Question

1. Wha are the five functions of financial intermediaries are presented. List and briefly describe these five functions, and for each, give an example of a financial intermediary that does that function?

2. Explain the two problems that asymmetric information causes for markets. What is an example of each of these two problems?

Answer 1

Function of financial intermediary are:

• They provide liquidity to funds.
• They reduce risk by diversifying investments.
• They provide safekeeping for payments.
• They pool individual funds together.
• They collect aggregate information which helps in reducing asymmetric information.

Asymmetric information leads to moral hazard and adverse selection.

Adverse selection occurs when buyers or sellers in the market do not have the proper knowledge of the product which they are buying or selling. Assume you are buying a second hand car, only the user known the internal problem of the car. If you are able to identify them you will ask for less price otherwise you will extra money for nothing. If you pay extra and get a lemon car, there is inefficiency created due to less information with the buyer.

Moral hazard occurs when one party among the buyer or seller pose more burden on other. Assume the case of insurance companies where if consumer buys the insurance plans, they loose all the incentives to take care of their health as they know if something bad happens to their health, insurance companies will bear the cost. This pose more burden on insurance market and creating inefficiency.