ECS3701
Monetary Economics
Done by Ranga: 0618441387
Assignment 2-Semester 01 and 02-2021
Question 2.1.
The term collateral security refers to an asset that a lender accepts as security for a loan. Collateral
may take the form of real estate or other kinds of assets, depending on the purpose of the loan. The
collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan
payments, the lender can seize the collateral and sell it to recoup some or all of his losses (Kagan
and Drury, 2020)
The eight basic facts about the financial structure throughout the world are:
i. Stocks are not the most important source of external financial – its borrowing (the need for
collateral);
ii. Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations;
iii. Indirect finance which involves the activities of financial intermediaries, is many times more
important than direct finance, in which businesses raise funds from lenders in financial
markets;
iv. Financial intermediaries, particularly, banks, are the most important source of external funds
used to finance business;
v. The financial system is among the most heavily regulated sectors of the economy
vi. Only large, well established corporations have easy access to securities markets to finance their
activities,
vii. Collateral is a prevalent feature of debt contracts for both households and business; and
, viii. Debt contractors typically are extremely complicated legal documents that place substantial
restrictions on the behavior of the borrower.
The basic facts highlight that borrowing, through financial intermediaries, banks is the most
important source of funding in financial system, and as such collateral security is a prevalent
feature in the debt contracts. Collateral security plays a very crucial role in that credit market.
Collateral is an important credit risk managing tool. It improves the proper function of the credit
market especially in scenarios of information asymmetry. It also reduces lenders risk and reduces
the borrowers’ careless tendencies-moral hazard. It makes the credit market functions smoothly
and mitigates the lemons problem which leads to missing markets (Hahn and Friedman, 1990).
Because the credit market is characterised by information asymmetry, without collateral security
and inability to properly screen borrowers, the credit market may disappear leading to a missing
market.
Question 2.2
A financial crisis refers to a major disruption in the functioning of the financial markets. It leads
to collapse, or malfunctioning of the financial markets. The initiation phase of the financial crisis
for developed economies is normally characterised by mismanagement of financial Innovation,
financial liberalization and globalisation
The start of a crisis is often shown when new types of loans or financial products are introduced,
known as financial innovation or when countries engage in financial liberalization, ie the
elimination of restrictions on financial markets and institutions and financial globalisation-the
internationalisation of financial markets.
Financial innovation, liberalization and globalisation, in the long run, can promote financial
development. In the short run it can promote a lending spree called a credit boom. Unfortunately,
lenders may not have the experience or expertise to manage the risk. Sooner or later, losses on
loans begin to mount, and the value of loans falls relative to liabilities, thereby driving down the
net worth of banks.
Monetary Economics
Done by Ranga: 0618441387
Assignment 2-Semester 01 and 02-2021
Question 2.1.
The term collateral security refers to an asset that a lender accepts as security for a loan. Collateral
may take the form of real estate or other kinds of assets, depending on the purpose of the loan. The
collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan
payments, the lender can seize the collateral and sell it to recoup some or all of his losses (Kagan
and Drury, 2020)
The eight basic facts about the financial structure throughout the world are:
i. Stocks are not the most important source of external financial – its borrowing (the need for
collateral);
ii. Issuing marketable debt and equity securities is not the primary way in which businesses
finance their operations;
iii. Indirect finance which involves the activities of financial intermediaries, is many times more
important than direct finance, in which businesses raise funds from lenders in financial
markets;
iv. Financial intermediaries, particularly, banks, are the most important source of external funds
used to finance business;
v. The financial system is among the most heavily regulated sectors of the economy
vi. Only large, well established corporations have easy access to securities markets to finance their
activities,
vii. Collateral is a prevalent feature of debt contracts for both households and business; and
, viii. Debt contractors typically are extremely complicated legal documents that place substantial
restrictions on the behavior of the borrower.
The basic facts highlight that borrowing, through financial intermediaries, banks is the most
important source of funding in financial system, and as such collateral security is a prevalent
feature in the debt contracts. Collateral security plays a very crucial role in that credit market.
Collateral is an important credit risk managing tool. It improves the proper function of the credit
market especially in scenarios of information asymmetry. It also reduces lenders risk and reduces
the borrowers’ careless tendencies-moral hazard. It makes the credit market functions smoothly
and mitigates the lemons problem which leads to missing markets (Hahn and Friedman, 1990).
Because the credit market is characterised by information asymmetry, without collateral security
and inability to properly screen borrowers, the credit market may disappear leading to a missing
market.
Question 2.2
A financial crisis refers to a major disruption in the functioning of the financial markets. It leads
to collapse, or malfunctioning of the financial markets. The initiation phase of the financial crisis
for developed economies is normally characterised by mismanagement of financial Innovation,
financial liberalization and globalisation
The start of a crisis is often shown when new types of loans or financial products are introduced,
known as financial innovation or when countries engage in financial liberalization, ie the
elimination of restrictions on financial markets and institutions and financial globalisation-the
internationalisation of financial markets.
Financial innovation, liberalization and globalisation, in the long run, can promote financial
development. In the short run it can promote a lending spree called a credit boom. Unfortunately,
lenders may not have the experience or expertise to manage the risk. Sooner or later, losses on
loans begin to mount, and the value of loans falls relative to liabilities, thereby driving down the
net worth of banks.
