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Why Banks?

Microeconomic Foundations of Financial Intermediaries

Series:

Ilonka Rühle

In the banking literature the existence of financial intermediaries is generally explained in terms of the transformation of risks, terms and lot-sizes. Yet these functions could also be performed by system of perfect and complete markets. Therefore, the approach taken in Why Banks? is to start by investigating the conditions that, in the real world, render markets imperfect and incomplete, namely asymmetric information distribution and uncertainty. Incentive compatible financing instruments (standard debt contracts as well as equity participation) provide a means of solving these problems. Financial intermediaries ultimately owe their existence to their ability to save transaction costs using these instruments and to solve problems relating to the enforcement of contracts.

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1. INFORMATION PRODUCTION MODELS 10

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10 Information Production Models 1 Information Production Models 1.1 The Information Problem: Adverse Selection as a Consequence of Hidden Characteristics This chapter will center on an analysis of the following information-related problem: How can a firm be evaluated correctly if its quality is known only to the entrepreneur himself? For the sake of simplicity, we shall consider only two types of firms - good ones and bad ones. The value of a firm is equal to the sum of its future discounted net cash-flows. In efficient markets, the price is a reflection of all available information. The earnings of firms are given by a term IJ, known only to the entrepreneur, and the attributes of a random variable with a mean of zero and a given variance. This latter component cannot be influenced by the actions of the entrepre- neur and is costlessly observable ex-post. In other words, low or high net cash-flows may be attributable to the (true) nature of the firm, or to incidental factors. For an outsider it is not possible to distinguish a priori between good and bad firms. This situation corresponds to the "lemons" market for used cars described by Akerlof (1970): As the buyers cannot tell a good car from a "lemon", there will either be only poor-quality cars available on the market, or it will break down completely. As Kreps has shown, the information problem is not due to the restriction to a choice between only two types - a generali- zation for...

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