Chapter 11 - The Economics of Financial Intermediation

Chapter 11
The Economics of Financial Intermediation

Chapter Overview

In theory, the market system may seem neat and simple, but in reality economic growth is
a messy, chaotic thing. Problems with the flow of information between parties in a
market system can derail economic growth unless they are addressed properly. This
chapter discusses some of those information problems and the ways that financial
intermediaries attempt to solve them.

Reading this chapter will prepare students to:

Explain how financial intermediaries reduce costs.
Define information problems that occur in financial transactions.
Assess the degree to which financial intermediaries are effective in solving
information problems.

Important Points of the Chapter

Economic well-being is inextricably tied to the health of the financial intermediaries that
make up the financial system. These institutions pool funds from people and firms who
save and lend them to people and firms that need to borrow, and when they do their job
correctly, investment and economic growth increase at the same time that investment risk
and economic volatility decrease. There is a strong link between financial development
and economic development; without a stable, well-functioning financial system, no
country can prosper.

Application of Core Principles

Principle #4: Markets. Financial intermediaries provide access to the payments system
and so facilitate the exchange of goods and services, promoting specialization.
Moreover, reducing the cost of financial transactions also promotes more trade and
specialization.

Principle #2: Risk. Banks mitigate risk by taking deposits from a large number of
individuals and make thousands of loans with them, thus giving each depositor a small
stake in each of the loans.

Principle #2: Risk. Risk requires compensation, and in the bond market this means that
the higher the risk, the greater the risk premium. If a lender cant tell whether a borrower
is a good or bad credit risk, the lender will demand a risk premium based on the average
risk. The good borrowers are likely to withdraw from the market rather than pay the high
rate, and only the bad borrowers will be left.

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Teaching Tips/Student Stumbling Blocks

To emphasize the five functions performed by financial intermediaries (i.e., they

pool the resources of small savers; they provide safekeeping and accounting
services as well as access to the payments system; they supply liquidity; they
provide ways to diversify small investments (reducing their risk); and they collect
and process information in ways that reduce information costs) have students list
the various financial intermediaries with which they do business. Which
function(s) are performed by each?

Have students consider the factors that might affect their credit scores. Students
may not realize that a credit card with no balance but which has a credit amount is
treated exactly as if that amount was owed; this is a good example of how a lender
deals with moral hazard (i.e., the borrower could go out tomorrow and charge that
amount to the credit card). On the other hand, lenders also look at how much of
the total credit a person has is available.

Features in this Chapter

Your Financial World: Your First Credit Card

The interest rate on your first credit card is likely to be very high because you have no
credit history, and the company issuing the card will assume the worst. This is adverse
selection at its worst. After a while, when you establish a track record, you should be
able to get a card at a lower rate.

Applying the Concept: The Madoff Scandal

The fraud perpetrated by Bernard Madoff stands out as extraordinary, though it was an
ordinary Ponzi scheme. Why do such schemes work? They work for a number of
reasons, including investors failing to screen and monitor the managers of their
investments, and public respectability of those managers. Further, sometimes the
government agencies responsible for overseeing the managers fail to detect the scheme.

Your Financial World: Private Mortgage Insurance

If you try to buy a house with a down payment of less than 20 percent of the purchase
price, the lender may require you to buy private mortgage insurance (PMI), which insures
the lender in the event that the borrower defaults on the mortgage. You can cancel the
insurance when the amount you owe on your mortgage falls to less than 80 percent of the
value of your home; this can happen as a result of your making payments to reduce the
principal on the loan or as a result of increases in home values.

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Applying the Concept: Deflation, Net Worth, and Information Costs

Deflation is bad because it aggravates information problems in ways that inflation does
not. It means that a firms net worth goes down as a result of drops in asset values,
making it less trustworthy as a borrower. This is what occurs at the start of a recession:
the value of the firm falls, lenders become more reluctant to lend, and the availability of
investment funds falls, pushing the economy further into the recession.

