Chapter Eleven Chapter 11 The Economics of Financial Intermediation Why do Financial Intermediaries Exist Countries With Developed Financial Systems Prosper Basic Facts of Financial Structure 1. Direct Finance (issuing marketable debt and equity securities) is not the primary way in which businesses finance their operations 2. Indirect finance (using financial intermediaries) is much more important than direct finance, in which businesses raise funds directly from lenders in financial markets 1
Sources of Business Finance Basic Facts of Financial Structure 3. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. Basic Facts of Financial Structure 4. The financial system is among the most heavily regulated sectors of economy. 5. Only large, well-established corporations have easy access to securities markets (direct finance) to finance their activities. 2
Basic Facts of Financial Structure 6. Collateral is a prevalent feature of debt contracts for both households and businesses. 7. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. Why Financial Intermediaries are Important Direct Finance is expensive. Lending and borrowing involves two types of costs: transactions costs and information costs. Financial institutions exist to reduce these costs. Transactions Cost Loans contracts are expensive. Financial intermediaries specialize in making loans and writing contracts. Take advantage of economies of scale. written and used over and over again - reducing cost. Why Financial Intermediaries are Important Information Costs symmetric information - the case where all parties to a transaction or contract have the same information symmetric information. In many situations, this is not the case. Information is not the same. We refer to this imbalance in information as asymmetric information. 3
Information Asymmetries and Information Costs Asymmetric information imbalance of information. Two types of asymmetric information: 1. Adverse selection arises before the transaction occurs. Lenders need to know how to distinguish good credit risks from bad. 2. Moral hazard occurs after the transaction. Will borrowers use the money as they claim? Classic Example of Adverse Selection Lemons Problem Used cars and the market for lemons: Suppose good cars worth $15,000 and bad cars worth $5,000 Used car buyers can t tell good cars from bad. Buyers will at most pay the expected value of good and bad cars say $10,000. Sellers know if they have a good car, so they won t accept less than the true value. If buyers are only willing to pay average value, good car sellers will withdraw cars from the market. Then the market has only the bad cars (adverse selection). Classic Example of Adverse Selection Lemons Problem Companies have been created to solve the asymmetric information problem fill the information gap in the used car market. Consumer Reports publishes information on particular models CARFAX provides potential buyers with detailed history on any car. You can also hire a mechanic to look over a car for you before you buy it. Many car manufacturers offer certified used cars, which usually come with warranties. CarMax in an intermediary 4
Adverse Selection in Financial Markets Bonds If lender can t tell whether a borrowers is a good or bad credit, the lender will demand a risk premium to compensate for average risk. Borrowers with good credit will not want to borrow at the elevated interest rate. They leave the market. Only bad credit remains in the market. Lenders will not buy these bonds, the market disappears 11-13 Adverse Selection in Financial Markets From a social perspective, the adverse selection problem is not good. Some companies will pass up good investments. Economy will not grow as rapidly as it could. Must fill the information gap and find ways for investors and lenders to distinguish well-run firms from poorly run firms. Solving the Adverse Selection Problem Disclosure of information Public companies that issue stock and bonds that are bought and sold in pubic financial markets are required to disclose large amounts of information. SEC registration, prospectus, annual and quarterly reports 5
Disclosure of Information Private collection and sale of information to investors. Research services like Moody s, Value Line, and Dun and Bradstreet collect information directly from firms and produce evaluations. But, private information services face a freerider problem. A free-rider is someone who doesn t pay the cost to get the benefit of a good or service. Banks, however, collect private information and keep it private. Collateral and Net Worth Another solution for adverse selection is to make sure lenders are protected/compensated if borrowers default. Collateral is something of value pledged by a borrower to the lender in the event of the borrower s default. It is said to back or secure a loan. Ex: Cars, houses Moral Hazard: Problem and Solutions The phrase moral hazard originated when economists studying insurance noted that an insurance policy changes the behavior of the person who is insured. Auto insurance Fire insurance Employment arrangement Moral hazard arises when we cannot observe people s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck. 6
Moral Hazard: Problem and Solutions In finance, the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project. or, the borrower may go to Tahiti. Moral Hazard in Debt Finance Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking on the part of owners. People with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their collateral. Lenders need to find ways to make sure borrowers don t take too many risks. Solving the Moral Hazard Problem in Debt Finance Bonds and loans have restrictive covenants that limit the amount of risk a borrower can assume. Require borrowers to maintain a certain level of net worth, a minimum credit rating, or a minimum bank balance. For example: home mortgages require home insurance, fire insurance, etc. 7
Lesson from the Financial Crisis Information Asymmetry and Securitization A key cause of the financial crisis of 2007-2009 was insufficient screening and monitoring in the securitization of mortgages. Loan Originators eased standards and reduced screening to increase the volume of loans and short-term profitability. They worked for a fee. No skin in the game. The firms that assembled the mortgages for sale, the distributors, could have required originators to demonstrate a high level of net worth. They worked for a fee. No skin in the game. Banks and Information Costs Much of the information that banks collect is used to: Reduce information costs, and minimize the effects of adverse selection and moral hazard. And, they keep it private (no free rider) To do this, banks establish processes: Screen loan applicants, Monitor borrowers, and Penalize borrowers by enforcing contracts. Role of Financial Intermediaries In their role as financial intermediaries, financial institutions perform five functions: 1. Collecting and processing information in ways that reduce information costs. 2. Pooling the resources of small savers, 3. Providing safekeeping and accounting services, as well as access to payments system, 4. Supplying liquidity by converting savers balances directly into a means of payment whenever needed, 5. Providing ways to diversify risk, and 8
Pooling Savings A straightforward economic function of a financial intermediary is to pool the resources of many small savers. By accepting many small deposits, banks are able to make large loans. In order to do this, the intermediary: Must attract substantial numbers of savers, and Must convince potential depositors of the institution s soundness. Safekeeping, Payments System Access, and Accounting Banks: Are a place for safekeeping. Provide access to the payments system the network that transfers funds from the account of one person or business to the account of another. Provide Liquidity Liquidity is a measure of the ease and cost with which an asset can be turned into a means of payment. Financial intermediaries offer us the ability to transform assets into money at relatively low cost - ATM s, for example. 9
Diversify Risk Financial institutions enable us to diversify our investments and reduce risk. Banks take deposits from thousands of individuals and make thousands of loans with them. Each depositor has a very small stake in each one of the loans. Financial intermediaries provide a low-cost way for individuals to diversify their investments. 10