Allen would like to open a business to produce a software that he thinks would be well-received by the market. However, the investment needed to start a business is very high and Allen could barely cover it on his own. The software is very likely to be successful and generate profits, but it takes 2 years before profits are generated. Explain why the existence of a financial intermediary, like a bank, makes Allen’s investment more likely.
Banks are financial intermediaries engaged in maturity transformation. Explain what it means for banks to engage in maturity transformation and what are the risks associated with it for banks and depositors. How do banks make profits? [8 marks]
Now assume that Allen needs to borrow £300 to produce his software, which will generate £500 in two years. There are N savers in the economy, each endowed with £2 and each facing a 25% chance that there will be an emergency and they will need their £2 back. What is the minimum value of N such that a financial intermediary can solve the problem of getting money from savers to borrowers?
After the 2009 financial crisis, countries in the Basel Committee on Banking Supervision have agreed to raise the mandatory reserves for banks. Explain what happens to the money multiplier and the bank deposit multiplier if the reserve ratio is increased and what governments need to do if they wish to maintain the previous level of broad money 𝑀𝑀.
What’s the difference between a liquidity crisis and a solvency crisis? When Lehman Brothers went under, its debts (liabilities) were much greater than its assets. Did Lehman Brothers experience a solvency or a liquidity issue?
