Financial Asymmetry And Agency Theory: The Theory Of Financial Intermediaries

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The theory of financial intermediation analyses the role of financial intermediaries in the economy and is associated with the following three key facts; information problem, transaction costs and regulation. This theory was started by (Gurley and Shaw, 1960). It is based chiefly on information asymmetry and agency theory.
The first fact and theory in explaining financial intermediation is the informational asymmetries argument. These asymmetries can be of an ex ante nature, generating adverse selection, they can be interim, generating moral hazard, and they can be of an ex post nature, resulting in auditing or costly state verification and enforcement. The informational asymmetries generate market imperfections, i.e. deviations from the neoclassical
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They interpret financial intermediaries as information sharing coalitions. Diamond (1984) shows that these intermediary coalitions can achieve economies of scale. Diamond (1984) is also of the view that financial intermediaries act as delegated monitors on behalf of ultimate savers. Monitoring will involve increasing returns to scale, which implies that specializing may be attractive. Individual households will delegate the monitoring activity to such a specialist, i.e. to the financial intermediary. The households will put their deposits with the intermediary. They may withdraw the deposits in order to discipline the intermediary in his monitoring function. Furthermore, they will positively value the intermediary’s involvement in the ultimate investment (Hart, 1995). Also, there can be assigned a positive incentive effect of short-term debt, and in particular deposits, on bankers (Hart and Moore, 1995). For example, Qi (1998) and Diamond and Rajan (2001) show that deposit finance can create the right incentives for a bank’s management. Liquid assets of the bank result in a fragile financial structure that is essential for disciplining the bank manager. Note that in the case households that do not
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