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The Economics of Financial Intermediation: Role of Intermediaries, Information Asymmetries, and Costs

This chapter summarizes the importance of financial intermediaries in mitigating information asymmetries, adverse selection, and moral hazard in financial markets. It discusses the challenges faced by borrowers and issuers of financial instruments in terms of disclosing information and reducing risks. The chapter also highlights the role of financial intermediaries in screening, certifying, and monitoring to minimize information costs.

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The Economics of Financial Intermediation: Role of Intermediaries, Information Asymmetries, and Costs

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  1. Chapter 11 The Economics of Financial Intermediation

  2. A Summary of the Role of Financial Intermediaries

  3. Information Asymmetries and Information Costs • asymmetric information • issuers of financial instruments – borrowers who want to issue bonds and firms that want to issue stock – know much more about their business prospects and their willingness to work than potential lenders or investors

  4. Information Asymmetries and Information Costs • Adverse Selection • potential borrowers know more about the projects they wish to finance than prospective lenders

  5. Information Asymmetries and Information Costs • If you can’t tell the difference between the two firms’ prospects, you will be willing to pay a price based only on the firms’ average quality. • The result is that the stock of the good company will be undervalued. • Since the managers know their stock is worth more than the average price, they won’t issue the stock in the first place. • That leaves only the firm with bad prospects in the market.

  6. Information Asymmetries and Information Costs • Solving the Adverse Selection Problem • Disclosure of Information • Collateral and Net Worth

  7. Information Asymmetries and Information Costs • Moral Hazard • Moral hazard arises when we cannot observe people’s actions, and so cannot judge whether a poor outcome was intentional or just a result of bad luck • principal-agent problem • The separation of ownership from control. • When the managers of a company are the owners, the problem of moral hazard in equity financing disappears.

  8. Information Asymmetries and Information Costs • Moral Hazard in Debt Finance • Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking • a good legal contract can solve the moral hazard problem that is inherent in debt finance. • Bonds and loans often carry restrictive covenants

  9. The Negative Consequences of Information Costs

  10. Financial Intermediaries and Information Costs • The problems of adverse selection and moral hazard make direct finance expensive and difficult to get. • These drawbacks lead us immediately to indirect finance and the role of financial institutions. • Much of the information that financial intermediaries collect is used to reduce information costs and minimize the effects of adverse selection and moral hazard

  11. Financial Intermediaries and Information Costs • Screening and Certifying to Reduce Adverse Selection • Monitoring to Reduce Moral Hazard

  12. Chapter 11 End of Chapter

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