Financial Markets And Institutions Report
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Financial markets and institutions
In economics, there is one assumption which is considered when analysing markets. This is the assumption that the market has perfect information. However, this is not always the case. Most markets do not have perfect information because it is impossible for consumers to have all information regarding transactions. Since perfect information is not possible in real world, economists have other means of studying markets with imperfect information. This study is known as information asymmetry. Information asymmetry arises when one person has less information concerning a transaction. The study of information asymmetry gives rise to “market for lemons” where a buyer may not know the quality of a product and yet pay a high price for it (ARKELOF, 2003). The agency problem also arises because of information asymmetry which brings rise to hidden information, also known as adverse selection, and hidden effort, also known as moral hazard. Adverse selection arises before a transaction is done and it is the possibility that the lender for example will give a loan to a person who is not credit worthy. Moral hazard is the possibility that once the loan has been advanced, the lender does not know how it will be used; only the borrower knows. These differences in information lead to high transaction costs if a person were to search for it. It is because of information asymmetry that financial intermediaries are considered to play a great role in dealing with it. Financial intermediaries act as links between those with surplus and those with deficit (CHANDRA, 2011). They collect small amounts of money from various depositors and then give large loans to investors. They ensure that deposited money is safeguarded and when given as loan it is returned. Financial intermediaries incur heavy costs to reduce information asymmetry in adverse selection and moral hazard. Without intermediaries, high losses could be incurred. Thus financial intermediaries act as a shield to both the depositors and the banks.
Financial intermediaries act as middlemen because they link people with extra money to those who do not have (CHANDRA, 2011). For example, banks are financial intermediaries because they collect money as deposits from customers and use the same money to lend to those parties who do not have. Therefore, financial intermediates aid in transferring money from savers to lenders. The saver incurs a cost for money deposited unless the money is deposited in a fixed account. The lenders obtain the money at a cost called interest rate and other charges which the intermediary may deem fit (MADARA, 2008). The roles of financial intermediaries include:
Collect resources from savers – Generally, most savers save small amounts of money and most borrowers borrow large amounts of money. The work of intermediaries is to accept small deposits from many savers which in turn is lent to investors who require large amounts of money to carry out their various investments. This action of intermediation is seen in banks, insurance companies which charge small premiums in order to pay large claims and mutual funds which buy large stock and bond portfolio from small investments.
Safety, accounting and automated services – Financial intermediaries provide custody for all money and other valuables belonging to depositors. They also provide interim or monthly accounts in form of statements showing deposits, withdrawals and bank charges and other commissions. They provide automated services such as automated teller machine (ATM) which help in reducing queues in the banking halls. Some other banking services can also be performed at the automated teller machines such as deposit and accessing transaction receipts. All these processes are possible because of economies of scale which lowers the transaction cost per unit.
Liquidity – Liquidity means the ease of converting an asset into cash. With financial intermediaries, it is possible to convert assets from points such as ATMs and debit cards to make payments of any kind provided the service is available. Due to the differences between long-term and short term outflows and investments, the financial intermediaries make some profits from all transactions made by customers.
Diversification of risk – Diversification of risk means minimizing risk by way of spreading and sharing it among different individuals or entities. Financial intermediaries lend to different customers thereby reducing the risk of huge losses in the event one customer should default.
Gathering and processing information – Financial intermediaries collect information regarding investments. This is helpful in reducing information asymmetry which is a factor which influences investment returns.
In order to perform their duties efficiently, financial intermediaries incur huge transaction costs which are covered by the commissions, interest rates and bank charges levied against deposits and loans (MADARA, 2008). Transaction costs involve costs of maintaining depositors’ accounts, monitoring costs, administrative costs and other operating costs which relate to technology in order to maintain or improve services offered to clients. All the actions that financial intermediaries use to reduce information asymmetry have a corresponding cost. This is an indication that financial intermediaries must operate at a profit in order to be able to remain in business (THOMAS, 2006). This means that without information asymmetry, financial intermediaries would not exist because they only operate efficiently when the market has imperfect information (SCHOLTENS, 2009). Therefore, it is crucial to expand further study in the future which analyses financial institutions in a perfect market and the real contributions it would have on the economy.
