Money, Banking, and Financial Markets : Econ. 212

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Money, Banking, and Financial Markets Econ. 212

• Stephen G. Cecchetti Chapter 11
• The Economics of Financial Intermediation

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• The Role of Financial Intermediaries
• As a general rule, indirect finance through
  financial intermediaries is much more important
  than direct finance through the stock and bond
  markets.
• In virtually every country for which we have
  comprehensive data, credit extended by financial
  intermediaries is larger as a percentage of GDP
  than stocks and bonds combined.
• Around the world, firms and individuals draw
  their financing primarily from banks and other
  financial intermediaries.
• The reason for this is information financial
  intermediaries exist so that individual lenders
  dont have to worry about getting answers to all
  of the important questions concerning a loan and
  a borrower.

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• Lending and borrowing involve transactions costs
  and information costs, and financial
  intermediaries exist to reduce these costs.
• Financial intermediaries perform five functions
  1. they pool the resources of small savers 2.
  they provide safekeeping and accounting services
  as well as access to the payments system 3. they
  supply liquidity 4. they provide ways to
  diversify risk and 5. they collect and process
  information in ways that reduce information
  costs.
• The first four of these functions have to do with
  the reduction of transactions costs.
• International banks handle transactions that
  cross borders, which may mean converting
  currencies.

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• Pooling Savings
• The most straightforward economic function of a
  financial intermediary is to pool the resources
  of many small savers.
• To succeed in this endeavor the intermediary must
  attract substantial numbers of savers. This is
  the essence of indirect finance, and it means
  convincing potential depositors of the soundness
  of the institution.
• Banks rely on their reputations and government
  guarantees like deposit insurance to make sure
  customers feel that their funds will be safe.

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• Safekeeping, Payments System Access, and
  Accounting
• Goldsmiths were the original bankers people
  asked the goldsmiths to store gold in their
  vaults in return for a receipt (banknote) to
  prove it was there.
• People soon realized that trading the receipts
  (banknotes) was easier than trading the gold
  itself.
• Eventually the goldsmiths noticed that there was
  gold left in the vaults at the end of the day, so
  it could safely be lent to others.
• Today, banks are the places where we put things
  for safekeeping we deposit our paychecks and
  entrust our savings to a bank or other financial
  institution because we believe it will keep our
  resources safe until we need them.

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• Banks also provide other services, like ATMs,
  checkbooks, and monthly statements, giving people
  access to the payments system.
• Financial intermediaries also reduce the cost of
  transactions and so promote specialization and
  trade, helping the economy to function more
  efficiently.
• The bookkeeping and accounting services that
  financial intermediaries provide help us to
  manage our finances.
• Providing safekeeping and accounting services as
  well as access to the payments system forces
  financial intermediaries to write legal
  contracts, which are standardized.

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• Much of what financial intermediaries do takes
  advantage of economies of scale, which means that
  the average cost of producing a good or service
  falls as the quantity produced increases.
  Information is also subject to economies of
  scale.
• Providing Liquidity
• One function that is related to access to the
  payments system is the provision of 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 (ATMs are an example).

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• By collecting funds from a large number of small
  investors, a bank can reduce the cost of their
  combined investment, offering the individual
  investor both liquidity and high rates of return.
• Financial intermediaries offer depositors
  something they cant get from the financial
  markets on their own.
• Financial intermediaries offer both individuals
  and businesses lines of credit, which are
  pre-approved loans that can be drawn on whenever
  a customer needs funds.
• Risk Sharing
• Financial intermediaries enable us to diversify
  our investments and reduce risk.

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• Banks mitigate risk by taking deposits from a
  large number of individuals and make thousands of
  loans with them, thus giving each depositor a
  small stake in each of the loans.
• Providing a low-cost way for individuals to
  diversify their investments is a function all
  financial intermediaries perform.
• Information Services
• One of the biggest problems individual savers
  face is figuring out which potential borrowers
  are trustworthy and which are not.

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• There is an information asymmetry because the
  borrower knows whether or not he or she is
  trustworthy, but the lender faces substantial
  costs to obtain the same information.
• Financial intermediaries reduce the problems
  created by information asymmetries by collecting
  and processing standardized information.
• Information Asymmetries and Information Costs
• Information plays a central role in the structure
  of financial markets and financial institutions.
• Markets require sophisticated information in
  order to work well, and when the cost of
  obtaining information is too high, markets cease
  to function.

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• Asymmetric information is a serious hindrance to
  the operation of financial markets, and solving
  this problem is one key to making our financial
  system work as well as it does.
• Asymmetric information poses two obstacles to the
  smooth flow of funds from savers to investors
  adverse selection, which involves being able to
  distinguish good credit risks from bad before the
  transaction and moral hazard, which arises after
  the transaction and involves finding out whether
  borrowers will use the proceeds of a loan as they
  claim they will.
• Adverse Selection
• Used Cars and the Market for Lemons In a market
  in which there are good cars (peaches) and bad
  cars (lemons) for sale, buyers are willing to
  pay only the average value of all the cars in the
  market. This is less than the sellers of the
  peaches want, so those cars disappear from the
  markets and only the lemons are left.

