Banking and Financial Institutions

Functions of Financial Intermediaries

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Functions of Financial Intermediaries

▶ A healthy and vibrant economy requires a financial system

that moves funds from people who save to people who have
productive investment opportunities.
▶ How does the financial system make sure that savings get
channeled to those with productive investment opportunities?

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Sources of external funds for nonfinancial firms

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Basic facts about the global financial system

1. Stocks are not most important sources of external financing

for businesses
2. Issuing marketable debt & equity securities is not primary way
in which businesses finance operations
3. Indirect finance is many times more important than direct
finance
4. Financial intermediaries, particularly banks, are most
important source of external funds used to finance businesses

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Basic facts about the global financial system

5. Financial system is among most heavily regulated sectors

6. Only large, well-established firms have easy access to
securities markets
7. Collateral is prevalent feature of debt contracts for both
households and businesses
8. Debt contracts are complicated legal documents with many
covenants

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Explaining the structure of financial systems

▶ Many of these facts can be explained asking why two parties

enter into financial transactions
▶ These issues include
▶ Payment and liquidity
▶ Transaction costs
▶ Risk sharing
▶ Asymmetric information: borrower knows more than a
lender/investor
▶ Adverse selection: problem occurs before transaction
▶ Moral hazard: problem occurs after transaction
▶ Financial intermediation deals with these issues
▶ Agency theory is an important part of economics, here applied
to financial markets

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Payment and liquidity services

▶ Banks facilitate the transfer of money across agents by

providing payment services:
▶ Debit/credit cards, checks, bank transfers
▶ Safety: safe storage + avoidance of carrying cash
▶ Lower costs: it would be very expensive for us to store our
cash + to carry it around
▶ Banks facilitate the transfer of money across time.
▶ Financial intermediaries help make financial assets more liquid
▶ By taking deposits from people with excess money today
(savers) and lending it to those with excess money in the
future (borrowers).
▶ As a result, banks operate as an intertemporal insurance.
▶ Helps to explain fact 4

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Transaction costs

▶ Time and money spent in carrying out a financial transaction

▶ Costs of hiring a lawyer to write the contract for a transaction
▶ Costs of a trade or exchange - brokerage commission charged
for buying or selling a financial asset
▶ If these costs are larger than the benefits from a transaction,
the transaction will not be carried out
▶ Financial intermediaries have evolved to reduce transaction
costs
▶ Economies of scale: reduction in average cost that results from
an increase in volume of a good or service produced
▶ Expertise: banks are better able to develop expertise to lower
transaction costs
▶ Helps to explain fact 3

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Risk Sharing

▶ Financial intermediaries also promote risk sharing by helping

individuals to diversify and thereby lower the amount of risk
to which they are exposed.
▶ Diversification entails investing in a collection (portfolio) of
assets whose returns do not always move together, with the
result that overall risk is lower than for individual assets.
▶ Low transaction costs allow financial intermediaries to do this
by pooling a collection of assets into a new asset and then
selling it to individuals.
▶ Helps to explain fact 3

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Risk Sharing

▶ Consider a very risky project in the 17th century: finance a

ship to sail to the spice islands.
▶ Although the spice trade was generally a very profitable
enterprise, the risk of total loss was substantial.
▶ And there were many sail expeditions ready to receive
financing

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Risk Sharing

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Risk Sharing
▶ If one investor with ₤3,000 pounds finances one expedition

→ With 30% probability she earns ₤20,000, but with 70%

probability she gets zero and looses everything!
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Risk Sharing
▶ If 20 investors with ₤3,000 pounds finance 20 independent
expeditions

→ The probability of loss (< ₤3,000) falls from 70% to 3.56% and
that of of total ruin (= ₤0) to 0.08%
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Asymmetric information

▶ Asymmetric information leads to two major problems in

financial markets:
1. Adverse selection: investors cannot distinguish low-risk firms
from high-risk firms before making an investment
2. Moral hazard: people will take actions after they have entered
into transaction that will make other party worse off
▶ Famous example for adverse selection?

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Asymmetric information

▶ A firm has more information on true characteristics of the

business than a potential supplier of funds (lender/investor)
▶ For an investor who does not know the quality of the firm, the
expected payoff is

E[Payoff] = Prob(firm=good) × E[Repayment good firm]

+ Prob(firm=bad) × E[Repayment bad firm]

▶ Interest rate/price that potential lenders/investors are willing

to agree to reflects lack of information on true firm
characteristics
▶ If quality cannot be assessed, lender/investor is willing to
agree only to interest rate/price that reflects average firm
quality

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Adverse selection

▶ Who more likely asks for funds? – Good or bad firm?

