Answering questions - Assignment Example

How can financial intermediation be used to trade risk? Financial intermediaries provide a combined platform to the providers and users of funds.Gurley and Shaw (1955 cited in Spajic)) argue that financial intermediaries play a vital role in alleviating trade frictions between lenders and borrowers. They tolerate risk on behalf of investors by making investments in different sectors of business thereby, transforming risk through risk pooling and risk spreading. Moreover, the diverse investments allow these intermediaries to allocate their assets in such a way that they could bear risk more efficiently. 2. Using the collapse of the subprime mortgage market in the U.S., describe the components of good management and how regulation can contribute to prudent lending or encourage excessive risk taking.

(What forms of discrimination are to be encouraged.) The subprime mortgage crisis in the U.S. has revealed various imperfections in the financial system. This collapse happened when most of the borrowers over-reached their demand for big homes and a number of borrowers availed the loan offers without having a suitable understanding to the implications of terms and results in an environment of declining real estate prices and increasing interest rates. Regulations can play a very significant role in ensuring stability in finance system by covering the safety and reliability of depository institutions and by maintaining a capital adequacy.

In other words, a suitable regulated housing finance system is less vulnerable to institution failure. The less vulnerability may increase the confidence of investors in the system thereby, encouraging them to take risks. Moreover, the regulations and law should intend to reduce discriminations in house financing. For example, in the mortgage crisis institutions traded and resold the subprime mortgages in the secondary securitization market which made it hard for the regulators and homeowners to follow the predatory lenders.

Therefore, regulations should make clear discriminations between different forms of subprime mortgages. 3. What is the significance of the large increase in excess reserves held by the banking system? The vault cash and deposits held by the banks at Reserve Banks are known as Bank Reserves (Melicher and Norton). Melicher and Norton explain that when the reserves of bank are greater than required reserves; the banking system has excess reserves. Having excess reserves in the banking system is significant because with excess reserves the banks do not face the pressure of reduced reserves.

Therefore, by adding excess reserves in the banking system, the depositories are encouraged to expand their lending to maximize their profits to the fullest extent. Bibliography Melicher, Ronald W und Edgar A Norton. Introduction to Finance: Markets, Investments, and Financial Management, 14th Edition. Unites States of America: John Wiley & Sons Inc., 2011. Spajic, Luke Drago. Financial intermediation in Europe. Norwell: Springer, 2002.