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• To solve this problem caused by asymmetric
  information, companies like Consumer Reports
  provide information about the reliability and
  safety of different models, and car dealers will
  certify the used cars they sell.
• Adverse Selection in Financial Markets
  Information asymmetries can drive good stocks and
  bonds out of the financial market.
• Solving the Adverse Selection Problem
• Disclosure of Information Generating more
  information is one obvious way to solve the
  problem created by asymmetric information.

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• This can be done through government required
  disclosure and the private collection and
  production of information.
• However, the accounting scandals of 2001 and 2002
  showed that in spite of such requirements
  companies can distort the profits and debt levels
  published in their financial statements.
• Reports from private sources such as Moodys and
  Value Line are often expensive.
• Collateral and Net Worth Lenders can be
  compensated even if borrowers default, and if the
  loan is so insured then the borrower is not a bad
  credit risk.
• The importance of net worth in reducing adverse
  selection is the reason owners of new businesses
  have so much difficulty borrowing money.

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• Moral Hazard Problem and Solutions
• An insurance policy changes the behavior of the
  person who is insured. Moral hazard plagues both
  equity and bond financing.
• Moral Hazard in Equity Financing people who
  invest in a company by buying its stock do not
  know that the funds will be invested in their
  best interests.
• The principal-agent problem, which occurs when
  owners and managers are separate people with
  different interests, may result in the funds not
  being used in the best interests of the owners.

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• Solving the Moral Hazard Problem in Equity
  Financing The problem can be solved by if
  owners can fire managers and by requiring
  managers to own a significant stake in their own
  firm.
• Moral Hazard in Debt Finance Debt goes a long
  way toward eliminating the moral hazard problem,
  but it doesnt finish the job debt contracts
  allow owners to keep all the profits in excess of
  the loan payments and so encourage risk taking.
• Solving the Moral Hazard Problem in Debt Finance
  To some degree, a good legal contract with
  restrictive covenants covenants can solve the
  moral hazard problem in debt finance.

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• Financial Intermediaries and Information Costs
• Screening and Certifying to Reduce Adverse
  Selection
• Borrowers must fill out a loan application that
  includes information that can be provided to a
  company that collects and analyzes credit
  information and which provides a summary in the
  form of a credit score.
• Your personal credit score tells a lender how
  likely you are to repay a loan the higher your
  score the more likely you are to get a loan.
• Banks collect additional information about
  borrowers because they can observe the pattern of
  deposits and withdrawals, as well as the use of
  credit and debit cards.

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• Financial intermediaries superior ability to
  screen and certify borrowers extends beyond loan
  making to the issuance of bonds and equity.
• Underwriting represents screening and certifying,
  because investors feel that if a well-known
  investment bank is willing to sell a bond or
  stock then it must be a high-quality investment.
• Monitoring to Reduce Moral Hazard
• Intermediaries monitor both the firms that issue
  bonds and those that issue stocks.
• Banks will monitor borrowers to make sure that
  the funds are being used as intended.

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• Financial intermediaries that hold shares in
  individual firms monitor their activities, in
  some cases placing a representative on a
  companys board of directors.
• In the case of new firms, a financial
  intermediary called a venture capital firm does
  the monitoring.
• The threat of a takeover helps to persuade
  managers to act in the interest of the stock and
  bondholders.

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• Lessons of Chapter 11
• Financial intermediaries specialize in reducing
  costs by
• pooling the resources of small savers and lending
  them to large borrowers.
• providing customers with safekeeping and
  accounting services, as well as access to the
  payments system.
• providing customers with liquidity services.
• allowing for risk sharing by offering financial
  instruments in small denominations.
• providing information services.
• For potential lenders, investigating a borrowers
  trustworthiness is costly. This problem, known
  as asymmetric information, occurs both before and
  after a transaction.
• Before a transaction, the least creditworthy
  borrowers are the ones most likely to apply for
  funds. This problem, known as adverse selection,
  is similar to the lemons problem in the used
  car market.
• Adverse selection can be reduced by
• collecting and disclosing information on
  borrowers.
• requiring borrowers to post collateral and show
  sufficient net worth.
• After a transaction, a borrower may not use the
  borrowed funds as productively as possible. This
  problem is known as moral hazard.
• In equity markets, moral hazard exists when the
  managers interests diverge from the owners
  interests.
• Finding solutions to the moral hazard problem in
  equity financing is difficult.

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• In debt markets, moral hazard exists because
  borrowers have limited liability. They get the
  benefits when a risky bet pays off, but they
  dont suffer a loss when it doesnt.
• The fact that debt financing gives
  managers/borrowers an incentive to take too many
  risks gives rise to restrictive covenants, which
  require borrowers to use funds in specific ways.
• Financial intermediaries can solve the problems
  of adverse selection and moral hazard.
• They can reduce adverse selection by collecting
  information on borrowers and screening them to
  check their creditworthiness.
• They can reduce moral hazard by monitoring what
  borrowers are doing with borrowed funds.

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Key Terms adverse selection asymmetric
information Collateral deflation economies of
scale free rider moral hazard net
worth unsecured loan venture capital firm