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What is one of the primary vulnerabilities of banks according to the Diamond-Dybvig model?
What is one of the primary vulnerabilities of banks according to the Diamond-Dybvig model?
During which period did the USA experience 7 bank panics?
During which period did the USA experience 7 bank panics?
Which measure is NOT proposed to prevent bank panics according to the Diamond-Dybvig model?
Which measure is NOT proposed to prevent bank panics according to the Diamond-Dybvig model?
What type of depositor may withdraw based on the observed length of the queue at a bank?
What type of depositor may withdraw based on the observed length of the queue at a bank?
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Which bank panic theory emphasizes the role of specific information about a bank's investments?
Which bank panic theory emphasizes the role of specific information about a bank's investments?
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Which statement accurately describes the relationship between bank panics and business cycles according to Gorton?
Which statement accurately describes the relationship between bank panics and business cycles according to Gorton?
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What does narrow banking propose as a way to reduce bank panic risks?
What does narrow banking propose as a way to reduce bank panic risks?
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An informed depositor will withdraw their money if the bank invests in which type of assets?
An informed depositor will withdraw their money if the bank invests in which type of assets?
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What problem does adverse selection represent in financial transactions?
What problem does adverse selection represent in financial transactions?
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Which of the following best describes moral hazard?
Which of the following best describes moral hazard?
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What has significantly influenced the changes in demand conditions for mortgages?
What has significantly influenced the changes in demand conditions for mortgages?
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What role do financial derivatives play in lending practices?
What role do financial derivatives play in lending practices?
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How do financial intermediaries primarily respond to market failures?
How do financial intermediaries primarily respond to market failures?
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How do technological innovations impact supply conditions in finance?
How do technological innovations impact supply conditions in finance?
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What is one key advantage of financial intermediaries?
What is one key advantage of financial intermediaries?
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Which method can mitigate adverse selection in financial transactions?
Which method can mitigate adverse selection in financial transactions?
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What characterizes the primary function of private banks?
What characterizes the primary function of private banks?
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What is a key feature of credit cooperatives?
What is a key feature of credit cooperatives?
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What does financial disintermediation refer to?
What does financial disintermediation refer to?
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What is the primary function of a savings bank?
What is the primary function of a savings bank?
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What primarily drives financial disintermediation?
What primarily drives financial disintermediation?
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Which of the following is NOT a benefit provided by financial intermediaries?
Which of the following is NOT a benefit provided by financial intermediaries?
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What is a crucial regulatory feature of savings banks regarding profits?
What is a crucial regulatory feature of savings banks regarding profits?
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How do electronic money institutions function according to the regulations?
How do electronic money institutions function according to the regulations?
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What characterizes inefficient equilibria in banking?
What characterizes inefficient equilibria in banking?
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Which theory helps to explain banking panics?
Which theory helps to explain banking panics?
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What is a consequence of the sequential service restriction in deposit agreements?
What is a consequence of the sequential service restriction in deposit agreements?
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How does deposit insurance generally affect moral hazard?
How does deposit insurance generally affect moral hazard?
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What does Gorton's (1988) empirical evidence suggest about bank runs?
What does Gorton's (1988) empirical evidence suggest about bank runs?
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What issue arises from deposits being non-negotiable debt contracts?
What issue arises from deposits being non-negotiable debt contracts?
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Why might direct finance be preferred over bank deposits?
Why might direct finance be preferred over bank deposits?
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Which statement about moral hazard and deposit insurance is accurate?
Which statement about moral hazard and deposit insurance is accurate?
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What is one of the main purposes of using collateral in a loan agreement?
What is one of the main purposes of using collateral in a loan agreement?
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How does capital function as a signal in borrowing situations?
How does capital function as a signal in borrowing situations?
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What issue do long-term bank-client relationships help mitigate?
What issue do long-term bank-client relationships help mitigate?
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What effect does increasing interest rates have on credit rationing according to Stiglitz & Weiss?
What effect does increasing interest rates have on credit rationing according to Stiglitz & Weiss?
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How does a guarantee benefit the bank concerning moral hazard?
How does a guarantee benefit the bank concerning moral hazard?
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Why might a bank refuse to grant a loan even if a borrower is willing to pay a higher interest?
Why might a bank refuse to grant a loan even if a borrower is willing to pay a higher interest?
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What is a potential cost associated with implementing collateral for the bank?
What is a potential cost associated with implementing collateral for the bank?
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What enables banks to learn about their borrowers over time in long-term relationships?
What enables banks to learn about their borrowers over time in long-term relationships?
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Study Notes
Financial Intermediaries
- Financial Intermediaries acquire funds by issuing liabilities and use those funds for purchasing securities or lending.
- They provide a link between lenders and borrowers through indirect financing, minimizing market failures, and reducing the risk of adverse selection and moral hazard.
Asymmetric Information
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Adverse Selection: Occurs before the transaction. One party possesses information relevant to the transaction, unknown to the other party. This disadvantages higher-quality agents who are treated equally by the market.