Lessons from the Crisis: Information Asymmetry and Securitization

A key source of the financial crisis of 2007-2009 was insufficient screening and
monitoring in the securitization of mortgages. These problems began with the loan
originators who eased standards and reduced screening to increase the volume of lending
and their own profitability. The distributorsthe next stage of lending that assembled
these loans into securitiesdid little to forestall the decreased standards although they
could have had higher requirements. The securitization then resulted in frequent trading
to get rid of the security before it defaulted. Rating agencies continued the problem by
awarding high ratings to MBSs and investors relied on others opinions of the securities.
Had housing prices continued to increase, this collateral system would have worked.

In the News: In a Tight Market, Borrowers Turn to Peers

Websites that facilitate peer-to-peer lending are growing in popularity as credit becomes
more difficult to get because of higher standards and interest rates. The industry has
become so popular that the SEC ruled that companies must register with them. These
clubs often have credit score and other requirements for borrowers that lenders can use to
determine if they will lend.

Lessons of the Article: Will this really work? Will peer-to-peer lenders find
ways to overcome the adverse selection and moral hazard problems inherent in
individual lending arrangements and replace financial intermediaries? The
answer hinges on a number of things. Do credit scores allow lenders to predict
default rates accurately enough? Will lenders be able to diversity sufficiently?
And finally, is this really more efficient and cheaper than a bank? To take over
from financial intermediaries, the answer to all these questions will have to be a
yes.

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Additional Teaching Tools

In an article from the Wall Street Journal, Jane Kim discusses the appealing switch from
banks to credit unions. Benefits include higher interest rates on deposits, lower fees, and
lower rates on borrowing.

Virtual Tools

Give students an overview of the different aspects of financial intermediaries by visiting

the Citigroup website. Students can click on logos to find out more about the different
components of that corporation. Among other interesting facts: Banamex, Mexicos
largest commercial bank, is part of Citigroup.
http://www.citigroup.com/citigroup/business/index.htm

Students can find out more about their states lemon laws by visiting the site of the
National Lemon Law Center. Use this as a jumping off point for a discussion of the role
of government in addressing information problems.
http://www.nationallemonlawcenter.com/

For more information on credit scores, students can visit this site from Wikipedia:
http://en.wikipedia.org/wiki/Credit_score

Credit reports can be obtained on this site set up by the big three credit-reporting agencies
to provide such reports for free:
https://www.annualcreditreport.com/cra/index.jsp

More and more states (25 at the time of writing) are allowing people to freeze their credit
reports. For a discussion of the pros and cons see this page from Bankrate.com:
http://www.bankrate.com/brm/news/cc/20030613c1.asp

For More Discussion

Have students consider a transaction like selling a car or a house; you may wish to do this
as a role-playing exercise. Students are likely to quickly discover that they need
information about whether a potential buyer actually has the resources to complete the
transaction.

Heres another topic for discussion: have students consider whether they would buy a
used car from a person or from a dealership. What are the pros and cons of each and how
does that relate to the chapter material?

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Chapter Outline

I. The Role of Financial Intermediaries

1. As a general rule, indirect finance through financial intermediaries is much
more important than direct finance through the stock and bond markets.
2. In virtually every country for which we have comprehensive data, credit
extended by financial intermediaries is larger as a percentage of GDP than
stocks and bonds combined.
3. Around the world, firms and individuals draw their financing primarily from
banks and other financial intermediaries.
4. The reason for this is information; financial intermediaries exist so that
individual lenders dont have to worry about getting answers to all of the
important questions concerning a loan and a borrower.
5. Lending and borrowing involve transactions costs and information costs, and
financial intermediaries exist to reduce these costs.
6. Financial intermediaries perform five functions: they pool the resources of
small savers; they provide safekeeping and accounting services as well as
access to the payments system; they supply liquidity; they provide ways to
diversify small investments; and they collect and process information in ways
that reduce information costs.
7. The first four of these functions have to do with the reduction of transactions
costs.
8. International banks handle transactions that cross borders, which may mean
converting currencies.
A. Pooling Savings
1. The most straightforward economic function of a financial intermediary is to
pool the resources of many small savers.
2. To succeed in this endeavor the intermediary must attract substantial numbers
of savers.
3. This is the essence of indirect finance, and it means convincing potential
depositors of the soundness of the institution.
4. Banks rely on their reputations and government guarantees like deposit
insurance to make sure customers feel that their funds will be safe.
B. Safekeeping, Payments System Access, and Accounting
1. Goldsmiths were the original bankers; people asked the goldsmiths to store
gold in their vaults in return for a receipt to prove it was there.
2. People soon realized that trading the receipts was easier than trading the gold
itself.

