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Bafin Module 2

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32 views2 pages

Bafin Module 2

Uploaded by

mdotcdot
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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BAFIN 101B MODULE 2

Introduction:
A vibrant and healthy economy requires a financial system that makes or channels funds from
people who save to people who have productive investment opportunities. The financial system
is complex in structure and functions throughout the world. A developed economy relies on
financial markets and institutions for efficient transfer of funds. Every person's life, family,
business, and government are affected by the financial system.

The environment both determines the available financial alternatives and effects the outcome of
various decisions. Thus, it is crucial that investors and finance managers have a good
understanding of the environment in which they operate.

Nature and objective of the Financial System


The financial system consists of all financial intermediaries and financial markets and their
relations with respect to the flow of funds to and from households, governments, business firms
and foreigners, as well as the financial infrastructure.
Having a well-functioning financial system in place that directs funds to their most productive
uses is a crucial prerequisite for economic development.

FUNCTION OF FINANCIAL SYSTEM


The primary responsibility of the financial system is to direct money from industries with mutual
funds, stockbrokers, insurance firms, and other financial services surplus to areas with a of
funding. Financial institutions like banks and financial services are offered to consumers and
corporations by competing businesses.
According to economists, the financial system offers three essential functions. Providing risk
sharing, liquidity, and information.
a. Risk Sharing
b. Liquidity
c. Information
RISK SHARING
Risk sharing is a method of risk management that involves allocating the risk to two or more
parties that concur to work together and share any positive or negative results.
RISK is the possibility that the value of financial assets will fluctuate in contrast to your
expectations.
LIQUIDITY
It measures how easily an asset may be converted into cash.
INFORMATION
Information about borrowers and projected returns on financial assets can be found in the
financial markets.

THE PROBLEM OF ADVERSE SELECTION AND MORAL HAZARD


A key consideration for savers is the financial health of borrowers. Savers do not lend to
borrowers who are unlikely to pay them back.
A vital service of the financial system is the collection and communication of information or
facts about borrowers and expectation of returns on financial assets. Financial markets convey
information to both savers and borrowers by determining the prices of stocks, bonds, and other
securities.

ASYMMETRIC INFORMATION
- describes the situation in which one party to an economic transaction has better information
than does the other party.

Two Problems arising from Asymmetric Information are:


1. ADVERSE SELECTION - This is the problem investors experience in distinguishing low-
risk borrowers from high-risk borrowers before making an investment.
2. MORAL HAZARD - This is the problem investors experience in verifying that borrowers are
using their funds as intended.

NATURE AND IMPACT OF TRANSACTION AND INFORMATION COSTS

TRANSACTION COSTS - The cost of a trade or a financial transaction; for example, the
brokerage commission charged for buying or selling a financial asset.

INFORMATION COSTS- The costs that savers incur to determine the creditworthiness of
borrowers and to monitor how they use the funds acquired.

HOW FINANCIAL INTERMEDIARIES REDUCE "ADVERSE SELECTION"

The Problem of "adverse selection" can be minimized if not totally avoided using the following
approaches:
1. Requiring borrowers to disclose - Material information on their financial performance and
financial position.
- Financial market participants and the government have taken the steps to try to reduce
problems of adverse selection in financial market.
-The Security Exchange Commission (SEC) requires the publicly traded firms report in their
performance in financial statements such as balance sheet
- Value of firm's assets, liabilities, stockholders, and equity and income statements. Show a
firm's revenue, costs and profit.
- In addition disclose material information would likely affect the price of a firm's stock
2. Collecting information on firms and selling that information to investors.
3. Convincing lenders to require borrowers to pledge some of their assets as collateral which the
lender can claim of the borrower defaults.

How Financial Intermediaries Reduce Moral Hazard Problems


- Specializing in monitoring borrowers and developing effective techniques to ensure that the
funds they load are used for their intended purposes
Imposing Restrictive Covenants
-may involve placing limitations on the uses of funds borrowed.

How financial intermediaries reduce transaction cost.

Transaction cost may be reduced by adopting the following techniques. Financial intermediaries
can take advantage of the following:
1. Economies of scale
- refers to the reduction in average cost that results from an increase in the volume of good or
service produce.
2. Technology
- Financial services can be done through technology such as those automated teller machine.
3. Rely on sophisticated software
- Financial intermediaries also increasingly rely on sophisticated software to evaluate the credit
worthiness of loan applicants.

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