Roles of Financial Intermediaries Pool savings

Roles of Financial Intermediaries • • Pool savings Extend credit Keep depositors savings safe – Accounting statements that track assets • • Provide liquidity Provide risk sharing – Even small deposits can be diversified • Provide information – Collect and process large amounts of standardized financial information

Information Asymmetries and Information Costs • Asymmetric information – issuers of financial instruments (ious, bonds, stock) know more about their business prospects and their willingness to work than potential lenders or investors • Adverse Selection – before a deal is struck – potential borrowers know more about the projects they wish to finance than prospective lenders If it’s such a good deal, why are you offering it to me? • Moral Hazard – after the deal is struck – Borrowers may not do what they said they would • They may take too many risks with your money

Adverse selection and market breakdown • 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 stock of the good company is undervalued. • Managers of the good company 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. – But why buy their stock? … it’s a lemon! Solving the Adverse Selection Problem Disclosure / Collateral / Net Worth

Addressing Moral Hazard – Borrowers may not do what they said they would • They may take too many risks with your money Solutions • Monitor management actions • Require managers to invest substantial resources • Restrict what borrowers can do with borrowed funds – Restrictive covenants on bonds and loans

Financial Intermediaries and Information Costs • Adverse selection and moral hazard make direct finance expensive and hard to get. • Financial intermediaries collect information to reduce these costs and minimize the effects of adverse selection and moral hazard – Screening and certifying before a deal – Monitoring after the deal