Boğaziçi University Department of Economics Money, Banking and Financial Institutions L.Yıldıran PART II-FINANCIAL INSTITUTIONS (INTERMEDIARIES) What do banks and other intermediaries do? Why do they exist? (Chp6) How should banks be optimally managed? (Chp7) How did banks evolve in the last decades? (Chp8) Why and how are banks regulated? How did recent banking crises unfold? (Chp9) Chapter 6 - ROLES OF FINANCIAL INTERMEDIARIES Financial Systems, comprised of financial markets and financial intermediaries (banks, pension funds, insurance firms, finance companies, etc.), are vital to improve/maximize - Growth/employment: If financial systems are efficient (in allocational, informational, operational sense), best projects are picked and they are financed in the cheapest way, so that maximum number of projects (best ones) are financed with scarce resources. - Welfare: By enabling consumption smoothing, financial systems improve welfare. Intermediaries Assets Liabilities Life/fire/causality Bonds, Stocks Premiums insurances Pension funds Bonds, Stocks Contributions from employees/ employers / government Mutual/participation/hedge Bonds, Stocks Shares funds Finance companies Short-Term Consumer Credits Bonds, Commercial Papers Intermediaries pick good firms and finance them on households behalf indirect finance. Investment banks, private equity firms, money management firms are also intermediaries. Explore what they do! See Appendix. Types of Financial Systems: 1. Bank-Based Financial Systems (E.g., Continental Europe, Japan, Developing Countries) 2. Market-Based Financial Systems (E.g., Anglo-Saxon Countries) The underlying difference is the Social Security System (SSS): 1. Pay-As-You-Go SSS in Bank-Based Financial Systems 2. Fully/Partially funded SSS in Market-Based Financial Systems ( Big institutional investors emerge and grow demand for securities rises firms can more easily issue securities) Pecking Order Hypothesis (the order in which firms raise capital/funds) (Relinquished control rights, cost, difficulty ): Retained Earnings Internal Funds Bond Issuance (Public Debt) Bank Loans (Private Debt) Stock Issuance (Public Equity) External Funds Venture Capital (Private Equity) E.g. External funds raised in the USA (1970-1996) Bank loans: 40.2% Non-bank loans: 15.1% Bonds: 35.5%, Stocks: 9% 1
Of marketable securities: only 10% are sold to households, 90% to intermediaries Of external funds: only 5% are obtained through direct finance, 95% through indirect finance (BEWARE of the distinction between direct and indirect finance!) Stylized Facts about Financial Systems (How to explain them?): 1) Stocks are not an important source of external finance despite so much emphasis in news (They reflect the expectations about economy) 2) Issuing marketable securities is not the primary source 3) Indirect finance is far more important than direct finance even in the US. (However, the dominance of indirect finance has been declining recently: financial markets develop, AI problems decline, regulations become more sophisticated) 4) Banks are the most important source. 5) Financial system is among the most heavily regulated sectors. 6) Only well established firms have access to securities markets. 7) Collateral is a prevalent feature of debt contract. Roles of Intermediaries (Esp. Banks) 1. Transformations (Asset Transformation) Liquidity: Illiquid projects of firms are financed with liquid deposits of households [ Liquidity Insurance, Optimal Risk Sharing (Diamond-Dybvig 1983)] Size: Big projects of firms are financed with small deposits of households. Risk/Quality: Small deposits of households are invested in diversified portfolios (Not possible to diversify with small amounts quality improvement) 2. Eliminating/Reducing Asymmetric Information Adverse selection: ex-ante type/quality is unobservable Screening Moral hazard: interim effort/behavior is unobservable Monitoring Costly state verification: ex-post outcome is unobservable Auditing Adverse Selection (Unobservability of Type/Quality): i. Health insurance: An insurance firm faces two types of agents with equal probability, each with Prob(illness) Treatment cost Expected cost π₁=0.3 1000 $300 π₂=0.6 1000 $600 A competitive, risk neutral insurer should break even in expectation. He charges Insurance premium=0.5 300+0.5 600=$450 Type 1 rejects, only type 2 accepts. Insurance contract can attract only the adverse type (Type 2) Adverse Selection In equilibrium, insurer only sells to type 2 at $600. No insurance for type1 because of AI. ii. Lemon's market: In the second hand car market a buyer faces two types of cars, lemon and peach, with values $500 and $1000. For a car whose quality is unobservable, a risk neutral buyer pays at most Price=0.5 500+0.5 1000=750 In equilibrium, peaches will not be sold; only lemons will be sold at $500. Collapse/decay of the used car market 2
