Small investors prefer to put their savings in banks or mutual funds to avoid the problem of asymmetric informationOne party has more information than the other partyTypically, in financial transactions, the borrower has more info than the lenderCrowd funding: raising small amounts of money from large numbers of peopleTransactions costs: costs of a trade or financial transactionInformation costs: costs savers incur to determine the creditworthiness of borrowers and monitor how they use the acquired fundsEconomies of scale: the reduction in average cost that results from an increase in volume of a good or service produced.Mutual funds have a portfolio of investments instead of having individual costs on each different investmentFinancial intermediaries take advantage of economies of scale to reduce transaction costsSmall to medium sized investors turn to financial intermediaries to avoid more costs2 problems arise from asymmetric info:adverse selection: problem in distinguishing high risk form low risk borrowersmoral hazard: problem in verifying that borrowers are using funds as intendedas interest rates rise, the creditworthiness of potential borrowers deteriorates making adverse selection problem worseinvestors likely reduce the number of loans they are willing to give out rather than raise interest rates to meet supply and demandCredit Rationing: the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate.Happens in the bond marketReduce adverse selection by:Making information available to the publicCredit rationingCollateralRelationship banking: ability of banks to assess credit risks on the basis of private information about borrowersPrinciple agent problem: moral hazard problem of managers(agents) pursuing their own interests rather than those of shareholders(principals)-- incentive contracts are also used to decrease moral hazard in the stock marketReduce moral hazard in the bond market:Restrictive Covenant: a clause in a bond contract that places limits on the uses of funds that borrowers receive.Venture Capital firms: a firm that raises equity capital from investors to invest in startup firms.Private Equity Firm: firm that raises equity capital to acquire shares in other firms to reduce free-rider and moral hazard problemsTarget young firms failing to maximize profitsTake positions on board of directors and can monitor what they doBalance Sheet: statement that shows an individual or firm’s financial position on a particular dayAssets(uses of funds) is on the left side (loans)Liabilities(sources of funds) + bank capital on the right side (deposits)Bank capital: difference between value of bank’s assets and the value of its liabilitiesBorrowing by banks includes:Short term loans in the federal funds marketLoans from a bank’s foreign branchesRepurchase agreements: banks sell securities, such as Treasury Bills, and agree to repurchase themDiscount loans from the FedBank Assets:Reserves: most liquid, includes vault cash and deposits they have with the FedClaims on other banks: (cash items in the process of collection)Securities: marketable securities, liquid assets banks trade in financial markets.Loans: largest category of bank assets; illiquid relative to marketable securities which means higher interest ratesOther assets include physical assets(equipment, buildings, seized property)T account: accounting tool used to show changes in balance sheet itemsNet interest Margin: difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by total value of its earning assetsReturn on assets (ROA): ration of the value of after tax profits to the value of its assetsROA= After-tax ProfitBank AssetsReturn on Equity (ROE): ration of the value of after tax profit to value of its capital.ROE= After Tax ProfitBank CapitalROA and ROE are related in thatROE= (ROA) x Bank assetsBank capitalLeverage: how much debt an investor assumes in making an investmentBank Leverage: ratio of value of assets to value of capital.The inverse is called bank leverage ratioHigh leverage increases the degree of risk financial firms are exposed to by magnifying swings in profits as measure by ROELiquidity Risk: the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.Minimize this by holding fewer loans/securities and more reservesAsset management and liquidity managementCredit Risk: risk that borrowers might default on their loansReduce by:Diversification: lend to different types of borrowersCredit risk analysis: process used by banks to screen loan applicantsCollateral: assets pledged to the bank if borrower defaultsCredit Rationing: restriction of credit by lenders, result that borrowers cannot obtain all the funds they desire at the given interest rate.Monitoring and Restrictive CovenantsLong term business relationshipsInterest Rate Risk: the effect of a change in market interest rates on a bank’s profit or capitalHigher interest rate= lower PV of a bank’s assets and liabilitiesLower interest rate= higher PV of a banks assets and liabilitiesGap Analysis: the difference, gap, between $ value of bank’s variable-rate assets and the $ value of its variable-rate liabilitiesUsed to measure interest rate riskPg. 297Duration analysis: an analysis of how sensitive a bank’s capital is to changes in market interest ratesDifference b/w avg duration of assets and avg duration of liabilitiesOff-balance sheet activities: activities that don’t affect bank’s balance sheet because they don’t change its assets or liabilitiesStandby Letter of credit: promise by bank to lend funds if necessary to a seller of commercial paper at the time that the commercial paper maturesLoan Commitment: agreement by bank to provide a borrower with a stated amount of funds during a specified period of timeLoan Sale: financial contract in which a bank agrees to sell the expected future return from an underlying bank loan to a third partyInvestment Bank: financial activities that involve underwriting new security issues and providing advice on mergers and acquisitionsProviding advice on new securitiesUnderwriting new security issuesUnderwriting: investment bank guarantees to the issuing corp. the price of a new security and then resells the security for profitSyndicate: group of investment banks that jointly underwrite a security