FINANCIAL MARKETS & INSTITUTIONS LECTURE 2: THE IMPORTANCE OF FINANCIAL INSTITUTIONS

TUTORIAL 2

1. How can economies of scale help explain the existence of financial intermediaries?
Financial intermediaries can take advantage of economies of scale and thus lower transaction costs. For
example, mutual funds take advantage of lower commissions because the scale of their purchases is
higher than for an individual, while banks large scale allows them to keep legal and computing costs
per transaction low. Economies of scale which help financial intermediaries lower transaction costs
explains why financial intermediaries exist and are so important to the economy.

2. Describe two ways in which financial intermediaries help lower transaction costs in the economy.
Financial intermediaries develop expertise in such areas as computer technology so that they can
inexpensively provide liquidity services such as checking accounts that lower transaction costs for
depositors. Financial intermediaries can also take advantage of economies of scale and engage in large
transactions that have a lower cost per dollar of investment.

3. Would moral hazard and adverse selection still arise in financial markets if information were not
asymmetric? Explain.
No. If the lender knows as much about the borrower as the borrower does, then the lender is able to
screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly, if
the lender knows what the borrower is up to, then moral hazard will not be a problem because the lender
can easily stop the borrower from engaging in moral hazard.

4. Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their
activities? Why?
Smaller firms that are not well known are the most likely to use bank financing. Since it is harder for
investors to acquire information about these firms, it will be hard for the firms to sell securities in the
financial markets. Banks that specialize in collecting information about smaller firms will then be the
only outlet these firms have for financing their activities.

5. Would you be more willing to lend to a friend if she put all of her life savings into her business than you
would if she had not done so? Why?
Yes. The person who is putting her life savings into her business has more to lose if the business takes on
too much risk or engages in personally beneficial activities that dont lead to higher profits. So she will
act more in the interest of the lender, making it more likely that the loan will be paid off.

6. Why can the provision of several types of financial services by one firm lead to a lower cost of information
production?
Because one information resource can be used in providing several services, thus lowering the cost for
each.

1
FINANCIAL MARKETS & INSTITUTIONS LECTURE 2: THE IMPORTANCE OF FINANCIAL INSTITUTIONS
TUTORIAL 2

7. How does the provision of several types of financial services by one firm lead to conflicts of interest?
Conflicts of interest arise because higher profits might arise in providing one kind of service if the
service provider misuses, provides false information, or conceals information when providing another
kind of service.

8. How can conflicts of interest make financial service firms less efficient?
Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric
information problems become worse, which prevents financial markets from channeling funds into
productive investment opportunities. The result is that financial markets become less efficient.

9. Describe two conflicts of interest that occur when underwriting and research are provided by a single
investment firm.
a. Research analysts in investment banks might distort their research to please issuers of securities so
underwriters in the investment bank can get their business.
b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but
underpriced, IPOs to executives in return for their companies future business.

10. Describe two conflicts of interest that occur in accounting firms.

a. Clients may be able to pressure auditors into skewing their opinions in order to get fees for other
accounting services.
b. Auditors may be auditing information systems or structuring (tax and financial) advice put in place
by their non-audit counterparts within the firm, and thus may be reluctant to criticize this advice or
systems.
c. Auditors may provide overly favorable opinions in order to solicit or retain business.

Source: Question 1, 2, 3, 6, 8, 13, 14, 15, 16, 18 Financial Markets & Institutions, Mishkins, Eakins, 7th Edition