Financial Intermediation

1
Financial Intermediation

• Lecture 12
• More theories of financial intermediation

2
What is a Financial Intermediary?

• An institution that transforms (1) risk, (2)
  scale, (3) place, and (4) maturity
• FR an agent who specializes in buying and
  selling financial contracts and securities at the
  same time
• Bhattacharya a FI is involved in (1) brokerage,
  and (2) qualitative asset transformation

3
Asset Transformation

• (1) Time, (2) Place, (3) Risk, (4) Maturity
• Or (a) convenience of denomination, (2)
  qualitative asset transformation, (3) maturity
  transformation
• Banks are special in this process

4
Are banks special?

• Banks deal with private contracts and securities
• Banks assets and liabilities differ in nature
• Banks fulfill a role in the payments system
• Banks are money creating institutions
• Banks are faced with systematic risk (bank runs
  and bank panics)

5
Why do FIs/banks exist?

• In an Arrow-Debreu economy we have no banks, FIs
  or money (as such)
• We need some kind of imperfections to be able to
  explain the existence of banks and/or money
• What kind of imperfections? Information problems,
  missing markets, price stickiness (the latter not
  so handy in banking models!)

6
Old-fashioned views

• FIs transform risk, maturity, indivisibilities,
  place, etc. Example from deposits to long-term
  loans
• Why do borrowers not do the job themselves?
• Economies of scope banking and insurance
• Economies of scale lower costs reusability (in
  various directions) of information

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New insights

• 1 Liquidity insurance (Diamond-Dybvig, 1983)
  see Chapter 6
• 2 Information sharing coalitions (Leland,Pyle,
  1977) to be discussed here
• 3 Delegated monitoring (Diamond, 1984) see
  Lecture 3
• 4 Coexistence of direct and intermediated
  lending (Diamond, 1991)

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1 Liquidity insurance

• Idea consumers are uncertain about the timing of
  consumption and invest their funds at the bank in
  a deposit as an insurance
• FIs are a pool of liquidity
• If households vary in risk profiles FIs do not
  need to hold full cash for the deposits

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2 Information sharing coalitions

• Idea if a group of firms can credibly
  communicate the quality of investment projects,
  borrowing costs will decrease with the number of
  members of the group
• A FI is a coalition of firms
• Scale economies are generated in lender-borrower
  relationships if firms are better informed on the
  quality of the investment project

10
Leland and Pyle capital markets with adverse
selection

• Firms invest 1 unit. Net returns R(?) are
  normally distributed with unknown mean ?, and
  variance ?2 (?2 equal for all firms). The
  distribution of ? is known. Firms have initial
  wealth W0gt1
• Investors are risk neutral and have a costless
  storage technology

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Leland-Pyle (2)

• Firms are risk averse and want to sell the
  investment project. They use a CARA utility
  function in final wealth w U(w)-exp-?w, ?gt0
  is the CARA-index
• If ? was observable, the entrepreneur would sell
  the project at a price P(?)ER(?) ? and final
  wealth would be W0 ?
• Since ? is private information the price of
  equity will be the same for all firms

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Leland-Pyle (3)

• Self financing the project will give
  Eu(wR(?))u(W0 ? -½??2)
• Selling the project to the market will yield
  u(W0P)
• So entrepreneurs with low expected return ? ?
  ?bP½??2 will issue equity!
• Price of equity is P? ? lt ?b not so
  efficient

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Leland-Pyle (4)

• Equilibrium of the equity market is characterized
  by the price P and the cut-off rate ?b. Suppose
  the distribution of ? is binomial PE?
  ?1?1?2?2
• Efficiency requires that all investors get
  outside finance ?b? ?2
• So ?1(?2-?1) ? ½??2

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Signaling through self-financing

• Idea high quality firms signal by investing part
  ? of their internal wealth
• As long as bad firms do not mimic the good firms,
  we get two equity prices (good and bad)
• Leland and Pyle prove that the informational cost
  of capital is ½ ? ?2 ?². This increases with the
  level of self-financing ?

