Full Name: ....Trần Thị Huyền..... Class: ................ Student Code:...... 11216431......

Mark:

TEST 3

 TOPIC 3: ROLES OF FINANCIAL INTERMEDIARIES

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 Financial intermediaries E A The problem occurs when people do not pay for
information that others have to pay for.
2 Differences in preferences H B A moral hazard problem that occurs when the
of lenders and borrowers managers in control act in their own interest rather
than in the interest of the owners due to differing
set of incentives.
3 Asset transformation K C The inequality of knowledge that each party to a
transaction has about the other party.
4 Transaction costs D D The time and money spent trying to exchange
financial assets, goods, or services.
5 Asymmetric information C E Institutions that borrow funds from people who
have saved and then make loans to others

6 Adverse selection I F The risk that one party to a transaction will engage
in behavior that is undesirable from the other
party’s point of view.
7 Moral hazard F G Savings that can be achieved through increased
size.
8 Free-rider problem A H The conflicting requirements of lenders (needs for a
high degree of liquidity in their asset holdings) and
borrowers (needs for permanent or long-term
capital).
9 Principle-agent problem B I The problem created by asymmetric information
before a transaction occurs: the people who are the
most undesirable from the other party’s point of
view are the ones who are most likely to want to
engage in the financial transaction.
10 Economies of scale G K The process by which the financial intermediaries
turn risky assets into sales assets for investors.
11 Economies of scope L L Increased business that cab e achieved by offering
many products in one easy-to-reach location.
SECTION 2 – Match the solutions with their problems. Some solutions are used more than
once.

Differences in Transaction Liquidity Asymmetric information

preferences of costs needs Adverse Moral hazard
lenders and selection Equity Debt
borrowers
markets markets
*Expertise *Economi *Liquidit *Screening *Diversyfin *Debt
*Financial es of scale y loan g risk; contracts;
intermediari * insurance applications *Pooling *Making
es Economies *Monitorin risks debt
of scope g; contracts
* incentive-
Monitoring compatibl
and e
enforcemen
t of
restrictive
covenants

1. Screening loan applications 2. Economies of scale

3. Liquidity insurance 4. Diversifying risk
5. Debt contracts 6. Private production and sale of information
7. Expertise 8. Financial intermediaries
9. Economies of scope 10. Monitoring and enforcement of restrictive covenants
11. Government regulation 12. Pooling risks
13. Monitoring 14. Making debt contracts incentive-compatible

SECTION 3 – Choose the best answers for the questions below

1. The presence of transaction costs in financial markets explains, in part, why

(a) financial intermediaries and indirect finance play such an important role in financial markets.
(b) equity and bond financing play such an important role in financial markets.
(c)corporations get more funds through equity financing than they get from financial
intermediaries.
(d) direct financing is more important than indirect financing as a source of funds.

2. Financial intermediaries can substantially reduce transaction costs per dollar of

transactions because their large size allows them to take advantage of
(a) poorly informed consumers.
(b) standardization.
(c) economies of scale.
(d) their market power.

3. Through risk-sharing activities, a financial intermediary _________ its own risk and
_________ the risks of its customers.
(a) reduces; increases
(b) increases; reduces
(c) reduces; reduces
(d) increases; increases

4. The presence of _________ in financial markets leads to adverse selection and moral
hazard problems that interfere with the efficient functioning of financial markets.
(a) noncollateralized risk
(b) free-riding
(c) asymmetric information
(d) costly state verification

5. When the lender and the borrower have different amounts of information regarding a
transaction, _________ is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud

6. When the potential borrowers who are the most likely to default are the ones most actively
seeking a loan, _________ is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud
7. When the borrower engages in activities that make it less likely that the loan will be repaid,
_________ is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud

8. The concept of adverse selection helps to explain

(a) which firms are more likely to obtain funds from banks and other financial intermediaries,
rather than from the securities markets.
(b) why indirect finance is more important than direct finance as a source of business finance.
(c) why direct finance is more important than indirect finance as a source of business finance.
(d) only (a) and (b) of the above.
(e) only (a) and (c) of the above.

9. Adverse selection is a problem associated with equity and debt contracts arising from
(a) the lender’s relative lack of information about the borrower’s potential returns and risks of his
investment activities.
(b) the lender’s inability to legally require sufficient collateral to cover a 100 percent loss if the
borrower defaults.
(c) the borrower’s lack of incentive to seek a loan for highly risky investments.
(d) none of the above.

10. When the least desirable credit risks are the ones most likely to seek loans, lenders are
subject to the
(a) moral hazard problem.
(b) adverse selection problem.
(c) shirking problem.
(d) free-rider problem.
(e) principal-agent problem.

11. Financial institutions expect that

(a) moral hazard will occur, as the least desirable credit risks will be the ones most likely to seek
out loans.
(b) opportunistic behavior will occur, as the least desirable credit risks will be the ones most
likely to seek out loans.
(c) borrowers will commit moral hazard by taking on too much risk, and this is what drives
financial institutions to take steps to limit moral hazard.
(d) none of the above will occur.
12. Successful financial intermediaries have higher earnings on their investments because
they are better equipped than individuals to screen out good from bad risks, thereby reducing
losses due to
(a) moral hazard.
(b) adverse selection.
(c) bad luck.
(d) financial panics.

13. In financial markets, lenders typically have inferior information about potential returns
and risks associated with any investment project. This difference in information is called
(a) comparative informational disadvantage.
(b) asymmetric information.
(c) variant information.
(d) caveat venditor.

Homework
Summary
Financial intermediaries

Why – exist

To solve or reduce transactions costs by “exploiting economies of scale” – transactions costs per
dollar of investment decline as the size of transactions increase.

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What – types

- Def: A financial intermediary is an entity that acts as the middleman between two parties in a
financial transaction, such as a commercial bank, investment bank, mutual fund, or pension
fund……………………………………………………………………………………………….

………………………………………………………………………………………………………

- Types: According to the dominant economic view of monetary operations, the following
institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings
banks, Building societies, Credit unions, Financial advisers or brokers, Insurance companies,
Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges.
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How – solve/reduce (Explain solutions used by financial intermediaries in details)

Financial intermediaries enjoy economies of scale since they can take deposits from a large
number of customers and lend money to multiple borrowers. The practice helps to reduce the
overall operating costs that they incur in their normal business routines.

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