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ECS3701 Assignment 2 (COMPLETE ANSWERS) Semester 2 2024 (833935) - DUE 27 September 2024
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ECS3701 Assignment 2(COMPLETE ANSWERS)
Semester 2 2024 (833935) - DUE
27 September 2024
CONTACT: biwottcornelius@gmail.com
, ECS3701 Assignment 2 (COMPLETE ANSWERS)
Semester 2 2024 (833935) - DUE 27 September 2024
2.01 Discuss how collateral and indirect finance are used
in explaining the basic facts about financial structure
around the world. [10]
Collateral and Indirect Finance in Financial Structures
1. Collateral as a Mitigating Tool for Risk
Collateral plays a significant role in financial structures worldwide by mitigating risks for
lenders. Borrowers provide collateral—assets pledged to secure a loan—as protection
against default. If a borrower fails to repay, the lender can seize the collateral to recover
the loan amount. This system reduces the lender's risk and encourages lending, especially
in situations where the borrower's creditworthiness is uncertain. In global financial
structures, collateral-backed loans (secured loans) are common in both developed and
developing countries.
2. Enhancement of Loan Accessibility
Collateral increases access to credit for borrowers who might otherwise struggle to secure
loans due to weak credit histories or limited financial standing. It allows financial
institutions to extend credit to individuals or businesses who can provide valuable assets,
even if their income levels or credit scores are insufficient. This enhances the efficiency
of financial markets by allowing a broader spectrum of participants to engage in
borrowing.
3. Indirect Finance through Financial Intermediaries
Indirect finance involves the use of financial intermediaries—such as banks, investment
funds, and insurance companies—to channel funds from savers to borrowers. Rather than
lending money directly, savers deposit funds with intermediaries, which in turn lend the
money to borrowers. This system increases the efficiency of the financial structure by
reducing the costs associated with direct lending, such as the need for extensive borrower
screening and monitoring.
4. Reduction of Transaction Costs
Financial intermediaries, through economies of scale, reduce transaction costs for both
savers and borrowers. By pooling funds from multiple savers and lending them to various
borrowers, intermediaries can perform credit assessments more efficiently. This is a
crucial aspect of financial structures globally, where direct finance (borrowing directly
from individuals) may be expensive or impractical due to high transaction costs.
5. Risk Management through Diversification
Indirect finance also allows intermediaries to diversify their lending portfolios, spreading
the risk across multiple borrowers. This risk reduction attracts savers, who may prefer the
safety and security of placing their money with intermediaries rather than lending it
directly to individual borrowers. This diversification is a fundamental principle in global
financial markets, helping to stabilize financial structures.
6. Mitigation of Information Asymmetry
Collateral and indirect finance help mitigate issues related to information asymmetry—
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