Question

1. Why failure of (commercial) banks and many other financial intermediaries (such as investment banks) can lead to a recession, such as the one observed after 2008 financial crisis? (Hint: your answer should relate to role of financial intermediaries and asymmetric information).

Answer 1

Failure of commercial banks and Financial institutions can lead to recession because there is a a role of Financial institutions as intermediaries in the whole system.

Banks are always acting as a intermediaries between the savers and the depositors and they are also acting as intermediaries among various sectors of the organisation, and Financial system is always considered the bloodline of the whole economy, so when banks are started to collapse there is a contagion in the overall economy and that can lead to collapse of multiple organisations and ultimately push the economy into recession.

Banks are interlinked with different sectors of economy as it can be seen that bank will always be lending to multiple organisation and it would be lending the money of the the various depositors, so if the borrower will default,it would mean that the bank repayment capability for the depositors will decrease and it would lead to reduction in the overall asset quality of the bank and since multiple organisation have exposures through the bank, they are also facing problems regarding their recoveries, so overall it can be said that the bank are always acting as an intermediary in the whole financial world and collapse of bank can lead to contagion.

There are also presence of asymmetric information between different participants of the market that could create moral hazards and eventually lead to collapse of multiple organisations in the overall system