theory. (13 marks) 2009-2b-ZA
• refer to pp.76–77 of the subject guide.

• Here candidates are expected to demonstrate their knowledge and understanding of
hypotheses, framework and key findings of the delegated monitoring theory, as
formulated by Diamond (1984). Excellent answers will describe this theory by using the
appropriate technical terms.
• Main idea of the delegated monitoring theory: Since monitoring borrowers is costly, it is
efficient for surplus units (lenders) to delegate the task of monitoring to specialised
agents such as banks. Banks have a comparative advantage relative to direct lending in
monitoring activities in the context of costly state verification. In fact, they have a better
ability to reduce monitoring costs because of their diversification. (Up to 2 marks for the
explanation of the main idea.)
Hypotheses required for delegated monitoring to work:

1. existence of scale economies in monitoring, that means that a typical bank finances many
projects
2. small capacity of investors as compared to the size of investments, that means that each project
needs the funds of several investors
3. low cost of delegation, that means that the cost of monitoring the financial intermediary itself has
to be less than the surplus gained from exploiting scale economies in monitoring investment
projects.
(One mark awarded for each of the hypotheses.)
Framework of the delegated monitoring theory: it is based on the existence of n identical firms
that seek to finance projects and the requirement by each firm of an investment of one unit. The
cash flow y that the firm obtains from its investment is a priori unobservable to lenders. This is
where moral hazard arises
• Moral hazard can be solved by:
– either ‘monitoring’ the firm (at cost K)
– or ‘designing’ a debt contract characterised by a non-pecuniary cost C.
(Up to 3 marks awarded for the description of the framework.)

Review Exercise 4
• Main findings: Assume that K<C. If the firm has a unique financier, it would be efficient
to choose the monitoring option. However, assume that each investor owns only 1/m,
so that m of them are needed for financing the project. Assume also that the total
number of investors is m*n, so that all the projects can be financed. Direct lending
implies that each of the m investors monitors the financed firm: the total cost is n*m*K.
• If a bank (financial intermediary) emerges, it can choose to monitor each firm (total cost
n*K) or to sign a debt contract with each of them (total cost n*C). Since K<C, the first
solution is preferable: the bank is a delegated monitor, which monitors borrowers on
behalf of lenders (note that the bank is not monitored by its lenders – the depositors).
Financial intermediation (delegated monitor) dominates direct lending as soon as n is
large enough: this means that diversification exists (i.e. a large number of loans are
held by the intermediary). Diversification is important because it increases the
probability that the intermediary has sufficient loan proceeds to repay a fixed debt claim
to depositors. (Up to 5 marks awarded for the explanation of the findings.)
2(b) Examine the role of delegated monitoring (Diamond model) in explaining financial
intermediation. (15 marks) 2015-2-ZA
• See subject guide, Chapter 3, pp.82–83.

• The Diamond model provides an explanation of why lenders delegate the monitoring of
ultimate borrowers to a specialist lender. An answer would need to set out the model
and the conditions under which such a model works (i.e. many lenders to one borrower
and the delegated bank has a pooled and diversified portfolio of loans and therefore
reduces risk for the ultimate lender).
• A better answer would provide a full explanation of the model, including the algebra.
A diagram is also useful in conveying the key features of the model.

Review Exercise 4
Future For Financial Intermediaries

declined declined) in recent years (e.g. USA, UK).
• Traditional banking has (inclined/
• Mutual companies have (increased/decreased)
increased their market share dramatically.
• The share of financial assets held by US financial intermediaries changed over the period 1970–2005. Since 1970
the bank share of financial assets has steadily declined. Thrift institutions (savings & loan associations) have lost
even more ground than banks.
US commercial bank
Last 4 decades Assets to nominal GDP ratio increased (Boyd and Gettler, 1994).
loans to nominal GDP
1980s & early 1990s Banks performed badly
1992, 1993-2006 Profitability to GDP increased sharply then stable (Mishkin & Eakins, 2009).
152
Source: M. Buckle (2012) Principle of Banking and Finance, ch4
Future For Financial Intermediaries - Changing Trends in Banking Industry