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Proof

• Binomial no mimicking condition
  u(W0?1)?Eu(W0(1-?)?2?R(?1)), or utility of a
  ?1 firm must be bigger than mimicking a ?2 firm
  and self-financing ?
• Expected utility equivalent of the last term on
  the right-hand side ??1-½??2?2
• The last term is the informational cost of capital

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Coalition of borrowers

• If high quality firms can credibly signal the
  quality of their projects, the variance can be
  reduced from ?2 to ?2/N (because of
  diversification).
• Diamond (1984) shows that the unit cost of
  capital decreases with the size of the coalition
  of borrowers

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3 Delegated monitoring Diamond (1984)

• Idea banks are good in monitoring projects
  increasing returns to scale
• Pool resources in a bank that has an efficient
  monitoring technology
• See Lecture 3

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4 Coexistence of direct and intermediated lending

• Listed firms often have bank loans
• Non-listed firms sometimes have to rely on loans
  alone
• Why do we observe both? Foundations in moral
  hazard models
• Firms with insufficient assets (monetary or
  reputational) cannot obtain direct finance

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Moral hazard in the credit market

• Two technologies good produces G with a
  probability ?G and bad produces B with a
  probability ?B
• Investment costs 1
• Expected values ?GGgt1gt ?BB
• But BgtG, so ?Ggt?B
• Fixed return R on a loan

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Moral hazard

• The firm will pick the good technology if
  ?G(G-R)gt ?B(B-R), or
• RltRC(?GG- ?BB)/(?G-?B)
• RCltGltB
• From the lenders point of view the probability
  of repayment p depends on R p(R) ?G if R?RC and
  p(R) ?B if RgtRC

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Competitive equilibrium

• In absence of monitoring there are no profits
  p(R)R1
• If R?RC p(R) ?G, so ?GR1 and so ?GRC must be
  gt1.
• On the other hand if ?GRClt1 the model breaks
  down. Let R?RC P(R) R ?GR? ?GRClt1 not
  feasible. If RgtRC p(R)R ?BRlt ?BBlt1 is
  infeasible as well

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Monitoring

• Costs C, bank can prevent borrowers from using
  the bad technology
• Perfect competition ?GRm1C, where Rm is the
  repayment under monitoring
• For bank lending we need (1) RmltG ?GGgt
  ?GRm1C, (2) direct lending has to be
  impossible ?GRCgt1

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Financing intervals

• I Direct debt issuance ?Ggt1/RC firm issues debt
  at a rate R11/RG
• II firms borrow in the interval
  ?G ?(1C)/G, 1/RC at a rate R2(1C)/ ?G
• III ?Glt(1C)/G credit market collapses

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Theory of the optimal number of bank relations

• Why do firms want to borrow from a single bank?
  There are five major classes of explanations
• I cost minimization (ex ante screening,
  monitoring, and ex post situations like debt
  renegotiations or bankruptcy). Examples Diamond
  (1984), Bolton-Scharfstein (1996)

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Optimal number . (2)

• II competition on the banking market fewer
  banks give less choice. Examples Von Thadden
  (1994), Petersen and Rajan (1995).
• III liquidity insurance. A firm wants more
  credit lines if it faces higher liquidity risk.
  Nice example Detragiache et al. (2000)

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Optimal number.(3)

• IV coordination of lending activities. A firm
  with a high default risk will observe an increase
  of the coordination costs. Example Dewatripont
  and Maskin (1995)
• V type of business. An innovating firm will try
  to keep its inventions secret to the market and
  look for fewer loan contacts. Examples Yosha
  (1995), Von Rheinhaben and Ruckes (1998).

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Empirical findings

• Size and age mixed results
• Bank market concentration relevant
• Liquidity risk relevant
• Type of activity leads to significant results
  RD, home or foreign orientation, etc
• Financial structure mixed results