iii. Securities Markets: 2 Types of Stocks, with equal probability: 0.5 high return, low risk: P H 0.5 low return, high risk: P L Good stocks will not be sold; people may be unwilling to buy bad stocks. 2 Types of Bonds, with equal probability: 0.5 low risk: i L 0.5 high risk: i H Good bonds will not be sold; people may be unwilling to buy bad bonds. Result1: In AI, the contract you can offer is likely to be accepted by the adverse type. The possibility of attracting only the adverse type makes contracting difficult in AI. Result2: In AI, good firms cannot sell their securities; investors may be unwilling to buy the securities of bad firms. If AI problems are not solved, financial markets cannot develop, firms cannot easily issue/sell securities, the size/depth of stock and bond markets will be small. iv. Credit markets: 2 Types of Entrepreneurs, with equal probability, each wants to borrow $100 for a project Prob(success) Profit 0.5 π G =0.8 $200 0.5 π B =0.6 $200 A competitive and risk neutral creditor charges (if he can observe the types of entrepreneurs): I B =100/0.6=166 i B =66% I G =100/0.8=125 i G =25% But, in asymmetric information (AI), the creditor charges i AI =0.5 (66%+25%)=45%. Only the bad type accepts. Creditor may refuse to lend to the bad type, even with i B > 66% Credit Rationing: Disequilibrium in credit markets (i.e., D>S). Borrowers are ready to pay high interest rates, but creditors foresee that such borrowers are of high risk. Thus, they refuse to lend to such risky borrowers (See Chp7). Result3: In AI, good entrepreneurs may not find credit; investors may be unwilling to lend to bad entrepreneurs. Result4: In developing countries information problems are more severe. Banks play a more important role in these countries. Solutions to Adverse Selection: 1) Private production and sale of information. Private companies (S&P, Fitch) can provide information about firms; you can subscribe (pay) to have access. But, free riders may observe and imitate subscribers. 2) Government regulation. Government cannot reveal/announce good firms and bad firms (competition policy?), but can require firms to disclose information regularly (like the listed firms in stock markets). The disclosed information may not be reliable though. Insiders have incentives to hide negative information, e.g. Enron Implosion. Also, households may not be sufficiently informed and motivated to evaluate the disclosed information. 3) Collateral and/or net worth can reduce the lender s potential loss. Good type can signal with his high collateral and/or net worth. 4) Financial intermediaries can screen out bad firms and extend (private) credit to good firms. Similarly, in used car markets car dealers solve such AI problems by offering implicit/explicit guarantees. 3
Moral Hazard (Unobservability of Behavior/Effort) and Costly State Verification (Unobservability of Outcome): Suppose that you have to raise capital to invest in a profitable project. The outcome of your investment depends on how hard/serious/effective you will work. Your creditor (lender/partner) has to be sure of your good behavior, and thus wants to monitor you. But monitoring is costly. (Moral Hazard) What is worse is that your creditor suspects that you are likely to conceal the true outcome not to give his share. (Costly State Verification) Example: I unit of investment randomly returns R. Financing alternatives: Debt contract (public or private): I (1+r) for lender, and residual for yourself Equity contract (public or private): (R/2) for each Debt Contract Equity Contract Debt Holder Equity Holder Both Equity Holders 1+r) R /2 45 0 45 0 I (1+r) R I (1+r) R R R Auditing only in this state Auditing in all states Auditing to reduce/eliminate misreporting is costly. The need for auditing is less with debt contract. Thus, debt contract is preferred to equity contract in costly state verification. [But, beware of a potential moral hazard problem associated with debt contract; the borrower tends to take higher risk than the lender will accept negative externality] Solutions to Moral Hazard and Costly State Verification: 1) Private production of information. One bondholder monitors/audits (he incurs the cost), others will benefit from this public good free riding. In equilibrium, inefficient/insufficient level of monitoring/auditing. Moreover, the monitor can collude with the entrepreneur. 2) Government regulation. Government can require regular disclosures. The same criticism as before applies. 3) Covenants can reduce shirking incentives Restrictive Encouraging Information Collateral 4) Net worth and collateral can align the incentives of borrower and creditor. The more a borrower has to lose in the business, the more he will make effort. 5) Financial intermediaries (delegated monitoring) 4