a) Increased inflation in the 1960s & regulatory restriction on interest payable on checkable deposits
caused investors were more sensitive to interest rate differentials. Low-cost deposits were not
Reduction in
ready as a source of funds for banks. 3 consequences:
C_________ (i) a d_________________ process occurred:
low interest rate on deposits - investors take their deposits out of banks & to look for higher-yielding investment
advantages in opportunities.
(ii) M_________M_________M___ funds appeared & grew dramatically in USA (1980s):
acquiring funds MMMF are issued by financial intermediaries to raise funds to be invested in short-term money market securities, investors
get interest payments. MMMF enable investor to write cheques against the held shares (like banks), although they are not
legally deposits & are not subject to reserve requirements & prohibitions on interest payments. so investors can have
checking account-like services & earn high interest.
(iii) D_______________ in 1980s (eliminate the ceilings interest rate on time deposit) increase banks
competitiveness in acquiring funds, but higher costs. Banks experienced reduced cost-competitive advantage over
other institutions
(b) (i) Improved i_________t__________ & diffusion of c_______ r________ agencies
Reduction in make it easier for firms to issue securities (e.g. short-term commercial papers or
i__________ long-term bonds) directly to the public. As investors can screen out bad and good
advantages in credit risks, firms go to the cheaper commercial paper market (rather than to banks)
using funds to raise short-term funds. Firms go to the bond market (& use banks less often)
even if they are less well-known corporations with lower credit ratings (junk bond
market) (ii) Sec________________ (see next slide)

Review Exercise 4
ZA2013-2d
2(d) Explain and give examples of disintermediation. (5 marks)
See subject guide, Ch 4, section headed `What is the future for financial intermediaries?'.
• Disintermediation is essentially the process of business that would normally be
conducted through intermediaries being conducted directly between ultimate
lenders and borrowers.
• Companies may raise debt by issuing corporate bonds or commercial paper into
markets rather than borrowing from banks.
160
3. (a) Explain what is meant by disintermediation and

discuss to what extent disintermediation has lead to a decline in banks. (13 marks)
• See pp.82–84 of the subject guide. 20111a

• Disintermediation is a process whereby borrowers bypass banks and borrow
directly from markets. This has been a growing trend since the 1970s for large
companies.
• Answers need to discuss the evidence for this and the reasons.
The reasons include:
(i) banks have lost low cost funding because of competition from other institutions
(e.g. mutual funds) and
(ii) greater opportunities for large companies to issue debt into markets.
• Banks have clearly not gone into decline as a result of disintermediation but have
diversified into other types of activities. This is to be covered in more detail in part
(b).
• Better answers will discuss the fact that banks are still involved in facilitating capital
raising by companies but now off the balance sheet.

Review Exercise 4
2(b) Explain disintermediation and discuss its consequences for banks.

(12marks) 2006-2b-ZA
• a clear definition of disintermediation as the process of lenders and borrowers bypassing

the banking system and lending/borrowing directly.
• discuss this in more detail to show that you understand the definition and have not simply
learnt it from a book. The examiners would award marks for students who constructed clear
paragraphs which made the following points:
– Lenders look for higher yielding assets and take their deposits out of banks.
– Borrowers issue securities directly into markets due to lower cost and development of
credit rating agencies.
– Development of securitisation allows other types of intermediaries to originate loans and
then bundle them to enable securities to be issued. This lowers the advantages banks
have in the loan markets.
• discuss the consequences for banks which include the growth in off balance sheet activities
– often facilitating direct capital raising by firms and expansion into new riskier areas of
business.
Future For Financial Intermediaries - Changing Trends in Banking Industry
b(ii) Securitization
= process of transforming illiquid f________________ assets (e.g. loans & mortgages) into
m______________ s_______________.
• Financial intermediaries can cheaply bundle together a portfolio of l_________
(e.g. m_________, c_______ card receivables, commercial & computer l__________) with varying
small denominations (less than $_____,000), collect the interest & principal payments on the loans
in the bundle, & then pay them out to 3rd parties.
• By dividing the portfolio of loans into standardised amounts, the claims to the principal & interests can be
sold to t_______ parties as securities which are liquid & well diversified.
• Financial institutions make profits by servicing the loans & charge a fee to the third party for this service.
• Securitisation allows other financial institutions to originate loans, accurately evaluate credit risks, bundle
these loans & sell them as securities. Banks have lost their advantage in the loan business.
• Securitisation reached a peak in 2007 but declined dramatically due to
securitised s___________ m____________ debt & other securitised debt products during the financial crisis
2007–09.
169

Review Exercise 4
1(a) What is meant by securitisation? Outline the process and identify the advantages to a
financial institution in securitising its assets. (5 marks) 20091a
• refer to pp.79–80 of the subject guide

