Unit : 3 ( Fiscal and

Monetary Policy )
Sub Theme : Finance and the Macroeconomy
Reference : Mishkin, Chapter 14 ( The Financial System and Economic
Growth , Pages 345 – 357 )
Broad Outline of the Chapter : Role of the Financial
system in promoting long run economic Growth
The Main focus :
• Role of the financial system in channelling funds in the economy
• Two kinds of information problems can interfere with the flow of
funds in the financial system
• Role of the Govt. and Banks in solving those problems
• Building blocks for the financial crisis
• Empirical evidence
 Channelization of surplus funds by the
financial system
• On one side , households and firms are having surplus of funds
( looking for investment opportunities ) , on the other side some
individuals and firms are having investment opportunities ( looking for
funds)
• A well functioning financial system performs this co-ordinating job of
channelizing funds from who has it to who does not have it .
• By directing funds to where they can do most good , promoting
economic stabilization and growth.
Structure of the Financial System
• Banks ( Depository Institutions ) : Commercial Banks, Saving and
Loan associations, Mutual Saving Banks, Credit Unions .
• Insurance Companies : Life insurance companies, Fire and casualty
insurance companies .
• Pension Funds : Private and Government Pension Funds
• Finance Companies
• Mutual Funds
• Hedge Funds ( Special type of mutual funds )
 Primary Assets and liabilities of Financial
Intermediaries
Type of Financial Intermediaries Primary Assets ( Uses of Funds ) Primary Liabilities
( Sources of Funds)
Banks Business, consumer loans, mortgages, Deposits
government securities
Insurance Companies Corporate bonds, mortgages ,business loans, Premium from policies
govt. securities
Pension Funds Corporate bonds, mortgages ,business loans, Employer and employee
govt. securities contributions

Finance Companies Consumer and Business loans Commercial paper

( short term debt
instrument) , stocks and
bonds
Mutual Funds Stocks and bonds shares
Hedge Funds Numerous types of securities and financial shares
derivatives
 Ways of channelizing funds by the financial
System
There are two ways :
• Direct Finance : Borrowers directly borrowing from the savers via the
financial market by selling them various financial instruments ( equities,
bond , debt securities ) . These borrowers and savers ( or their agents /
brokers ) directly can conduct the trade in the stock exchange market or get
the help from investment banks .
• Indirect Finance : A financial intermediary stands between lender-savers
and borrower –spender. This process is called Financial intermediation.
Lender/ saver ( Households, firms , govt foreigners) Financial
Intermediaries Financial Markets Borrowers/spenders
( Households, firms , govt foreigners).
Why do we need Financial Intermediation

Asymmetric
• Adverse Selection
• Moral Hazard

Information

Free Rider
• Impediment to information collection
• The inability to fully profit from the information collection
• Information collected by one reputed investor used by the other
investors and that shoot up the value of those securities where

Problem the reputed one invested and hence profit falls.

• Limitation of information availability in the market place .
 Financial Intermediaries addressing the
Asymmetric Information & Free
RiderProblems

Role of •Private loans are not traded in the financial market

• So information collected remain available for the sole consumption of the

Private
Financial Intermediary who collected the information.
• Enhancement of the ability to profit from the information collection

Loans
• Screening ( collecting information about the potential borrower before the
financial transaction : income slip, employment record, bank a/c details,
value of your property etc.)

Role of Banks • Monitoring ( Once the loan has been given monitoring the usage of the
loan : observing the

• borrowers checking a/c details , having a long term relationship )

• Restrictive Covenants ( Legal Debt Contracts : forbidding going into risky
business, promote desirable behaviour, borrower submitting periodic a/c
statement , keeping certain % of its asset in cash
 Bank’s Role As Economic Developer
• In Developing countries where stock and bond markets are often tiny
and non existent., almost all lending is done through financial
intermediation : underdeveloped security market
• The problem of Asymmetry of information is particularly severe in
developing countries due to the , poor accounting standard and weak
information technology.
• Role of the Bank is more prominent in the Developing countries.
• As financial system develop, information about firms becomes much
easier to acquire, problem less severe, easier for a firm to issue
securities. Role of the bank get diminished ( Developed countries)
Another Tool used by the Financial
Intermediaries to solve the problem : Collateral
• A house is a collateral for a mortgage ( house loan ).
• An automobile is a collateral for an auto loan
• Property is pledged for a commercial and Farm mortgage.
• Collateral makes up around one quarter of borrowing by nonfinancial business
• It eliminates / reduces both adverse selection and moral hazard problems.
• Lenders can sell the collateral in auction market in case borrowers default
( reducing adverse selection )
• It decreases the incentives for borrowers to take on too much risk , coz if they do
then they have too much to loose including the collateral ( reducing the moral
hazard )
 Tyranny of Collateral
• Often in the developing or less developed countries, getting a legal
ownership of any property is very expensive , time consuming due to the
numerous bureaucratic hurdles and corruption.
• Without legal title properties cant be used for collateral
• Due to the inefficient legal system in the developing countries , suing a
default borrower and getting a favourable verdict , suing the default
borrower once again for obtaining legal title of collateral property is often
very long. By that time the property often get stolen , neglected , damaged
and loss of value.
• In a politically powerful sectors ( agriculture ) Govt often block lenders from
foreclosing on borrowers .
 Govt. Regulations
• U.S Securities and Exchange Commission ( SEC ) requires firm selling
their securities in public markets to disclose information about their
assets, sales , earnings
• Govt also has laws to force firms to adhere to standard accounting
principles that allow for profit verification and impose stiff criminal
and civil penalties on individuals who commit fraud by hiding and
stealing profits .
 Govt. Safety Net
• Deposit Insurance ( avoid bank failure problem )

• Making funds available directly to the troubled financial institutions

• But this will create moral hazard problem.

 Prudential Regulation and
Supervision
• Govt .can limit bank’s risk level by adopting regulations to promote
disclosure of their activities.
• Govt can establish regulations to restrict those activities and assets,
that the Govt. considers too risky for bonks.
• Encourage banks to diversify
• Prudential Supervision : monitoring banks by examining them on a
regular basis
THANK YOU