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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.