Financial intermediation and information asymmetry
Financial intermediaries have been considered to be agents of promoting development and economic growth as they help in efficient allocation of resources hence reducing market failures. The theory of financial intermediation focuses on the theory of information asymmetry and agency theory (GURLEY, 1960). Three factors were considered to affect intermediation theory which included high transaction costs, incomplete information and lack of proper regulation. They further argued that information asymmetry was divided into two; adverse selection (before a transaction) and moral hazard (after the transaction). They noted that information asymmetry led to imbalance in power and market failures and perfect market never existed. Another study about financial intermediation concluded that markets are perfect; the only difference arise because of transaction costs (FAMA, 1980). The study cautioned that transaction costs do not only involve processing fees but also include monitoring and research costs and therefore what matters is the technological costs incurred by the intermediaries (BENSTON, 1976). However, the study did not analyse the impact of information asymmetry on financial intermediation. The last financial intermediation theory was based on monetary creation through saving and providing finance to economy (GUTTENTAG, 1968) and (MERTON, 1995). Regulation of financial intermediaries is useful because it helps them maintain their liquidity and solvency (DIAMOD, 2000). Most of the arguments developed by other researchers are based on these three fundamental theories which dealt with information asymmetry, transaction costs and regulation of financial intermediaries. However, some scholars feel that the study of financial intermediation does not only concern information asymmetry, but also covers other aspects such as the real reason why financial intermediaries exist, what helps them survive and the real contribution they have on the economy (SCHOLTENS, 2009). They argue that without the existence of an imperfect market the financial institutions would be redundant and hence would not exist.
Information asymmetry arises when one party, usually the buyer, has information which the other party to the transaction does not have (SLANGENS, 2008). Information asymmetry leads to market failure and imbalance of power. Some examples of information asymmetry are a relationship between a mechanic and a customer. A mechanic can overcharge a customer for car repair because the customer does not understand how mechanics work.
Adverse selection arises before a transaction is done and moral hazard arises after a transaction has been done (AGARWALA, 2009). Adverse selection arises when the worst candidates (adverse) are likely to be selected for a transaction. When advancing credit, there is a high possibility of advancing credit to customers who are not credit worthy and leave out those who are credit worthy. Therefore, creditors do not know the character of those borrowing their money but the persons know themselves very well. However, since financial intermediaries have access to important information, they are able to distinguish between those that are credit worthy and those that are not. Therefore, when you lend to the bank through deposits, the bank lends to a third party who is credit worthy. Banks have an investigation department whose work is to access the credit worthiness of all customers seeking to borrow and this helps reduce the adverse problem. Moral hazard arises because the lender of a loan does not know how the money will be used. This is also referred to as risk (hazard) since the borrower may decide to misuse the money which he may be unable to repay. Financial intermediaries have experts who can monitor and ensure every contract is enforced and thus help in reducing the moral hazard problem. Another example of moral hazard is where a patient decides to take an insurance cover when he knows he is very sick and will definitely die. He knows that once he dies his estate will benefit from the insurance company. On the other hand, the insurance company does not know that this person is very sick because if they had known, they would not accept to provide insurance cover.
There are various methods that intermediaries use to reduce adverse selection and moral hazard. These include:
Screening – This is done through rating firms or individuals in order to access their credit worthiness. A bank investigates the borrowers to determine their financial worth and this is compared to the amount they want to borrow. After financial information has been fed into the computer system, it ranks the firms and individuals to determine who is credit worthy.
Monitoring – When banks are advancing a loan to borrowers, they ensure that the loan contract has another attachment called restrictive covenants which prohibits the borrower in using the borrowed money in any other way other than the one indicated in the contract. This way the bank is able to monitor the usage of borrowed money.
Collateral – Banks require security for all loans advanced to borrowers. The banks retain custody of the security until the loan is fully repaid. In case of default by the borrower, the bank can sell the security and recover all or part of the loan.
Credit rationing – This involves charging high interest rate to riskier borrowers because banks are not willing to lend to those type of borrowers. This is helpful because it protects the banks from risky borrowers.
Disclosure – This is a requirement for public companies which sell securities to publish on quarterly basis the financial statements and disclose any useful information.
Maintaining long-term relationship – Banks may wish to consider those clients who repay their loans in good time and cultivate a long-term relationship with them in order to advance loans to them. This can help reduce information asymmetry because the bank has all information relating to the borrower.
Market for lemons
Information asymmetry leads to a market failure called market for lemons. Market for lemons is assumed to be a car market where there are buyers and sellers (AGARWALA, 2009). Lemons are the used cars and plums are the new cars. The buyer does not know about the quality of the cars in the market. This leads to adverse selection. The buyers are willing to buy high quality cars at a low price and the sellers are not willing to sell. The sellers are willing to sell the low quality cars which the buyers are not willing to buy. The sellers will sell low quality cars at high prices thereby driving the high quality cars from the market. This leads to the lemons problem. The market fails because buyers cannot buy high quality cars but they can buy low quality cars at a high price. This means that the only cars in the market are low quality cars and very few high quality cars (AKERLOF, 2003). Financial intermediaries are helpful in this scenario if they are financing the purchase of the asset a person wants to buy. They will gather the necessary information regarding that asset in terms of quality, make, model, manufacturer and other details but this will be done at an additional cost to the buyer. However, the cost will be relatively cheaper (economies of scale) if done by the bank than if the buyer were to gather the information himself.
