Roles of Financial Intermediaries Pool savings  Extend credit Keep depositors savings safe –Accounting statements that track assets Provide liquidity Provide risk sharing –Even small deposits can be diversified Provide information –Collect and process large amounts of standardized financial information

Information Asymmetries and Information Costs Asymmetric information –issuers of financial instruments (iou s, bonds, stock) know more about their business prospects and their willingness to work than potential lenders or investors Adverse Selection – before a deal is struck –potential borrowers know more about the projects they wish to finance than prospective lenders If it’s such a good deal, why are you offering it to me? Moral Hazard – after the deal is struck –Borrowers may not do what they said they would They may take too many risks with your money

Adverse selection and market breakdown If you can’t tell the difference between the two firms’ prospects, you will be willing to pay a price based only on the firms’ average quality. –the stock of the good company is undervalued. Managers of the good company know their stock is worth more than the average price –they won’t issue the stock in the first place. That leaves only the firm with bad prospects in the market. –But why buy their stock? … it’s a lemon! Solving the Adverse Selection Problem Disclosure / Collateral / Net Worth

Addressing Moral Hazard –Borrowers may not do what they said they would They may take too many risks with your money Solutions Monitor management actions Require managers to invest substantial resources Restrict what borrowers can do with borrowed funds –Restrictive covenants on bonds and loans

Financial Intermediaries and Information Costs Adverse selection and moral hazard make direct finance expensive and hard to get. Financial intermediaries collect information to reduce these costs and minimize the effects of adverse selection and moral hazard –Screening and certifying before a deal –Monitoring after the deal