ECS3701 ASSIGNMENT 2 SEMESTER 1 & 2 2023

QUESTION 1 Discuss how collateral and indirect finance are used in explaining the basic facts aboutfinancial structure around the world. Collateral is a prevalent feature of debt contracts for both households and businesses. Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well. The majority of household debt in South Africa consists of collateralized loans: Your automobile is collateral for your auto loan, and your house is collateral for your mortgage. Commercial and farm mortgages, for which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial businesses; corporate bonds and other bank loans also often involve pledges of collateral. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct finance involves the sale to households of marketable securities, such as stocks and bonds. The 43% share of stocks and bonds as a source of external financing for American businesses actually greatly overstates the importance of direct finance in our financial system. Since 1970, less than 5% of newly issued corporate bonds and commercial paper and less than one-third of stocks have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries, such as insurance companies, pension funds, and mutual funds. These figures indicate that direct finance is used in less than 10% of the external funding of American business. Because in most countries marketable securities are an even less important source of finance than in the United States, direct finance is also far less important than indirect finance in the rest of the world Downloaded by: lilliem637 | Distribution of this document is illegal This study source was downloaded by from CourseH on :33:23 GMT -05:00 S - The Marketplace to Buy and Sell your Study Material QUESTION 2 Differentiate between the main factors in the initiation of financial crises between the advanced and emerging market economies. Financial crises in advanced economies can begin in several ways: mismanagement of financial liberalization/ innovation, asset-price booms and busts, or a general increase in uncertainty caused by failures of major financial institutions. Mismanagement of Financial Innovation/Liberalization The elimination of restrictions on financial markets and institutions, or when new innovations are introduced. Often there is a lack of understanding of the changing situations which leads ultimately to banks taking greater risks and then having to face the consequences of bad debts arising from these risks. When this occurs banks are forced to restrict lending (deleveraging) and this puts pressure on the economy, leading to a severe decrease in economic activity. Lending boom becomes a lending crash Asset price booms and busts Irrational expectations” tend to drive asset prices above the real value of these assets. Assetprice bubbles (tech stock market 1990s, house prices 2007) are often driven by credit booms, where the large increase in credit is used to fund purchases of assets, thereby driving up their price. When “reality” eventually prevails, the assets are largely devalued and the consequences for an economy can be devastating. Increase in uncertainty During periods of uncertainty (after a recession, stock market crash or failure of major financial institution) accurate information is harder to obtain and consequently the problems of adverse selection and moral hazard increase, financial frictions increase, lending declines and economic activity decreases. Crises in emerging market countries develop along two basic paths: either the mismanagement of financial liberalization and globalization, or severe fiscal imbalances. Mismanagement of financial liberalization/globalization. The opening up of economies to flows of capital and financial firms from other nations is called globalization. Problems arise when institutional weakness (fiscal imbalances, ineffective screening and monitoring of borrowers and lax government supervision of banks) prevents a country from successfully handling the liberalization or globalization process. Only when prudent regulation and supervision are strong, the lending boom and bust that often follows the opening up the em