ECON30005 · Money and Banking
Banking and Financial Intermediation
Week 4 explains why financial intermediaries exist. Transaction costs and, above all, asymmetric information create two problems — adverse selection before a loan (the lemons problem) and moral hazard after it — and banks reduce these frictions through screening, monitoring, collateral, covenants and relationship lending. The week also covers the history and core economic functions of banking. Expect true/false distinguishing the two information problems and short essays on why intermediation is necessary and why it exposes banks to risk.
What this chapter covers
- 01The flow of funds: direct finance (securities) vs indirect finance (via an intermediary); indirect finance dominates
- 02The eight basic facts about finance (banks are the main external funding source; collateral and covenants are pervasive)
- 03Three fundamental frictions: transaction costs, risk in lending, asymmetric information
- 04Adverse selection (before lending): the lemons problem — the riskiest borrowers are keenest to borrow
- 05Moral hazard (after lending): borrowers take hidden actions that raise default risk
- 06How banks address the frictions: economies of scale, screening, incentive-compatible contracts, monitoring, diversification, relationship banking
- 07Core economic functions of banking: payments, liquidity provision, intermediation, money and credit creation
- 08Why intermediation inherently exposes banks to risk (transforming safe liquid liabilities into risky illiquid assets)
Classifying information problems and the bank's tool
- +1(a) Adverse selection — a before-lending (hidden-type) problem: the pool of applicants is skewed toward the worst risks because they value the loan most. Bank tools: screening applicants, requiring collateral, and using covenants to attract and identify safer borrowers.
- +1(b) Moral hazard — an after-lending (hidden-action) problem: once funded, the borrower has an incentive to take on more risk than promised. Bank tools: monitoring the borrower, restrictive covenants, and staged or collateralised lending that keeps the borrower's own funds at stake.
- +1(c) Adverse selection — the lemons problem: because quality is hidden, an average price drives good borrowers out and leaves the bad, so the market can partly collapse. Bank tool: information production (screening) to price borrowers by quality rather than by an uninformative average.
- +1Why banks are necessary: a bank produces information and monitors once, on behalf of many small savers, spreading the fixed cost and avoiding the free-riding and duplication that plague direct finance — so intermediaries reduce the adverse-selection and moral-hazard frictions that would otherwise choke lending.
Key terms
- Financial intermediation
- The process of indirect finance in which an institution acquires funds by issuing liabilities and uses them to acquire assets (loans, securities), linking lender-savers to borrower-spenders. It is empirically far more important than direct finance.
- Adverse selection
- An asymmetric-information problem before a transaction: the parties most eager to trade (borrow) are the worst risks. In credit markets it is the lemons problem, which banks address by screening, collateral and covenants.
- Moral hazard
- An asymmetric-information problem after a transaction: once funded, a borrower has an incentive to take hidden actions that raise default risk. Banks address it through monitoring, covenants and keeping borrower net worth at stake.
- The lemons problem
- Akerlof's result that when quality is hidden, an average price drives high-quality participants out of the market, degrading average quality and potentially causing the market to unravel — the mechanism behind adverse selection in lending.
- Relationship banking
- A bank's accumulation of private information about a borrower through a long-term lending relationship, which lowers the cost of screening and monitoring and helps overcome both information problems.
- Delegated monitoring
- The idea that a bank monitors borrowers once on behalf of many depositors, avoiding the free-riding (no one monitors) or duplication (everyone monitors) that would occur with many small direct lenders.
Banking and Financial Intermediation FAQ
What is the difference between adverse selection and moral hazard?
Timing. Adverse selection happens before the loan is made: because borrowers know their own type and lenders do not, the applicant pool is skewed toward the riskiest projects (the lemons problem). Moral hazard happens after the loan is made: once the borrower has the money, they may take hidden actions that raise the chance of default. Banks fight selection with screening, collateral and covenants, and hazard with monitoring and covenants.
Why is indirect finance so much more important than direct finance?
Because most borrowers cannot cheaply overcome transaction costs and asymmetric information on their own. Only large, well-established firms can access securities markets directly; everyone else relies on banks, which pool funds, exploit economies of scale, produce information, and monitor. Empirically, financial intermediaries — especially banks — are the most important source of external funds for business, and marketable securities are not the primary way firms finance operations.
Why does intermediation inherently expose banks to risk?
Because the value banks create comes from transformation: they turn safe, liquid, short-term deposits into risky, illiquid, long-term loans. That mismatch is exactly what makes banks useful — savers get liquidity, borrowers get patient funding — but it also exposes banks to credit, liquidity and interest-rate risk. You cannot get the benefits of intermediation without bearing the risks it creates, which is the theme that carries into the banking-risk chapter.
Can AI help me with financial intermediation in ECON30005?
Yes. Sia can drill the adverse-selection versus moral-hazard distinction on fresh scenarios, explain why banks arise as delegated monitors, and help you structure a mark-by-mark short essay on why intermediation is necessary. Use it to rehearse the concepts, not to write graded work for you, and confirm assessment details on Canvas.
Exam move
This is a conceptual week where precision earns marks. Build a two-column card: adverse selection (before, hidden type, lemons, tools = screening/collateral/covenants) versus moral hazard (after, hidden action, tools = monitoring/covenants/net worth), and practise sorting scenarios into it instantly. Be able to explain, mark by mark, why banks exist — economies of scale on transaction costs, information production, delegated monitoring, diversification and relationship banking — and why the same transformation that creates value creates risk. Memorise the core economic functions of banking (payments, liquidity provision, intermediation, money and credit creation) as a ready short-essay skeleton. Because this week sets up the costly-state-verification and Diamond-Dybvig models, getting the frictions straight now makes those models far easier. Confirm the assessment structure on Canvas.
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