APPENDIX: Investment Banks: Their operations are classified as sell side and buy side (or as firms /governments side and households side). For example, they help companies and governments issue securities (sell side), help investors purchase securities (buy side), manage financial assets, trade securities, provide financial advice, etc. They also engage in underwriting, M&As, project finance, structured finance, derivatives, equity and fixed income research, international sales/emerging markets, public finance, retail brokerage/private client coverage/stockbroker, institutional sales. Private Equity Firms purchase equity of companies, but not from public equity markets (Leveraged buyouts, venture capital, growth capital, mezzanine investments, and turnarounds). General partners provide their expertise; limited partners provide capital (e.g., university endowments, insurance companies, corporate pension plans, public employee retirement plans and high net worth individuals). Conflicts of Interest: Financial intermediaries, with the information they have already produced, can provide multiple services economies of scale and scope efficiency enhancement. But, multiple and often conflicting objectives may reduce the quality of the information they disclose. Brokerage and underwriting activities of investment banks Auditing and consulting activities of accounting companies (e.g., Arthur Anderson and Enron) Credit rating and consulting activities of rating agents (e.g., Tech Boom) Financial Development and Economic Growth: Two important tools to solve AS & MH: collateral and restrictive covenants. Legal system in developing countries often does not enable the effective use of these tools. Bankruptcy procedures and lawsuits take several years. Poor and corrupted legal system makes it difficult for lenders to enforce restrictive covenants and to foreclose. Other problems: weak accounting standards, inadequate government regulation, government intervention through directed credit program, etc. Result: Lenders are unwilling to provide funds for productive investments slow growth. China (a counter example?): No rule of law, not a developed financial system yet. But, growth is unprecedented. It has to install institutions immediately (legal system, bankruptcy laws, enforcement, privatization of public banks, etc.). Financial crisis (Asymmetric Information Explanations): Disruption in financial markets, plunge in asset prices, failure of many financial and nonfinancial firms sharp increase in AS & MH, markets are unable to channel funds, sharp contraction in economic activity. Factors: Increase in interest rates: If interest rates rise due to an increase in demand for credit or a decline in money supply or an increase in interest rates abroad, good credit risks are less likely to borrow AS Lenders will no longer give loans. Lending, investment, economic activity Increase in uncertainty: Failure of a prominent financial institution, recession, stock market crash AI, Lending Asset market effects on balance sheet: Deterioration in bank balance sheets, steep decline in stock market net worth. Unanticipated devaluation (or a fall in price level deflation) liability of firms net worth, AS, MH. Lenders are less willing to lend. Problems in banking sector: Contraction in capital capital crunch lending Government fiscal imbalances: Government may force banks to hold GSs. If fears of government default, price of GSs, net worth 5
Emerging Market Crisis: - Mexico & Asia: Financial market deregulation, lending boom, weak supervision, lack of expertise of banks in screening and monitoring borrowers, deterioration in bank B/S because of increasing loan losses credit crunch - Argentina: Not lending boom, well supervised banking system. Recessions, fiscal deficits, banks hold GSs, prices of GSs, net worth - Mexico & Argentina: Rise in interest rates abroad, FED increased interest rates to control inflation in 93-94, upward pressures in interest rates in Mexico & Argentina AI, MH. - Stock market declines prior to Mexico, Thailand, Korea, Argentina crises, political shocks in Mexico and Turkey; uncertainty speculative attacks in FX markets, devaluation. 6