• p.461 (fifth edition) or p.459 (sixth edition) of Mishkin and Eakins, Financial markets and institutions.
• definition of securitisation, which is the process of transforming illiquid financial assets (such as
loans and mortgages) into marketable securities.
• Financial intermediaries can cheaply bundle together a portfolio of loans (e.g. mortgages, credit card
receivables, commercial and computer leases) with varying small denominations (often less than
$100,000), collect the interest and principal payments on the loans in the bundle, and then pay them out
to third parties.
• By dividing the portfolio of loans into standardised amounts, the claims to the principal and interests can
be sold to third parties as securities. These securities are liquid and well diversified.
• Financial institutions make profits by servicing the loans and charge a fee to the third party for this service.
• The development of securitisation allows other financial institutions, and not only banks, to originate loans,
evaluate credit risks, bundle these loans and sell them as securities.
173
1. (a) What is meant by securitisation? Outline the process and identify the advantages
to a financial institution in securitising its assets. (5 marks)
• refer to pp.79–80 of the subject guide, and to p.461 (fifth edition) or p.459 (sixth edition) of Mishkin and
Eakins, Financial markets and institutions. 2009-1a-ZAB
• begin with a clear definition of securitisation, which is the process of transforming illiquid financial
assets (such as loans and mortgages) into marketable securities. (1 mark.)
• discuss this more in detail to show that they understand the process used by a financial institution in
securitising its assets. An outstanding answer would also provide an intuition about the advantages
associated to the phases of the process of securitisation. Financial intermediaries can cheaply bundle
together a portfolio of loans (e.g. mortgages, credit card receivables, commercial and computer leases)
with varying small denominations (often less than $100,000), collect the interest and principal
payments on the loans in the bundle, and then pay them out to third parties. (1 mark.)
• By dividing the portfolio of loans into standardised amounts, the claims to the principal and interests
can be sold to third parties as securities. These securities are liquid and well diversified. (1 mark.)
• Financial institutions make profits by servicing the loans and charge a fee to the third party for this
service. (1 mark.)
• The development of securitisation allows other financial institutions, and not only banks, to originate
loans, evaluate credit risks, bundle these loans and sell them as securities. (1 mark.)

Review Exercise 4
1(b) What factors have caused the decline in the share of financial assets held by banks in
recent years? What are the main consequences for banks? (15 marks) 20071b
• Refer to page 60 of the subject guide.

• definition of disintermediation as the process of lenders and borrowers bypassing the banking system
and lending/borrowing directly
• Lenders look for higher-yielding assets and take their deposits out of banks
• Borrowers issue securities directly into markets due to lower cost and development of credit rating
agencies
• Development of securitisation allows other types of intermediaries to originate loans and then bundle
them to enable securities to be issued. This lowers the advantages banks have in the loan markets.
179
Bank Reactions to the Decline in Their Intermediation Role

1. Banks expand into new, r_________
riskier lending
(e.g. to real estate companies, to corporate takeovers & to leverage buyouts).
In 80’s, Japanese banks expanded real estate construction lending rapidly.
In 90’s, interest rate increased sharply & the asset price bubble burst, & land prices declined
sharply over many years. Resulted many ‘bad loans’. Economic downturn in Japan & the Asia crisis
deteriorated bank loan portfolios further. In 1997, Hokkaido Takushoku Bank (10th largest commercial bank)
merger with a smaller regional bank stalled, caused the larger bank collapsed. Similar problems happened
in the US & Europe financial crisis 2007–09 as banks provide many housing loan when rapidly rising house
prices. When the housing bubble burst, banks ended with many bad debt. Many banks in solvent
2. Banks use oOff-balance

-b sheet s activities (e.g. loan commitments & LC)
which produce fee income instead of interest income.
Bank income = net interest income (earnings from balance sheet assets net of interest costs) +
non-interest income (non-interest earnings from off-balance activities).
Income from off-balance sheet activities increased strongly as a share of total bank income in the
period since the 1960s. Banks’ profitability are stable & traditional banking businesses has
declined. But, non-traditional activities might be riskier for banks.
3. Poprietary trading increased dramatically in the 15 years prior to 2007 crisis whereby
banks hold assets & derivatives for speculative purposes. Market risk increases due to bank’s
trading activities 180

Review Exercise 4
1 (d) What has been the two main reactions of banks to the decline in their traditional role?
(5 marks) 20081d
• refer to p.61 of the subject guide.