Information asymmetry and agency problem
Information asymmetry is a source of market failure because it leads to adverse selection (hidden information) and moral hazard (hidden action). The interaction between principal and agents need to be strategic because lack of strategy leads lemons market. The relationship between the principal and the agent is that of hidden action because the principal does not know whether the agent performs his work diligently and with due care (BAMBERG, 1989). The separation of ownership and control would not be a problem if one could write and enforce contracts specifying exactly what agents are expected to do under possible contingencies without additional cost (FAMA, 1980). However, it may not be possible for the principal to monitor all actions of the agent; thus, considerable discretion must be given to the agent. Since agent’s action is not observable, it is crucial for the principle to design contracts that make these strategic interactions recognisable. The principal may wish to observe the output of the agent in order to measure performance and design an incentive payment that depends on the output. Therefore, the agent will work hard to maximize his own utility given effort and incentive payment. In real life, higher wages increase workers efforts especially in situations where the firm cannot monitor performance perfectly. According to classical theory, all jobs are identical so to make them valuable; firms have to pay more as an incentive to work. Effort is a function of wages. Hidden action also arises between a loan borrower (agent) and the bank (principal). The agent can reduce some risks by exerting some effort through carefully studying loan applications. He can also deal with investment banks which are reputable advisers and rely on agency ratings instead of relying on minimizing risks.
Another form of principal agent relation exists between a firm which wishes to hire an employee of unknown skill or unknown intrinsic motivation. This is a case of adverse selection (hidden information). An employee may report to the office in the morning and fail to perform well. An employee’s work is measured through efficiency which is measured through marginal cost (SLANGEN, 2008). The efficient employee is assigned low marginal cost and the inefficient employee is assigned high marginal cost. Since employees use self-selection constraints (each employee seeks to maximize his own utility), it is possible to form incentive compatibility constraints. Therefore, an optimal contract must be designed such that the payment of an efficient employee who he pretends to be inefficient should be lower. In such a case, the efficient worker will continue to be efficient because he gets surplus payment for being efficient. The inefficient worker will also be compensated according to his effort and his payment will be lower. With this kind of incentives, both the efficient employee and the inefficient employee will work hard to minimize their marginal costs in order to maximize their utility. For a firm to operate at equilibrium, it has to design compensation incentives which will help it maximize its profit (MACHO-STADLER, 2001). These types of incentives could offer contracts to attract both types of workers (pooling equilibrium), offer a single contract to attract only one type of worker, or it can offer two contracts for each type of worker (separating equilibrium). In all these types of contracts, the firm seeks to maximize its profits using the available workers (efficient and inefficient).
An analysis about adverse selection and moral hazard has been done and it is clear that they are associated with various problems such as market failure and problems in designing compensation incentives by the principal (BEBCZUK, 2003). Buyers may incur high costs in acquiring a service simply because they lack the necessary information. There could be an imbalance of power in the market place because sellers want to maximize profits by selling low quality products. Large organizations such as insurance companies can incur high losses because there is a possibility that a very sick person will take an insurance policy cover. If either of the parties (buyer and seller) had information about a certain transaction, they would not involve themselves in such transaction. Therefore, adverse selection and moral hazard are not good conditions for efficient operation of market and parties must seek information first before engaging themselves in certain transactions.
In conclusion, financial intermediaries are crucial in the financial market because a perfect market does not exist in reality. Financial intermediaries shield against high loss of money which is deposited in the banks. Without financial intermediaries, investment would not be possible because they collect money from savers and lend it to investors who require huge amounts of money. Risks are reduced through lending to different people. This is called diversification. Since perfect market does not exist, the financial intermediaries deal with the problems of asymmetric information which is a condition that is inevitable in an imperfect market. Information asymmetry is divided in two namely adverse selection and moral hazard. Adverse selection arises before a transaction and moral hazard arise after a transaction. Adverse selection leads to a condition called market for lemons which is a problem in the market of cars where low quality cars have the possibility of being purchased at a high price. However, with financial intermediation, a buyer can reduce adverse selection if he engages financial intermediaries in the buying process. The financial intermediaries can also reduce the cases of asymmetric information by giving loans to borrowers through screening, collateral, disclosure, credit rationing and developing long term relationships with the customers. However, the process of reducing costs is very expensive especially if done individually. Because of economies of scale financial intermediaries are able to reduce information asymmetry at a relatively lower cost. Another consideration in information asymmetry is the relationship between a principal and an agent. The principal cannot observe the actions of an agent when he is not monitored (hidden action) and he does not know how skilled an agent is or the intrinsic value of the agent (hidden information). The principal must design an incentive which maximizes his output/ profit and also which maximises the agent’s utility and minimizes marginal cost.
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