Aasim Bin Bakr Roll:12 Class 04

Sources of Funding

The sources of direct finance are bonds and stocks. The sources of indirect finance are banks
and non-bank financial institution loans. Traditionally, indirect finance is the more popular
method of financing across the world. However, the scenario is the opposite in USA. Due to the
higher capacity to take risks, Americans invest their idol money in stocks and bonds. In
Bangladesh, 90% of the financing is sourced from bank loans.

The 8 points mentioned in Mishkin are:

1. Stocks are not the most important source of external financing for businesses.

2. Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations.

3. Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations.

4. Financial intermediaries, particularly banks, are the most important source of external
funds used to finance businesses.

5. The financial system is among the most heavily regulated sectors of the economy.

6. Only large, well-established corporations have easy access to securities markets to

finance their activities.

7. Collateral is a prevalent feature of debt contracts for both households and businesses.

8. Debt contracts typically are extremely complicated legal documents that place
substantial restrictions on the behavior of the borrower.

How Financial Intermediaries Reduce Transaction Costs

For individual small transactions, the commission rate is higher. Not everyone can buy all
securities or bonds due to the high denomination. Finally, diversification is not always possible
since the capital for individual investors is small. This goes on to increase the risk of individuals.
Due to these three reasons, financial intermediaries contribute through economies of scale and
their expertise to reduce transaction costs. They also enable individuals with liquidity services,
making it easier to conduct transactions.

How Financial Intermediaries Help to Solve Asymmetric Information

Asymmetric information arises from one party’s insufficient knowledge about another party’s
transactions. This leads to adverse selection and moral hazard before and after the transaction
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respectively. Bad loans are given out increasing default risk and eventually interest rate. The
lemon’s problem can be used to elaborate this phenomenon. Moral hazard problems are
associated with principal-agent problems. Solution to these problems are private production and
sale of information (e.g., Moody’s), government regulation to increase information (e.g., audits),
financial intermediation, and collateral and net worth.

Financial Crisis

Financial crisis occurs when financial intermediaries do not perform properly. As a result of this,
mobilization of funds stop, economic activity reduces, economy’s real sector growth stops,
employment reduces, and GDP reduces.

Asymmetric information problems are known as financial friction. Due to high financial friction,
lenders cannot properly assess the creditworthiness of borrowers and charge a higher interest
rate.

To study financial crisis, we look at the advanced economies because they have gone through
trial and error to come to modern state and have high impact on all other economies.

Reasons of Financial Crisis

The two main reasons behind financial crisis are:

1. Boom and Bust of Asset Price (1996 and 2010 Bangladesh stock market crash)

2. Failure of Major Financial Institutions (uncertainty leading to reputational risk, leading to

withdrawal of funds)

Financial innovation refers to the introduction of new kinds of financial products. Financial
liberalization refers to the elimination of restrictions on the financial markets and institutions.

Credit Boom and Bust: Lenders may not have the proper expertise and lend out to the wrong
people, resulting in high levels of default. Again, due to financial liberalization, lenders may go
on a lending spree, known as a credit boom and bust. When loans start to default, it effects the
balance sheet, driving down the capital and increasing the risk of the banks.

In Bangladesh, banks are expert in lending out to the RMG sector due to years of practice.
However, they are not as well adept in lending out to SMEs. As a result of this, higher levels of
default and interest rate are seen in SME lending.

Asset Price Boom and Bust: The rise of asset prices all of a sudden have similar circumstances
as the credit boom and bust. An example of this is the 2008 US real estate market crash.
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Reputational Crisis: Due to failure, financial institutions can fall into reputational crisis, leading to
a worse situation. One example of this was the Farmer’s Bank. Eventually it was renamed as
Padma Bank.

Great Depression

The Great Depression of the 1920s and the 1930s originated from the real sector due to the
suppression of the aggregate demand. As Keynesian economics was not popular back then,
classical economists couldn’t solve the problem. Years later at the advent of World War 2, the
problem was finally solved when USA started undertaking massive infrastructure projects. As a
result, aggregate demand rose.