Financial Intermediation

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Financial Intermediation

• Lecture 1
• Financial Systems

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The economics of financial markets

• In an equilibrium economy one wants to have a
  full set of markets to exchange assets/contracts.
  The equity and corporate bonds markets are
  examples
• Sometimes, financial exchange gets a more private
  nature e.g. banking contracts like loans or
  deposits
• Why do some economies have more markets, while
  others rely more on private contracts?

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Market failures

• Markets are missing. Think of corporate bonds
  markets in Africa, or equity markets for small
  and medium-sized firms in more developed
  economies
• Information might be asymmetrically distributed
• Transaction costs are too high
• Incentive problems between (financial) agents
  exist think of adverse selection and moral
  hazard
• There is a lack of competition long-term
  financial relations or powerful financial
  institutions

4
Market-based systems

• Think of the US and UK high market
  capitalization, active market for corporate
  control, strong competition in banking
• Asset pricing is the dominant instrument
• But even in these markets, firms use 90 internal
  finance, and
• not all financial markets exist (there is no
  complete spanning)

5
Bank-based systems

• Think of Germany (Hausbanks) and Japan
  (Citybanks) relative low market capitalization
  (especially Germany), weak markets for corporate
  control, large dominant banks
• Firm-bank relations rather dominant credit,
  appointments of bankers on the boards, equity
  ownership by banks

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Some data
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Relative size of housing and equity indicators
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House market indicators
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Equity market ownership
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How do markets and institutions interact?

• Financial institutions, intermediaries, and firms
  solve market failures and compensate for the
  limitations of financial markets
• Financial institutions operate on financial
  markets (and are sometimes the dominant
  suppliers/demanders), create new markets, or
  simply try to get the markets working (think of
  brokers)

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Competition versus risk sharing

• Markets competition among firms and investors
  makes that risks are spread widely, information
  is used efficiently, and prices are good signals.
  With imperfect information competition gets into
  a trade-off with efficiency and stability
• Drawback more market risk. Intermediaries can
  eliminate this risk through inter-temporal
  smoothing
• Insurance generally works for intra-temporal
  risk-sharing, not for inter-temporal problems

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The role of information

• Market-based systems more information is
  available. Agents are more sensitive to news.
  Decision-making is more efficient
• Drawback there might be a freerider problem in
  information gathering. This might lead to
  underinvestment in information processing

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Competition versus stability

• In the banking sector we want banks to operate
  efficiently competition will lead to low costs
  for clients
• But the banking sector as a whole is
  characterized by systematic risk if one banks
  goes into bankruptcy, a bank panic is likely and
  the whole system might collapse this leads to
  instability

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Private versus public assets

• Private assets have lower direct transaction
  costs
• Public assets have higher liquidity
• Public assets allow for more risk sharing
• Going public leads to a lower span of control for
  the owner
• Monitoring costs are lower for private assets

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Firm behaviour

• Modern insights the firm controlled by a
  principle (owner)-agent (manager) model. The
  manager knows more about investment projects.
  There can be conflicts between the two agents
• One important fact firms use internal finance to
  a large extent. They would not do under perfect
  market working. There is financing-order theory
  the pecking-order approach

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Pecking-order theory
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Dutch case 1991-2002
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Conflict between ultimate suppliers of capital
and demand

• Suppliers (households) want efficient markets,
  spread their portfolios, hedge against all
  possible risks (except market risk)
• Firms want to some extent internal control and
  control by banks
• The conflict of interest is the main raison
  dêtre for financial intermediaries

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Early financial systems

• Financial instruments precious metals
• Loans are made to individuals with consumption
  needs, agricultural production and trade
• Financial intermediaries money changers,
  lenders, and banks
• this holds to the thirteenth century

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Second/third step in financial development

• Instruments also trade credit, mortgages, and
  securities
• Institutions banks and insurance companies
• Trading informal markets
• Stage Medieval Italy
• Third step introduction of exchanges
  (Amsterdam), central banks (Riksbank)

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Allen and Gales lessons

• A wide range of different systems has emerged
  from these early developments
• Imperfections are important in explaining the
  development of financial systems
• Financial systems are fragile and crises are
  endemic (read about the South Sea bubble)
• Governments and central banks are important
  players on financial markets