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3. Eventually the goldsmiths noticed that there was gold left in the vaults at the
end of the day, so it could safely be lent to others.
4. Today, banks are the places where we put things for safekeeping; we deposit
our paychecks and entrust our savings to a bank or other financial institution
because we believe it will keep our resources safe until we need them.
5. Banks also provide other services, like ATMs, checkbooks, and monthly
statements, giving people access to the payments system.
6. Financial intermediaries also reduce the cost of transactions and so promote
specialization and trade, helping the economy to function more efficiently.
7. The bookkeeping and accounting services that financial intermediaries
provide help us to manage our finances.
8. Providing safekeeping and accounting services as well as access to the
payments system forces financial intermediaries to write legal contracts,
which are standardized.
9. Much of what financial intermediaries do takes advantage of economies of
scale, which means that the average cost of producing a good or service falls
as the quantity produced increases.
10. Information is also subject to economies of scale.
C. Providing Liquidity
1. One function that is related to access to the payments system is the provision
of liquidity.
2. Liquidity is a measure of the ease and cost with which an asset can be turned
into a means of payment.
3. Financial intermediaries offer us the ability to transform assets into money at
relatively low cost (ATMs are an example).
4. Financial intermediaries provide liquidity in a way that is both efficient and
beneficial to all of us.
5. By collecting funds from a large number of small investors, a bank can reduce
the cost of their combined investment, offering the individual investor both
liquidity and high rates of return.
6. Financial intermediaries offer depositors something they cant get from the
financial markets on their own.
7. Financial intermediaries offer both individuals and businesses lines of credit,
which are pre-approved loans that can be drawn on whenever a customer
needs funds.

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D. Risk Sharing
1. Financial intermediaries enable us to diversify our investments and reduce
risk.
2. Banks mitigate risk by taking deposits from a large number of individuals and
make thousands of loans with them, thus giving each depositor a small stake
in each of the loans.
3. Providing a low-cost way for individuals to diversify their investments is a
function all financial intermediaries perform.
E. Information Services
1. One of the biggest problems individual savers face is figuring out which
potential borrowers are trustworthy and which are not.
2. There is an information asymmetry because the borrower knows whether or
not he or she is trustworthy, but the lender faces substantial costs to obtain the
same information.
3. Financial intermediaries reduce the problems created by information
asymmetries by collecting and processing standardized information.
II. Information Asymmetries and Information Costs
1. Information plays a central role in the structure of financial markets and
financial institutions.
2. Markets require sophisticated information in order to work well, and when the
cost of obtaining information is too high, markets cease to function.
3. Asymmetric information is a serious hindrance to the operation of financial
markets, and solving this problem is one key to making our financial system
work as well as it does.
4. Asymmetric information poses two obstacles to the smooth flow of funds
from savers to investors: adverse selection, which involves being able to
distinguish good credit risks from bad before the transaction; and moral
hazard, which arises after the transaction and involves finding out whether
borrowers will use the proceeds of a loan as they claim they will.
A. Adverse Selection
1. Used Cars and the Market for Lemons: In a market in which there are good
cars (peaches) and bad cars (lemons) for sale, buyers are willing to pay
only the average value of all the cars in the market. This is less than the
sellers of the peaches want, so those cars disappear from the markets and
only the lemons are left.

