FINA-1094

• What is the main activity of banks?

  Financial intermediation
• How is financial intermediation defined?

  Process of transferring funds from savers to borrowers
• Why do funds need to be transferred between savers and borrowers?

  To meet different financial needs
• What are the two groups involved in financial intermediation?

  Savers and borrowers
• What are the differing objectives of savers and borrowers?

  Savers seek high returns; borrowers seek low costs
• In what three key areas do savers' and borrowers' requirements differ?

  Return/reward, risk, liquidity
• What do savers want regarding return/reward?

  High interest as a reward for investing
• What do borrowers want regarding the cost of funds?

  Low cost of funds
• What do savers want to minimize regarding risk?

  Risks of lending and investment
• What do borrowers seek in terms of risk?

  Willingness of savers to take high risks
• What do savers want regarding liquidity?

  High liquidity for quick cash access
• What do borrowers typically want regarding the duration of funds?

  Long-term access to funds
• How many methods are there for savers to lend to borrowers?

  Three methods
• What are the two methods of direct finance?

  Direct finance without intermediaries and through organized markets
• What is indirect finance?

  Involves a financial intermediary between savers and borrowers
• What major problems does direct finance face?

  Difficulty and cost of matching needs of borrowers and lenders
• What is information asymmetry?

  When parties to a transaction lack equal information
• What are the two sub-problems of information asymmetry?

  Adverse selection and moral hazard
• What is adverse selection?

  Wrong choices due to hidden information before a transaction
• What is moral hazard?

  Risky behavior after a contract is signed
• Why do banks exist according to theories of financial intermediation?

  To provide information and lower transaction costs
• What are the costs of entering into a financial transaction directly?

  Search, verification, contracting, monitoring, enforcement costs
• How do banks benefit from economies of scale?

  Cost savings due to large volumes of transactions
• What is delegated monitoring?

  When banks check on borrowers on behalf of savers
• How do banks provide liquidity to savers and borrowers?

  By creating financial instruments for easy access
• What is a deposit?

  A financial instrument giving rights to receive funds
• How do loans provide liquidity to borrowers?

  By giving access to liquid funds through contracts
• What is liquidity transformation?

  Turning liquid deposits into illiquid loans
• What is size transformation?

  Transforming small deposits into large loans
• How do banks manage risk transformation?

  By diversifying, screening, and monitoring borrowers
• What is maturity transformation?

  Transforming short-term deposits into long-term loans
• What assumption do banks rely on for transformations?

  Not all depositors will ask for money simultaneously
• What is consumption smoothing?

  Balancing saving and borrowing for stable spending
• What are the benefits of intermediation to savers?

  Greater liquidity, less risk, reduced transaction costs
• What benefits do ultimate borrowers receive from financial intermediaries?

  Longer maturity, larger size, lower transaction costs
• How do financial intermediaries benefit the economy?

  By improving fund allocation and increasing lending
• What is the role of banks in absorbing risk for higher-risk ventures?

  They diversify risk through pooling savings