• the growth in off balance sheet activities – which produce fee income instead of interest
income
• the expansion into new riskier areas of lending.
• problems of the Japanese banking system in the 1990s
• the stronger focus on trading activities
185
1(d) What has been the two main reactions of banks to the decline in their traditional
role? (5 marks) 2008-1d-ZAB
• p.61 of the subject guide.

• The Examiners would award marks for candidates who constructed clear paragraphs
which made the following points:
– the growth in off balance sheet activities – which produce fee income instead of
interest income (2 marks)
– the expansion into new riskier areas of lending. A good answer would illustrate
this by focusing on the problems of the Japanese banking system in the 1990s (2
marks).
• Excellent answers would also refer to the stronger focus on trading activities (1
mark).

Review Exercise 4
3(b) Explain how banks have responded to the decline in their intermediation role and
discuss to what extent this may have contributed to the banking crisis of 2007/8. (12
marks)
• See pp.85–87 of the subject guide.
20111a
• Banks have essentially responded by
(i) making more risky lending (better answers have the opportunity to link discussion
to sub-prime lending),
(ii) greater off-balance sheet activity and
(iii) (iii) greater trading of assets – giving rise to market risk.
• Better answers should link these activities to the recent financial crisis.
• For example sub-prime lending and trading activities – increased risks (both credit
and market risk) which banks felt could be better managed due to use of risk
models. However, problems with models and banks had inadequate capital in
relation to the increased risks.
Appendix---Securitization

Review Exercise 4
9-192
Securitizing Loans
• Securitization of loans and other assets is a simple idea for raising new funds
– Requires a lending institution to set aside a group of income-earning, relatively illiquid assets,
such as home mortgages or credit card loans, and to sell relatively liquid securities (financial
claims) against those assets in the open market
• In effect, loans are transformed into publicly traded securities
• The lender whose loans are securitized is called the originator
• These loans are passed on to an issuer, who is usually designated a special-purpose entity
(SPE)
– The SPE is separated from the originator to help ensure that, if the originating lender goes
bankrupt, this event will not affect the credit status of the pooled loans, supposedly making
the pool and its cash flow “bankruptcy remote”
• Securitization process:
9-193
Securitization
• A credit rating agency rates securities to be sold so that investors have a better
idea what the new financial instruments are worth
– Possible moral hazard problem
• The issuer then sells securities in the money and capital markets, often with the aid
of a security underwriter (investment banker)
• A trustee is appointed to ensure the issuer fulfills all the requirements of the
transfer of loans to the pool and provides all the services promised investors
• A servicer (who is often the loan originator) collects payments on the securitized
loans and passes those payments along to the trustee, who ultimately makes sure
investors who hold loan-backed securities receive the proper payments on time
• Investors in the securities normally receive added assurance they will be repaid in
the form of guarantees against default
– Credit enhancer
– Liquidity enhancer

Review Exercise 4
9-194
Securitization Process: Cash Flows and Supporting Services That Make the
Process Work and Generate Fee Income
Source: Rose (2013) Bank Management and Financial Services, ch9
9-195
Securitization
• The concept of securitization began in the residential mortgage market of the
United States
• Three government-sponsored enterprises (GSEs) worked to improve the
salability of residential mortgage loans
– The Government National Mortgage Association (GNMA, or Ginnie Mae)
– The Federal National Mortgage Association (FNMA, or Fannie Mae)
– The Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac)
• Unfortunately for Fannie Mae and Freddie Mac the long-range outlook for
their growth and survival is questionable due to recent record defaults on
many of the home loans they traded

Review Exercise 4
Collateralized Mortgage Obligation (CMO) 9-196
• Beginning in the 1980s, with the cooperation of First Boston Corporation (later a
part of Credit Suisse), a major security dealer, Freddie Mac developed a new
mortgage-backed instrument in which investors were offered different classes of
mortgage-backed securities with different expected payout schedules
– The collateralized mortgage obligation (CMO)
• CMOs typically were created through a multistep process in which home mortgage
loans are first pooled together, then GNMA-guaranteed securities are issued
against the loan pool and ultimately offered to investors around the globe
• These securities were placed in a trust account off the lender’s balance sheet and
several different classes of CMOs issued as claims against the security pool and
the income they were expected to generate
9-197
CMO
• Each class of CMO – known as a tranche – promises a different rate of return
(coupon) to investors and carries a different risk exposure
• The different security tranches normally receive the interest payments to which
they are entitled
– The loan principal payments flow first to security holders in the top (senior)
tranche until these top-tier instruments are fully retired
– Subsequently principal payments then go to investors who purchased securities
belonging to the next tranche until all securities in that tranche are also paid out,
and so on down the “waterfall” until payments are made to investors in the last
and lowest tranche
• The “senior” tranches of a CMO generally carry shorter maturities

