Financial intermediaries Essay
‘Risk aversion does not mean that people and institutions are not willing to take risks. However, they need to be compensated for taking risk.’ Explain and discuss Risk aversion can be defined as the avoidance of risk. Risk averters are those who do not wish to take risks, when facing choices of comparable returns they tend to chose the less risky alternative. In any financial system varying degrees of risk exist so there is no way to successfully avoid it altogether, but the principle that transactors seek to minimise risk forms the basis of risk aversion. It is important to understand the economic characteristics of the risk averter before assessing their actions within the financial market. Individuals and institutions have different appetites for risks. Risk avertors are at one end of the scale avoiding risk, risk lovers at the other and risk neutrals sit in the middle1.
Financial intermediaries channel funds from one set of agents to another2, and seek to invest the capital they receive in the most profitable way. They take full advantage of the problems and uncertainties faced by investors, the main one being that of asymmetric information. This exists because different people and institutions have different levels of knowledge
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Financial intermediaries not only have considerable experience in investing, they are also better equipped to investigate potential investments and are more skilled in judging premiums and interest levels that correctly reflect the rate of risk. It is this lack of information on the part of the borrower that increases the risk they take. Agents with surplus funds seek to invest for reasons of protection and capital gain. Within the financial market there are three main groups of contracts that the investor can enter in to. In every case the risk must be borne by someone, it is the averter’s choice to ensure his role in this is minimal.
The first of these contracts is debt. The simplest example is a bank loan, where the borrower is required to repay the loan on specified terms, usually a pre arranged interest rate and assurance of loan repayment on request. The risk to the lender is known as default risk- that is ‘the risk that the borrower will default on his obligations’3. This risk, measured as probability of default and the loss that the bank may need to absorb if default does occur, known as the LGD4. The probability measurement can be kept reasonably close to zero through arrangement of terms in advance and the acquisition of collateral- some form of capital (often property) which lessens the loss should default occur. The level of interest charged reflects the risk of loss considered by the lender, and does not depend on how successful the borrower is in using the funds profitably.
For the risk averting lender debt appears a favourable form of contract as the risks that must be taken can be compensated simply through interest rates and fixed terms that must be met. The main risk faced by the lender is that of asymmetric information, that ‘lenders may be less informed than borrowers about the contingencies under which borrowers operate’5. Credit history of the borrower can be investigated to a certain point but there is no certainty that the past is an accurate reflection of the future, or that the borrower will fulfill his obligations.
Lenders try to ensure the probability of any individual loan going into default is low. They consider the purpose of the loan and whether they consider it legitimate. They also look at the borrower’s income in order to be satisfied that the borrower has sufficient income to meet the terms of the loan. Other than taking collateral, the lender can protect against risk by writing ‘covenants’ into the agreement, to enable him to demand immediate repayment if the loan is in serious risk of being defaulted. All of these ways of protecting against risk makes the debt contract very attractive to the risk averse lender.
Once the loan is made, the borrower who invests their loan bears the risk alone. If investment is unsuccessful the loan must still be repaid. The lender does not share in the costs of failure, but equally shares in no benefits of success. The choice to use a debt contract in this situation may be more complicated to decide. The averter must consider the benefits gained from the investment. If returns are likely to be very high indeed the risk may be worth taking but a less risky alternative with slightly lower returns may be preferred.
An alternative would be the equity contract. The key to equity risk lies in spreading assets across a number of holdings6. A company issuing shares (known as equities) deals in such contracts. The return to the lender is determined by the performance of the borrower. With shares, the return takes the form of dividends, the value of which is determined by the success of the company in each time period. If the company is successful the investors share in the success, and equally failure is borne by both parties.
The equity risk surrounding this contract is derived from the uncertainty around income and performance of the business assets. The risk to the lender is less than within a debt contract, as the risk is shared, lessening cost of failure. However, the borrower is never required to repay equity capital to shareholders, so a break down of any company may see loss not only of capital gain, but also the initial capital invested, so in this way risk remains high.
The equity contract uses the principle of syndication to encourage investors into taking the risk of buying shares in the company. No one investor exists that will lend money to the company by buying all the shares at once. However, the risk can be spread across a large number of investors, who jointly provide capital to the company. To the risk averter this contract appeals as the risk is never solely on their back. If the company fails the loss is distributed across all shareholders, minimizing potential losses and therefore reducing the level of risk taken by the individual. The investor will take higher risks by buying more shares only if the potential dividends are high enough to justify the additional responsibility brought about by owning a higher stake, and therefore risk, in the company.