Question

Discuss why financial institutions cannot be fully replaced by financial markets or face-to-face interactions between borrowers and savers. Where appropriate, indicate how the phenomenon of asymmetric information creates conflicting interests among the involved parties and what the potential solutions could be.

Answer 1

Solution

Financial Institutions cannot be replaced by financial markets (or) face-to-face interactions between the borrowers and savers due to several reasons.

Financial institutions perform the role of intermediary / platform between the borrower and the lender.They connect the lenders to the borrowers (receive deposits from lenders and give out loans to borrowers)

1.They reduce the risk involved in the transaction as a whole between the lender and borrower as they can have greater risk absorption capability when compared to the single parties involved.

2.They ensure transparency in the process between the lender and borrower.They do this by evaluating both the parties involved (i.e., both the borrower and lender,so serves as a third party between both the parties involved)

3.They follow prescribed process / methodology in this process of borrowing and lending.

4.They perform the role of a regulator and also implement the norms put up by the government in the financial space.

The phenomenon of asymmetric information is a situation where one of the party has more information when compared to the other party during the transaction involved.

So,this creates conflicting interests among the parties involved.

Example.Insider trading is a result of Asymmetric information which creates undue advantage for some stakeholders in a company involved.So,one party may benefit at the cost of another party which is unethical.

Potential solutions are Usage of technology to improve transparency ; strict credit policies / standards like centralized tracking system,credit rating systems etc.; Intermediaries

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