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a. To solve this problem caused by asymmetric information, companies like

Consumer Reports provide information about the reliability and safety of
different models, and car dealers will certify the used cars they sell.
2. Adverse Selection in Financial Markets: Information asymmetries can drive
good stocks and bonds out of the financial market.
B. Solving the Adverse Selection Problem
1. Disclosure of Information: Generating more information is one obvious way
to solve the problem created by asymmetric information.
a. This can be done through government required disclosure and the private
collection and production of information.
b. However, the accounting scandals of 2001 and 2002 showed that in spite
of such requirements companies can distort the profits and debt levels
published in their financial statements.
c. Reports from private sources such as Moodys and Value Line are often
expensive.
2. Collateral and Net Worth: Lenders can be compensated even if borrowers
default, and if the loan is so insured then the borrower is not a bad credit risk.
a. The importance of net worth in reducing adverse selection is the reason
owners of new businesses have so much difficulty borrowing money.
C. Moral Hazard: Problem and Solutions
1. An insurance policy changes the behavior of the person who is insured.
2. Moral hazard plagues both equity and bond financing.
3. Moral Hazard in Equity Financing: people who invest in a company by
buying its stock do not know that the funds will be invested in their best
interests.
a. The principal-agent problem, which occurs when owners and managers
are separate people with different interests, may result in the funds not
being used in the best interests of the owners.
4. Solving the Moral Hazard Problem in Equity Financing: The problem can be
solved by if owners can fire managers and by requiring managers to own a
significant stake in their own firm.
5. Moral Hazard in Debt Finance: Debt goes a long way toward eliminating the
moral hazard problem, but it doesnt finish the job; debt contracts allow
owners to keep all the profits in excess of the loan payments and so encourage
risk taking.

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6. Solving the Moral Hazard Problem in Debt Finance: To some degree, a good
legal contract with restrictive covenants can solve the moral hazard problem
in debt finance.
III. Financial Intermediaries and Information Costs
A. Screening and Certifying to Reduce Adverse Selection
1. Borrowers must fill out a loan application that includes information that can
be provided to a company that collects and analyzes credit information and
which provides a summary in the form of a credit score.
2. Your personal credit score tells a lender how likely you are to repay a loan; the
higher your score the more likely you are to get a loan.
3. Banks collect additional information about borrowers because they can
observe the pattern of deposits and withdrawals, as well as the use of credit
and debit cards.
4. Financial intermediaries superior ability to screen and certify borrowers
extends beyond loan making to the issuance of bonds and equity.
5. Underwriting represents screening and certifying because investors feel that if
a well-known investment bank is willing to sell a bond or stock then it must
be a high-quality investment.
B. Monitoring to Reduce Moral Hazard
1. Intermediaries monitor both the firms that issue bonds and those that issue
stocks.
2. Banks will monitor borrowers to make sure that the funds are being used as
intended.
3. Financial intermediaries that hold shares in individual firms monitor their
activities, in some cases placing a representative on a companys board of
directors.
4. In the case of new firms, a financial intermediary called a venture capital firm
does the monitoring.
5. The threat of a takeover helps to persuade managers to act in the interest of
the stock and bondholders.
6. In the end, the vast majority of firm finance comes from internal sources,
suggesting that information problems are problems too big for even financial
intermediaries to solve.

Terms Introduced in Chapter 11

adverse selection

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asymmetric information
collateral
deflation
free rider
moral hazard
net worth
unsecured loan

Lessons of Chapter 11
1. Financial intermediaries specialize in reducing costs by
a. Pooling the resources of small savers and lending them to large borrowers.
b. Providing safekeeping, accounting services, and access to the payments system.
c. Providing liquidity services.
d. Providing the ability to diversify small investments.
e. Providing information services.

