1. Fundamentals of Banking
Asymmetric Information & Banking
ECO Money & Banking Dr. D. Foster

2. Banks Reduce Transaction Costs
Why are there banks?
Banks Reduce Transaction Costs
Spread fixed costs, economies of scale, liquid.
Banks must contend with problems…
Adverse Selection
Pre-contractual (Bad risks want to borrow.)
Moral Hazard
Post-contractual (Will borrower be prudent and repay?)
Principal-Agent Problems
Aligning incentives (Do managers act in the owners’ best interest?)

3. How do Banks Deal with Asymmetries?
Screen borrowers.
Requirements for collateral and net worth.
Imposing covenants and monitoring.
Variable interest rates and credit rationing.
How does this reduce both the adverse selection and moral hazard problems?
Should the government get involved with asymmetries?

4. Fundamentals of Banking
Asymmetric Information & Banking
ECO Money & Banking Dr. D. Foster