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CHAPTER 11
THE NATURE OF FINANCIAL INTERMEDIATION
In perfect markets buyers and sellers of securities can
transact with each other without COST.
The existance of financial intermediaries to so-called
market imperfections, with TRANSACTION COSTS.
PORTFOLIO DIVERSIFICATION is another important
function of financial intermediaries.
Financial Intermediaries are in the business of
producing information about borrower creditworthiness.
The need for this information arises because of public
enemy number one: ASYMMETRIC INFORMATION.
ASYMMETRIC INFORMATION occurs when buyers
and sellers are
not equally informed about the true
quality of what they are buying and selling.
The asymetry always runs in the same direction –the
selle knows more than buyers.
It occurs in two forms:
1.
Adverse Selection: arises before a financial
transaction is consumated.
e.g. It is related to information about a business
before the bank makes the loan.
2.
Moral Hazard:
arises after a Financial transaction is consumated. As
borrowers engaged in the activities that increase the
probability of
poor performance.
e.g. a small business borrower may deliberately
choose riskier projects after receiving a bank loan.