2. For potential lenders, investigating a borrowers trustworthiness is costly. This

problem, known as asymmetric information, occurs both before and after a
transaction.
a. Before a transaction, the least creditworthy borrowers are the ones most likely to
apply for funds. This problem is known as adverse selection.
b. Lenders and investors can reduce adverse selection by
i. Collecting and disclosing information on borrowers.
ii. Requiring borrowers to post collateral and show sufficient net worth.
c. After a transaction, a borrower may not use the borrowed funds as productively as
possible. This problem is known as moral hazard.
i. In equity markets, moral hazard exists when the managers interests
diverge from the owners interests.
ii. Finding solutions to the moral hazard problem in equity financing is
difficult.
iii. In debt markets, moral hazard exists because borrowers have limited
liability. They get the benefits when a risky bet pays off, but they dont
suffer a loss when it doesnt.
iv. The fact that debt financing gives managers/borrowers an incentive to take
too many risks gives rise to restrictive covenants, which require borrowers
to use funds in specific ways.

3. Financial intermediaries can solve the problems of adverse selection and moral
hazard.
a. They can reduce adverse selection by collecting information on borrowers and
screening them to check their creditworthiness.
b. They can reduce moral hazard by monitoring what borrowers are doing with
borrowed funds.

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c. In the end, the vast majority of firms finance comes from internal sources,
suggesting that information problems are too big for even financial intermediaries
to solve.

Conceptual Problems

1. Describe the problem of asymmetric information that an employer faces in hiring a

new employee. What solutions can you think of? Does the problem persist after the
person has been hired? If so, how and what can be done about it? Is the problem
more or less severe for employees on a fixed salary? Why or why not?

Answer: Prior to hiring a new employee, an employer may have difficulty identifying
candidates who would do the best job that is, there are difficulties in screening
candidates in the face of asymmetric information. Probationary periods when the
new employee can be terminated are a simple solution to this problem.
After someone has been hired, the employer may not know whether that person is
working hard due to problems with monitoring. Salaries based on performance can
mitigate the problem by providing the employee with the incentive to work hard
without constant monitoring.
A fixed salary makes it difficult to create the proper incentives for employees to do
their best and so the problem is likely to be more severe.

2. In some cities, newspapers publish a weekly list of restaurants that have been cited
for health code violations by local health inspectors. What information problem is
this feature designed to solve, and how?

Answer: This solves both adverse selection and moral hazard. People who dine out at
restaurants may have a difficult time identifying restaurants that dont meet certain
health standards. Because of this, some people may not want to eat out at all. Also,
restaurants dont have an incentive to follow health regulations since diners cant
distinguish restaurants that meet the health standards from those that dont. However,
publishing the names of restaurants cited for health code violations allows people to
identify unsanitary restaurants and thus holds restaurants accountable for following
health regulations.

3. What problem associated with asymmetric information was central to Bernard

Madoffs success in cheating so many investors for so long?

Answer: The Madoff fraud is an example of a moral hazard problem that arises from
the absence of perfect monitoring. Investors with Bernard Madoff did not adequately
monitor his behavior to insure that he was using their funds as they expected, perhaps
assuming that earlier investors had carried out this monitoring and so they did not
need to incur the cost, or that the oversight of the SEC was sufficient to safeguard
their funds.

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4. Financial intermediation is not confined to bank lending but is also carried out by
non-bank firms such as mutual fund companies. How do mutual funds help
overcome information problems in financial markets?

Answer: Mutual funds, like other financial intermediaries, are specialists at screening
and monitoring. They assess companies when deciding what stocks and bonds to
include in their funds and monitor these companies on behalf of individual investors.

5. In some countries it is very difficult for shareholders to fire managers when they do a
poor job. What type of financing would you expect to find in those countries?

Answer: When shareholders cant fire managers, people will be less willing to
purchase equity because there is no way to discipline managers who fail to act in the
interests of the shareholders. Companies in those countries are more likely to issue
bonds or seek bank loans to obtain funding.

