1.2. Demand for the financial intermediation

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Do curso por Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 rating

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 rating

Curso 1 de 5 em Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

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Perfect Capital Markets. Problems Caused by Private Information

In Week 1 we propose the set of assumptions and the framework of our discussion. We will discuss perfect capital markets and see how the deviations from this idealized model that are observed in our real life result in the demand for financial intermediation and for the services of financial institutions. We will discuss the fundamental problems caused by the existence of private information (moral hazard и adverse selection) and the damage they lead to. Based on the most simplistic models you will be able do delve deeper into the core of these problems and to evaluate their potential scale. You will learn what role the moral hazard plays in insurance, and how the adverse selection and moral hazard problems reduce the efficiency of lending.

1.1. Introduction – perfect capital markets5:27

1.2. Demand for the financial intermediation6:08

1.3. Model of private information – key assumptions6:15

1.4. Model of moral hazard14:11

1.5. Co-insurance as a market solution to the moral hazard problem4:17

1.6. Moral hazard in insurance (1) – a more advanced model12:37

1.7. Moral hazard in insurance (2) – incomplete insurance8:45

1.8. Model of adverse selection11:43

1.9. Adverse selection in credit markets (1) – expected cash flows to the bank12:54

1.10. Adverse selection in credit markets (2) – credit rationing8:20

1.11. Moral hazard from increasing interest rates9:45

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Well, in the first introductory episode,

we claimed that if the market would be perfect,

then there would be no problem and this course would be sort of irrelevant.

However, the reality is different.

And in this small episode, l will draw a simple,

maybe even a funny picture that will really show us,

Do these problems come from and how they can be treated and coped with.

Well, let's start with the following.

The picture is such, well, capital market can be represented as, first

of all huge crowd of ultimate savers that are sometimes nicely labelled investors.

So these are the people.

We have some cash saved, you, me and the majority of people in this world.

Now, we are all fine.

But we cannot produce more money from these small bags.

There is another part.

These are businesses.

So these are old way businesses.

These are sort of modern businesses.

That have a magic feature if they have some money swallowed.

Then they do something inside of them.

They produce more money, more cash from that.

So obviously, these black houses or

black computers they have the money of their own.

But if they can take other people's money, so the money from these small or

sometimes large through bags, then they can produce even more.

So you can see that there is a huge demand and natural demand for

other people's money.

And we can start with thinking about some contracts between these people so

that, let's say I lend money to the business and

we draw a contract on which the business says well I'll pay you back that much and

of course with a certain schedule and so on and so forth.

Now, in the perfect capital market world, that scheme is nice and

working and no problem occurs.

However, the existence of private information and

unobservability mainly, these guys do not observe

what these guys do with their money, what projects they choose.

And we are not here talking about fraud or theft, or any other criminal activity.

We talk about normal business situations in which

people make their choice based on their own benefit.

It can be shown, and we will do it in quite some detail,

that in this world in the existence of private information,

We can see the emergence of a diverse incentives that often times

force these people to behave in a way that is exposed harmful to these people.

And these problems are plentiful.

Corporate finance week six, episode one is called moral hazard and

the other is called adverse selection and

we'll study them in some greater detail this weekend later.

But for now, the important thing is that, what can be done in general?

Well, the result is that the demand for

the services of financial intermediaries is born.

So now we can see another player.

This is a red skyscraper that serves an intermediary and works like this.

And although sometimes in general you can say that intermediaries cost money and it

is not quite clear that the existence of these guys, is better than their absence.

But we will show quite clearly that they actually do alleviate the most egregious

problems caused by private information and they play a fundamentally positive role.

Now, this set up that is put here in such a funny way has been recognized ever since

capital markets were born,

or people recognized their existence and that counts hundreds of years.

You can think about the first banks in Florence or Geneva or

Venice maybe as early as 700 years plus ago.

But in the existence of some problems

of that would occur without them has also been recognized for quite a long time,

but it was not until the 1970s that the study

of this market took a certain, let's say systemic way.

It can be traced back to

the original works of George Akerlof, and then later Joseph Stiglitz.

Both of them later won Nobel Prizes in economics,

and many other authors who actually produced first general and

then more advanced models of private information that allowed them to arrive at

certain very important conclusions that were used

as a basis for a system of measures to alleviate these problems.

Now, starting from the next episode, we will build

a general model of private information that will allow us to study

all these problems in some greater detail and using some very simple arithmetic.

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