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
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.
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.
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
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
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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
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.
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.
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
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.
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.