6. Define the term economies of scale and explain how a financial intermediary can take
advantage of such economies.

Answer: Economies of scale occur when average costs fall as production increases.
By using standardized forms for gathering information about potential borrowers and
for issuing loans, financial intermediaries can take advantage of economies of scale.

7. The Internet can have a significant influence on asymmetric information problems.

a. How can the Internet help to solve information problems?
b. Can the Internet compound some information problems?
c. On which problem would the Internet have a greater impact, adverse selection or
moral hazard?

Answer:
a. The Internet provides people with a wealth of information, whether they are
evaluating a company before deciding whether to purchase its stock or doing a
Google search on someone before going out on a date.
b. Not all of the information available is accurate, which can make the problem of
adverse selection worse.
c. The Internet provides information to reduce adverse selection, but isnt very
helpful in reducing moral hazard, although in some circumstances it might
provide a less costly means of monitoring.

8. The financial sector is heavily regulated. Explain how government regulations help
to solve information problems, increasing the effectiveness of financial markets and
institutions.

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Answer: The government requires firms to disclose information. For example, public
financial statements prepared according to standard accounting practices are required
by the Securities and Exchange Commission. Investors can feel more secure in
assessing the financial health of a firm given this government-mandated and
standardized information, thus reducing problems associated with adverse selection.
Since they know they are required to disclosure certain information, firms may be less
willing to engage in excessively risky behavior, reducing problems associated with
moral hazard.

9. One of the solutions to the adverse selection problem associated with asymmetric
information is the pledging of collateral. Why did this solution not work adequately
to mitigate the mortgage securitization problems associated with the financial crisis of
2007-2009?

Answer: The ultimate collateral behind the mortgage-backed securities were the
houses purchased with the mortgages underlying these securities. When house prices
fell, the value of the collateral was not sufficient to cover the investments.

10. *Deflation causes the value of a borrowers collateral to drop. Define deflation and
explain how it reduces the value of a borrower's collateral. What is the effect on the
information problems a borrower faces?

Answer: Deflation is a fall in the overall price level. A borrowers liabilities will
remain the same, but the value of the borrowers assets will decline, decreasing the
net worth of the borrower. Lenders use the net worth of borrowers to overcome
information asymmetries; with a low net worth, it will be more difficult to borrow.

11. In 2002 the trustworthiness of corporate financial reporting was called into question
when a number of companies corrected their financial statements for past years.
What impact did their action have on the financial markets?

Answer: Investors became less sure of their ability to distinguish good firms from bad
ones, so their willingness to purchase stocks and bonds decreased.

Analytical Problems

12. *Your parents give you $2,000 as a graduation gift and you decide to invest the
money in the stock market. If you are risk averse, should you purchase some stock in
a few different companies through a web site with low transaction fees or put the
entire $2,000 into a mutual fund? Explain your answer.

Answer: As a small investor, a mutual fund is the best way to reduce risk by
diversifying your investment. By purchasing shares in a mutual fund, you can

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acquire fractions of shares in the large number of companies included in the fund. If
you opt to buy individual shares, you will be limited to a handful of companies.
Mutual funds offer investors a low-cost way to diversify a small sum across a wide
range of companies.

13. Suppose a new Web site was launched providing up-to-date, credible information on
all firms wishing to issue bonds. What would you expect to see happen to the overall
level of interest rates in the bond market?

Answer: You would expect interest rates overall to fall. The web site would reduce
the adverse selection problem by making it easier for investors to distinguish between
firms of different levels of creditworthiness. Demand for bonds should rise, reducing
interest rates.

14. Suppose two types of firms wish to borrow in the bond market. Firms of type A are
in good financial health and are relatively low risk. The appropriate premium over
the risk-free rate for lending to these firms is 2%. Firms of type B are in poor
financial health and are relatively high risk. The appropriate premium over the risk-
free rate for lending to these firms is 6%. As an investor, you have no other
information about these firms except that type A and type B firms exist in equal
numbers.
a. At what interest rate would you be willing to lend if the risk-free rate were 5%?
b. Would this market function well? What type of asymmetric information problem
does this example illustrate?

