Understanding the work of financial markets Essay

Understanding the work of financial markets - Essay Example Therefore, borrowers might end up putting the blame that the unfavorable outcome is as a result of bad luck rather than taking the correct action. A fixed cost has to be paid so that lenders can monitor the actions of borrower. This is not possible because no one would be willing to pay a monitoring cost as they want a free- ride. The solution to this problem is to hire a single monitor to monitor the actions of the borrowers. A single monitor cannot solve this problem alone thus he uses a model of delegated monitoring called diamond model (Diamond 1996 pg 41). They monitor borrowers by promising lenders a fixed return from the diversified portfolio which the intermediaries offer. The diamond model demonstrates how banks have an incentive to act as a delegated monitor and produce the necessary information for efficient resource allocation. Thakor (1996 pg 917) also build another model in view of banks delegated role of monitoring borrowers. This model assumes that there are three typ es of information problem. To begin with, there is incomplete information regarding future projects a firm has or is available. Secondly lenders do not observe how borrowers invest their funds. Lastly, the possibility of borrowers investing in risky projects is very high. The argument of Thakor (1996 pg 917) is that the first problem can be solved by the financial market while the second and third problems can be solved by intermediaries. Thakor also argues that the emerging financial system will be predominated by the banks and the informational advantages of the markets may allow them to develop mature financial system. According to Allen (2002 pg 398), market –based systems such as U.S have... The essay clearly discusses the role of the banks in bank-based system and market-based systems and the informational problems. Market based systems eliminate informational problems. You find that most information is publicly displayed in the market for public listed companies. Then the essay talks about the possible solution. The solution to this problem is to hire a single monitor to monitor the actions of the borrowers. A single monitor cannot solve this problem alone thus he uses a model of delegated monitoring called diamond model (Diamond 1996 pg 41). Then, risk sharing is discussed. Sharing of risks is one of the most important functions of the financial systems and is often argued that the financial markets are well suited in achieving this goal. Afterwards, the essay talks about the corporate governance role. In most countries, the role of corporate control or agency is weak, and as a result banks have been appointed to act as monitors for a large corporation. Financial cris es is another topic that the essay discusses. Banks collect deposits and raise short term funds in the capital markets and invest them in the long term assets. Another important aspect would be that close and durable banking relationships provide better access to clients and eliminate some of the information problems associated with lending. Banking relationships can either be multiple or single. In this report, we have pointed out and discussed the role of banks in the financial systems, comparisons between bank –based and market based systems and their merits and different.