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Solutions:
- Signalling: The informed party signals their quality to the uninformed party.
- Screening: The uninformed party designs contracts to induce the informed party to reveal their information.
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Solutions:
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Moral Hazard: Occurs after the transaction. It is difficult to ascertain if one of the parties fulfills their obligations, as such information isn't verifiable.
- Solution: Implementing incentive contract designs.
Financial Intermediary Advantages
- Manage Settlement (Payment) System: Facilitate efficient transactions.
- Portfolio Management: Provide expertise to manage a diversified portfolio of assets.
- Transformation Services: Convert liquid liabilities (deposits) into illiquid assets (loans).
- Minimize Transaction Costs: Utilize economies of scale to reduce transaction costs associated with financial operations.
- Long-Term Client Relationships: Building trust and understanding over time reduces information asymmetry risks.
Financial Disintermediation
- The process where lenders and borrowers re-engage in direct finance, bypassing financial intermediaries.
- Technological changes and financial innovations drive this trend, creating new avenues for direct financing.
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Contributing Factors:
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Changes in Demand Conditions:
- Increasing volatility in interest rates.
- Adjustable-Rate Mortgages (ARMs) allow for rate changes with market fluctuations, attracting borrowers seeking to hedge interest rate risk.
- Financial Derivatives Market offers tools for hedging against interest rate risks.
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Changes in Supply Conditions:
- Technological innovation and advances in information technology enable direct financing options:
- Bank Credit Cards
- Junk Bonds
- Commercial Paper
- Internationalization of financial markets
- Securitization
- Technological innovation and advances in information technology enable direct financing options:
- Regulation Avoidance: Innovation enables circumventing regulations like minimum reserve requirements by using Eurodeposits and Eurodollars, or restrictions on interest paid on deposits.
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Changes in Demand Conditions:
Financial Entity
- An institution that takes deposits and grants credit.
Financial Panics
- Historic Examples: Panics before 1865, National Banking Era panics (1873-1914), Great Depression (1929-1933), Subprime Mortgage Crisis (2007).
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Theories:
- Random Bank Panic Models (Diamond-Dybvig): Illustrate the potential for bank panics due to the transformation services banks offer.
- Information-Induced Banking Panic Models: Bank runs triggered by specific negative information about a bank's financial health.
Diamond-Dybvig Model
- Justifies financial intermediation based on the transformation service banks provide.
- Explains the vulnerability of banks to costly panics.
- Highlights the need for regulation (deposit insurance) to mitigate panic-related costs.
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Bank Panic Prevention Measures:
- Suspension of convertibility (limiting withdrawals).
- Deposit insurance.
- Narrow banking (segregating low-risk and high-risk investments with differing levels of insurance).
Adverse Information and Bank Runs Models
- Introduces three types of depositors:
- Informed depositors: Withdraw if the bank invests in high-risk assets.
- Impatient depositors: Always withdraw.
- Uninformed depositors: Observe how many depositors withdraw to infer information about the bank's financial health.
- Withdrawal queue length provides insights into the bank's condition.
- The model highlights how information asymmetry can lead to bank runs due to panicked depositors mistakenly interpreting withdrawal patterns.
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Equilibria:
- Inefficient equilibria: Withdrawal decisions are incorrect, potentially leading to bank runs despite a healthy bank.
- Efficient equilibria: Depositors withdraw only during financial distress.
Banking Panics
- The adverse information theory can explain banking panics caused by the spreading of negative information about a bank's financial health, leading to a broader panic across the banking system.
- Empirical evidence suggests a relationship between banking panics and economic cycles, supporting the information-specific theory.
Credit Rationing
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Stiglitz & Weiss:
- Refusal of Loans: Banks may refuse loans at any interest rate due to increased adverse selection risk as interest rates rise. The riskiest borrowers are more likely to seek loans at higher interest rates.
Long-Term Bank-Client Relationships
- Reduce information asymmetry, especially moral hazard, since borrowers are less likely to engage in actions that harm the bank if they require future loans.
- Allow banks to gather private information about borrowers over time, leading to better loan terms.
Guarantees
- Address information asymmetry problems:
- Signalling High Borrower Quality: A guarantee demonstrates a borrower's creditworthiness.
- Aligning Interests: Incentive compatibility between borrower and bank (both have a stake in successful outcomes).
- Reduce moral hazard by addressing asset substitution and improper effort issues.
- Involve costs for the bank.
Capital
- Solves information asymmetry problems:
- Signal of Owner Confidence: Capital injection signifies confidence in the venture's success.
- Aligning Interests: The company's stake in the success of the project mitigates moral hazard.
Economic Conditions
- Impact a borrower's ability to repay loans.
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Description
This quiz delves into the concepts of financial intermediaries and the challenges posed by asymmetric information, including adverse selection and moral hazard. It explores mechanisms like signalling and screening that help mitigate issues arising from information inequalities in financial transactions.
