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Asymmetric information, financial intermediation and basic banking

Asymmetric information, financial intermediation and basic banking. Chap 8 and 10, Mishkin. Corporate financial structures across developed nations reveal some common features :

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Asymmetric information, financial intermediation and basic banking

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  1. Asymmetric information, financial intermediation and basic banking Chap 8 and 10, Mishkin

  2. Corporate financial structures across developed nations reveal some common features: • The methods of financing in order of importance are – bank loans and non-bank loans (56%), bonds (32%) and stocks (11%) • Only a few large corporations have access to securities markets. • Collaterals are a common feature in debt contracts. These contracts also place substantial restrictions on activities • Financial systems are heavily regulated

  3. Facts point towards big role played by financial intermediaries in financial markets. • In chap 8 we study two reasons why financial intermediaries play a big role: • Financial intermediation and transactions costs • economies of scale • expertise

  4. 2. Financial intermediation and “Lemons” (adverse selection) problem • When a lender cannot distinguish between “good” stocks (bonds) and “bad” stocks (bonds), he/she is willing to pay only a price • As a result “good” stocks (bonds) • Ways to reduce adverse selection problems are, • private production and sale of information by specialized firms • this arrangement however can cause its own problem - • A free rider is • Govt. regulation to increase information • example: SEC requiring

  5. financial intermediation • collateral and “net worth” • net worth = firm’s assets – liabilities

  6. 3. Financial intermediaries and moral hazard principal-agent problem in financial markets tools to solve principal-agent problem monitoring government regulation

  7. Financial intermediation debt vs. equity contracts

  8. Reducing moral hazard problems in equity contracts net worth and collateral restrictive covenants

  9. 4. Banks are by far the most important category of financial intermediaries and merit special study. The Bank’s Capital Account: Checkable deposits: Bank reserves Discount loans, Repo’s Bank capital The building/equipment

  10. T-bonds, notes, bills Municipal bonds, Federal govt. agency bonds Non-transaction deposits: Federal funds Commercial loans Real estate loans Consumer loans

  11. 5. Basic Banking: T-account analysis 1. You deposit $100 cash into your account with the First National Bank (FNB) (FNB) Assets (FNB) Liabilities _______________ ___________________ 2.You deposit a $100 check into your account with the FNB. The check is drawn on Second National Bank (SNB). FNB (Initial) Assets FNB (Initial) Liabilities ____________________ _____________________ FNB (Final) SNB (Final) Assets Liabilities Assets Liabilities Conclusion:

  12. 6. Principles of bank management • Bank manager manages these four: • Liquidity – • Assets – • Liability – • 4. Capital –

  13. 7. Liquidity management The following bank maintains only the required amount of reserves at any point of time. Is it a wise decision?

  14. What can the bank do to acquire reserves at a short notice? Note the costs • Borrow from other banks (__________) /from corporations (_______) • Sell securities such as _______ • Borrowing from the FED (________ loans) • Calling in loans/selling of loans in secondary markets • Conclusion:

  15. 8. Asset management • basic principle of asset management:banks have high need of liquidity compared to other financial intermediaries, hence • find borrowers with ________ • these risks are compounded by Usual strategies to managing credit risks • (ii) find securities with ________

  16. (iii) diversify: besides the other most important type of risk banks face is ________. Managing ___________risk Assets Liabilities Rate sensitive assets 20m Rate sensitive liabilities 50m i. variable-rate loans i. variable rate CDs ii short-term loans ii. money market accounts Iii short term securities Fixed rate assets 80m Fixed rate liabilities 50m i.reserves i.checkable deposits ii.long-term loans ii.savings deposits iii.long-term securities iii.long-term CDs Conclusion: If interest sensitive assets are less than interest sensitive liabilities banks can _________ if interest rates _________.

  17. 9. Capital management • Bank capital • is a cushion against __________ • (ii) determines the rate of return for owners • Net profit after tax / equity capital • = (___________/ _________) x (_________/ ___________) • (iii) required by law

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