Question

Question 14

a)Allen would like to open a business to produce a software that he thinks wouldbe well-received by the market. However, the investment needed to start a busi-ness is very high and Allen could barely cover it on his own. The software isvery likely to be successful and generate profits, but it takes 2 years beforeprofits are generated. Explain why the existence of a financial intermediary, likea bank, makes Allen’s investment more likely. [4 marks]

b)Banks are financial intermediaries engaged in maturity transformation. Explainwhat it means for banks to engage in maturity transformation and what are therisks associated with it for banks and depositors. How do banks make profits?[8 marks]

c)Now assume that Allen needs to borrow £300 to produce his software, whichwill generate £500 in two years. There are N savers in the economy, each en-dowed with £2 and each facing a 25% chance that there will be an emergencyand they will need their £2 back. What is the minimum value of N such that afinancial intermediary can solve the problem of getting money from savers to borrowers? [6 marks]

d)After the 2009 financial crisis, countries in the Basel Committee on BankingSupervision have agreed to raise the mandatory reserves for banks. Explainwhat happens to the money multiplier and the bank deposit multiplier if the re-serve ratio is increased and what governments need to do if they wish to main-tain the previous level of broad money ??. [8 marks]

e)What’s the difference between a liquidity crisis and a solvency crisis? WhenLehman Brothers went under, its debts (liabilities) were much greater than itsassets. Did Lehman Brothers experience a solvency or a liquidity issue? [4marks]

Answer 1

Hope this answer solves your purpose. Do give it a thumbs up. All the best.

a)

Financial intermediary is a financial institution which acts as connecting link between surplus and deficit agents. Financial intermediaries exist because they develop on un-intermediated markets in which the ‘ultimate’ parties such as borrowers and savers, or firms and investors. The classic example of financial intermediary is a bank that accepts deposits and uses those funds to transmute them into loans. The job of financial intermediaries is to attach or connect borrowers to savers.

An intermediary might be convenient in a state where investors want facts and figures about prospective investment projects, but they lack the expertise to collect that information themselves. The intermediary might then be able to provide that information about the investment to the investor. This type of intermediary is known as a broker, and there are many different varieties of brokers, including investment analysts, credit-rating agencies, auditing firms, and various other specialist information services.

These intermediaries are divided into two types — banks and mutual funds — which are distinguishable from each other by the types of liability they issue.

In the case of Allen, Financial intermediaries acts in two ways –

Firstly , Financial intermediary like Bank can Lend Loan to Allens business to star. However as the business would take quite long time to establish, He will need some good investors to invest in his business. So The process of looking for money must match the needs of the company. Where and How Allen should look for money depends on the kind of money he needs.

So here comes the Second role of Financial intermediary like Mutual fund agencies (such as Fidelity) – “ When mutual funds use money from investors to invest in newly issued debt or equity securities(i.e business), they finance new investment by firms”

Further the Options for Allen to expand his business is huge , It depends upon the kind of funding he needs Like a high-growth internet-related company looking for second-round venture funding or like looking to finance a second Work location (Angle Broking, Venture Capital”).

b)

Maturity Transformation - Maturity transformation is when banks take short-term sources of finance, such as deposits from savers, and turn them into long-term borrowings, such as mortgages.

Banks engage in maturity transformation and its related risk -

1. Banks engage in maturity transformation to earn the average difference between the long- and short-term rates—the term premium—but this exposes them to interest rate risk.

How Banks Make money - Banks collect money, mostly in the form of members making deposits at the bank, and then sell that money by issuing loans, which are commonly home mortgages, for business pursuits, or for high-priced things like a new car or a college education.

2. Backfire Effect - For example, if there is a panic and a bank run, savers may all try to withdraw money at once. Equally, the money markets may suddenly dry up as lenders stop providing short-term loans to each other. Northern Rock demonstrated what can go wrong here just before it was bailed out by the government

Banks make Profits -
The concept of selling money may be confusing, but it is actually simple. Someone in need of a loan, for say $100,000, goes to a bank, and the lender (the bank) and the borrower agree that the borrower has to repay the initial amount ($100,000) and nominal interest, say 6% per year, over a term of 25 years. The bank is essentially charging the borrower 6% per year for the $100,000 that they are lending to then. In other words, the price that the bank charges to make the loan is 6% nominal interest.
So, this 6% nominal interest, in its simplest form, accounts for two things: inflation and real interest. The bank and the borrower both know that over time, goods and services tend to cost more than they did in the previous year; this is known as inflation. For the past century in the U.S., inflation has been, on average, 3% per year. Therefore, although the bank is getting 6% nominal interest from the borrower, the money that they are getting paid is worth 3% less than when they initially made the loan. The difference between the nominal interest rate, 6%, and the rate of inflation, 3%, is the real interest rate, in this case 3%.
nominal interest rate (6%) = inflation (3%) + real interest rate (3%)
Just like in any business, the difference between the price the bank charges, $100,000 + 6% nominal interest, and their cost to make that loan, $100,000 + 3% inflation, is known as their profit, or 3% real interest.
To sum it up, banks make profit by selling money at some nominal interest rate; they do this by lending.

I have answer A & B . Please raise separate questions for remaining . Thanks

Hope this answer solves your purpose. Do give it a thumbs up. All the best.