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

2. 2 Corporate financial structures across developed nations reveal some common features: 1.The methods of financing in order of importance are – bank loans and non-bank loans (56%), bonds (32%) and stocks (11%) 2.Only a few large corporations have access to securities markets. 3.Collaterals are a common feature in debt contracts. These contracts also place substantial restrictions on activities 4.Financial systems are heavily regulated

3. 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: 1.Financial intermediation and transactions costs economies of scale expertise

4. 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, 1.private production and sale of information by specialized firms this arrangement however can cause its own problem - A free rider is 2.Govt. regulation to increase information example: SEC requiring

5. 5 3.financial intermediation 4.collateral and “net worth” net worth = firm’s assets – liabilities

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

7. 7 Financial intermediation debt vs. equity contracts

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

9. 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. 10 T-bonds, notes, bills Municipal bonds, Federal govt. agency bonds Non-transaction deposits: Federal funds Commercial loans Real estate loans Consumer loans

11. 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) AssetsFNB (Initial) Liabilities ____________________ _____________________ FNB (Final) SNB (Final) AssetsLiabilitiesAssetsLiabilities Conclusion:

12. 12 6. Principles of bank management Bank manager manages these four: 1.Liquidity – 2.Assets – 3.Liability – 4.Capital –

13. 13 7. Liquidity management The following bank maintains only the required amount of reserves at any point of time. Is it a wise decision? Assets Reserves $10m Liabilities Deposits $100 m Loans $90 m Securities $10 m Bank capital $10 m

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

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

16. 16 (iii)diversify: besides the other most important type of risk banks face is ________. Managing ___________risk Assets Liabilities Rate sensitive assets 20mRate sensitive liabilities 50m i.variable-rate loans i. variable rate CDs iishort-term loans ii. money market accounts Iiishort term securities Fixed rate assets 80mFixed 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. 17 9. Capital management Bank capital (i)is a cushion against __________ (ii)determines the rate of return for owners Net profit after tax / equity capital = (___________/ _________) x (_________/ ___________) (iii) required by law