Answer:
.a The appropriate interest rate for type A firms bonds is 7% while that for type B
firms bonds in 11%. As investors dont know which type of firm they are dealing
with and there is an equal probability of either type of firm, they will be only be
willing to lend if they receive at least the average rate of 9%.
.b No. The type A firms would not be willing to pay this interest rate and so would
withdraw from the market, leaving only type B firms. This is an example of an
adverse selection problem. Only the less desirable firms are willing to borrow.

15. Consider again the low-risk type A firm described in question 14. If you were the
financial advisor to such a firm, what suggestions would you make to the firms
management about obtaining borrowed funds?

Answer: One suggestion would be to provide as much information as possible about

the firm to potential investors in order to identify itself as a type A firm. Ideally, the
information should come through someone other than the firm for credibility, so this
suggestion might be difficult to implement.
Another suggestion would be to utilize the services of a financial intermediary. If the
firm has been banking with the same institution for a while, that institution will have
evidence of the firms quality from its existing accounts and would likely be willing
to lend to the firm at a more favorable rate.

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16. Consider a small company run by a manager who is also the owner. If this company
borrows funds, why might a moral hazard problem still exist?

Answer: Even when the owner and the manager of the firm are the same person,
when he or she borrows money there is an incentive to take on excessive risk. The
downside is limited to the collateral posted while the upside is unlimited. The
owner/manager receives all the profits above the loan repayment.

17. *The island of Utopia has a very unusual economy. Everyone on Utopia knows
everyone else and knows all about the firms they own and operate. The financial
system is well developed on Utopia. Everything else being equal, how would you
expect the mix on Utopia between internal finance (where companies use their own
funds such as retained earnings) and external funding (where companies obtain funds
through financial markets) to compare with other countries? What role would
financial intermediaries play in this economy?

Answer: As Utopia doesnt suffer from asymmetric information problems to the same
degree as other countries, you would expect external finance to be more important.
Although overcoming information problems is a key function of financial
intermediaries, they also reduce transaction costs and therefore would still have a role
in this economy. For example, financial intermediaries could pool savings from small
depositors to make a large loan more cheaply than a group of islanders trying to
identify those with surplus funds and those needing to borrow in the absence of an
intermediary.

18. You and a friend visit the headquarters of a company and are awestruck by the
expensive artwork and designer furniture that graces every office. Your friend is very
impressed and encourages you to consider buying stock in the company, arguing that
it must be really successful to afford such elegant surroundings. Would you agree
with your friends assessment? What further information (other than the usual
financial data) would you obtain before making an investment decision?

Answer: The luxurious surroundings could be a result of the principal-agent problem,

where managers who do not own the company they run have different objectives than
the shareholders. You should find out if there is a separation between ownership and
management and if so, if there is any evidence of a pattern of lavish and unnecessary
spending by the management. If there is evidence of a clear disconnect between the
objectives of the management and the best interests of the shareholders, buying stock
in this company is probably not your best option.

19. Under what circumstances, if any, would you be willing to participate as a lender in a
peer-to-peer lending arrangement?

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Answer: Your willingness will likely be influenced by how well you believe the
problems associated with asymmetric information can be dealt with. For example,
the ability to review credit scores and other financial information of potential
borrowers and the accuracy of that information for predicting default should reduce
your concerns about adverse selection. The ability to spread your lending across a
group of borrowers rather than lend to just one would also reduce the risk associated
with choosing one poor-quality borrower. Moral hazard concerns might be alleviated
by a commitment from the peer-to-peer lending site you use to report missed
payments by borrowers to credit bureaus. You might also consider the time you have
available to monitor the loan yourself for signs of trouble.

* indicates more difficult problems

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