AAE EXAM

• There are two routes on how funds are transferred from lender-savers to borrower-spenders: direct and indirect finance.
• The costs of monitoring long-term customers are lower than the costs of monitoring new customers.
• Financial intermediaries play a crucial role in indirect finance.
• Financial intermediaries link investors/lenders/savers to borrowers/entrepreneurs/spenders by transforming assets.
• There are three types of financial intermediaries: depository institutions (e.g., banks, savings and loan associations, mutual savings banks, credit unions, etc.), contractual savings institutions (e.g., insurance companies and pension funds), and investment intermediaries (e.g., finance companies, mutual funds, money market mutual funds, and investment banks).
• Direct finance involves borrowers borrowing funds directly from lenders in financial markets by selling them securities (or financial instruments) which are claims on the borrower’s future income or assets.
• Indirect finance involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other.
• Financial intermediaries are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection.
• Financial intermediaries develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard.
• Credit investigation and approval involves the five C’s method and credit scoring.
• The five C’s method is normally used for large-value transactions.
• Capacity: ability of the credit applicant to repay the loan when it comes due can be measured by looking into the financial records of the applicant.
• Character: overall impression from applicant’s credit history, business track record (if the loan purpose is for business use), past dealings with other lending institutions, cases against individuals, etc.
• Capital: the applicant must not be highly-leveraged (or has very high amount of outstanding debts) since this will likely result to loan default.
• Collateral: these are properties pledged to the lending institution to serve as additional protection in case of default.
• Different credit terms (i.e., credit limit, interest, and credit period) may be offered to each class of clients appropriate to their credit risk.
• Credit scoring allows for a more uniform application of criteria for accepting credit clients and a segregation of clients into different credit risk levels.
• Financial Institutions (FIs) obtain information about their borrowers through screening and monitoring.
• If a prospective borrower has had a checking or savings account or other loans with a bank over a long period of time, a loan officer can learn quite a bit about the borrower.
• Lenders monitor the compliance of borrowers, and reinforce the covenants if they are not.
• The Five C’s method includes Capacity, Character, Capital, Collateral, and Conditions.
• The Five C’s method is normally used for large-value transactions.
• Credit scoring is normally applied for smaller accounts such as those granted to individual clients and uses a quantitative model to compute the credit score of an applicant on the basis of various explanatory variables deemed closely linked to credit risk of a borrower.
• The concepts of adverse selection (AS) and moral hazard (MH) provide a framework for understanding the principles that financial institutions have to follow to reduce credit risk and make successful loans.
• Banks often specialize in lending to local firms or to firms in particular industries to overcome the AS problem.
• Financial Institutions (FIs) must adhere to the principle for managing credit risk that a lender should write provisions (restrictive covenants) into loan contracts that restrict borrowers from engaging in risky activities.
• Long-term customer relationships reduce the costs of information collection and make it easier to screen out bad credit risks.
• Without a well-functioning set of FIs, it is very hard for an economy to reach its full potential.
• Financial Institutions (FIs) play a key role in improving economic efficiency by channeling funds from lender-savers to people with productive investment opportunities.
• To be profitable, FIs must overcome the AS and MH problems that make loan defaults more likely.
• Conditions: lending institutions must also consider the different external factors which may have significant impacts on its operations (e.g., macroeconomic variables, political climate, etc.)
• Credit scoring is normally used for smaller accounts such as those granted to individual clients.
• Adverse selection is a problem created by asymmetric information before the transaction occurs, occurring when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome – the bad credit risks – are the ones who most actively seek out a loan and are thus most likely to be selected.
• Financial intermediaries are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection.
• Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use those funds to acquire assets by purchasing securities or making loans.
• Asymmetric information is a problem in the financial system when one party often does not know enough about the other party to make accurate decisions.
• Real interest rates are interest rates adjusted for the expected erosion of purchasing power resulting from inflation, reflecting the true cost of borrowing.
• Financial intermediaries promote diversification by helping individuals to diversify and thereby lower the amount of risk to which they are exposed.
• Moral hazard is a problem created by asymmetric information after the transaction occurs, it is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back.
• Types of financial intermediaries include Depository institutions such as banks, savings and loan associations, credit unions, etc., Contractual savings institutions like insurance companies and pension funds, and Investment intermediaries like finance companies, mutual funds, money market mutual funds, and investment banks.