– Reduces their reinvestment risk exposure
– Attractive to risk-averse investors

Review Exercise 4
9-198
Collateralized Mortgage Obligations (CMOs)
Source: Rose (2013) Bank Management and Financial Services, ch9
9-199
Examples of Types of Securitized Assets
– Residential Mortgages – the beginnings of securitization
▫ The role of GSEs (GNMA, FNMA, FHLMC)
– Riskier CMOs
– Home Equity Loans
– Automobile Loans
– Commercial Mortgages
– Small Business Administration Loans
– Mobile Home Loans
– Credit Card Receivables
– Truck Leases
– Computer Leases

Review Exercise 4
Advantages of Securitization 9-200
– Diversifies a bank’s credit risk exposure

– Creates liquid assets out of illiquid assets
– Transforms these assets into new sources of capital
– Allows the bank to hold a more geographically diversified loan portfolio
– Allows the bank to better manage interest rate risk
– Allows the bank to generate fee income

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Review Exercise 4

Role of Financial Intermediation

Review Exercise 4 –Roles of Financial Intermediaries

Principles of Banking and Finance Ex4-pg1

Review Exercise 4 –Roles of Financial Intermediaries

19 Discuss the solutions aimed at reducing moral hazard in debt markets.2014-2b-ZB

Principles of Banking and Finance Ex4-pg2

32 Explain and give examples of disintermediation. (5 marks) 2013-2d-ZAB

Principles of Banking and Finance Ex4-pg3

Sources of Funds for the Firms

• Key buyers of marketable securities (stocks, bonds) are:

Existence of Financial Intermediaries- (1) Asset Transformation Theory

Principles of Banking and Finance Ex4-pg4

Banks transform the risks by:

Asset transformation does not explain:

2. Discuss the various theories proposed to explain the

Principles of Banking and Finance Ex4-pg5

3.Discuss the main theories to explain the existence of financial intermediaries.

Principles of Banking and Finance Ex4-pg6

• a brief explanation of the four main costs in lending/borrowing: Search costs,

Principles of Banking and Finance Ex4-pg7

Existence of Financial Intermediaries - (2) Transaction Costs Theory

Financial intermediaries can reduce the transaction costs by:

Existence of Financial Intermediaries –

Limitations of Transaction Costs Theory:

Principles of Banking and Finance Ex4-pg8

Existence of Financial Intermediaries –(3) Liquidity Insurance Theory

Existence of Financial Intermediaries (4) Asymmetric Information Theory

Consequences of asymmetric information:

Principles of Banking and Finance Ex4-pg9

Asymmetric Information Problems & Ways to Reduce them

Government r___________ Government regulation

• refer to page 55 of the subject guide.

Principles of Banking and Finance Ex4-pg10

2(a) Outline how adverse selection problems affect

Principles of Banking and Finance Ex4-pg11

• See subject guide, pp.73–76. 20122a

Existence of Financial Intermediaries (4) Asymmetric Information Theory

How Adverse Selection Influences Financial Structure?

Principles of Banking and Finance Ex4-pg12

Solutions for Adverse Selection Problem

Principles of Banking and Finance Ex4-pg13

The three solutions are:

Principles of Banking and Finance Ex4-pg14

2(a) Discuss how asymmetric information can cause problems in financial

Principles of Banking and Finance Ex4-pg15

2. (a) Examine the role of asymmetric information in explaining financial

Principles of Banking and Finance Ex4-pg16

Principles of Banking and Finance Ex4-pg17

Principles of Banking and Finance Ex4-pg18

Principles of Banking and Finance Ex4-pg19

I_____________ Economies Of Scale

How Moral Hazard Influences Financial Markets

Principles of Banking and Finance Ex4-pg20

How Moral Hazard Influences Financial Markets

How Moral Hazard Influences Financial Markets

Solution to reduce moral hazard in debt markets?

Principles of Banking and Finance Ex4-pg21

2(a) Explain how to reduce/solve the problems arising from

Principles of Banking and Finance Ex4-pg22

Principles of Banking and Finance Ex4-pg23

D_________ M_________ Theory by Diamond (1984)

Principles of Banking and Finance Ex4-pg24

D_ M_ Theory by Diamond (1984)