▶ Good firm does not want to raise funds at interest rate/price
for average firm quality
▶ Because of asymmetric information, market adversely selects
only bad firms → Lemon’s Market
▶ Problem especially severe in security markets...why?
▶ Explains fact 2 and partially fact 1

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Tools to solve adverse selection problems 1/3

▶ Private production and sale of information

▶ Companies collect information that distinguishes good from
bad firms and then sell it (e.g., rating agencies)
▶ But: free-rider problem
▶ Government regulation to increase information ...how?
▶ Government could produce information to help investors
distinguish good from bad firms and provide it to the public
▶ Government regulation requiring firms to have independent
audits
▶ Not always works to solve the adverse selection problem (see,
e.g., Enron and Wirecard)
▶ Explains fact 5

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Tools to solve adverse selection problems 2/3

▶ Financial intermediation...how does used car-market actually

work?
▶ Expert in producing information about firms so that bank can
sort out good credit risks from bad ones (no free-rider problem)
▶ Relationship banking is ability of banks to assess credit risks on
basis of private information about borrowers
▶ Explains facts 3, 4 & 6
▶ What do you think?
▶ Bank funding more or less important source of financing for
small firms?
▶ Bank funding more or less important source of financing in
developing countries?
▶ Role of banks more or less important in the future?

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Tools to solve adverse selection problems 3/3

▶ Adverse selection is only a problem if the lender suffers a loss

when the borrower cannot repay
▶ Collateral may solve this problem
▶ Collateral is an asset that the borrower pledges to the lender
▶ E.g. house as collateral for a mortgage
▶ If the borrower defaults on the loan, the bank can sell the
house to make up for the losses
▶ Explains fact 7
▶ Net worth
▶ Difference between value of a firm’s assets and value of its
liabilities
▶ Can perform similar role than collateral

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Has securitization increased adverse selection problems?

▶ Securitization involves bundling loans, such as mortgages, into

securities that can be sold in financial markets
▶ Leads to reduction of banks’ incentives to distinguish between
good and bad borrowers
▶ May have increased adverse selection
▶ Can be mitigated by requiring banks to hold a portion of
asset-backed securities that they sell

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Application

▶ Have a look at the file Class example adverse selection until

tomorrow.

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What is moral hazard?

▶ Moral hazard is another outcome of asymmetric information

▶ Here, the problem are unobservable actions taken after a
transaction has been made
▶ Equity contracts are subject to particular type of moral hazard
called principal-agent problem:
▶ Principal: less information (stockholder)
▶ Agent: more information (manager)
▶ Cause: separation of ownership and control of firm
▶ Managers put in inefficiently low effort level
▶ Managers pursue personal benefits and power rather than
firm’s profitability

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Tools to help solve principal-agent problem in equity
contracts

▶ Monitoring (costly state verification)

▶ Auditing the firm and checking on what management is doing
▶ Expensive, free-rider problem reduces efficiency
▶ Explains fact 1
▶ Government regulation to increase information (quality)
▶ Firms have to adhere to standard accounting principles
▶ Criminal penalties on committing fraud (e.g., diverting profits)
▶ Explains fact 5
▶ Intermediaries (e.g. private equity and venture capital)
▶ Explains fact 1
▶ Align incentives of management and shareholders (inside
ownership)
▶ Creates new problems in banks (we will talk about this later)

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Tools to help solve principal-agent problem

▶ Debt contracts may reduce the information problem

▶ If managers pursue activities that decrease profitability, no
problem as long it does not affect ability to make debt
payments
▶ Explains fact 1
▶ But: debt contracts are also subject to moral hazard
▶ Borrowing through a loan allows the firm to keep any profits
that exceed fixed debt payments
▶ Creates an incentive to assume more risk (“risk-shifting”) after
obtaining the loan
▶ Limited downside (other people’s money), high upside
▶ This decreases the likelihood of loan repayment

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Payoff structures

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Tools to help solve moral hazard in debt contracts

▶ Net worth and collateral

▶ Firm has “skin in the game” which makes debt contract
“incentive compatible”
▶ Explains fact 7
▶ Monitoring and enforcement of covenants
▶ Discourage undesirable and encourage desirable behavior
▶ Keep collateral valuable
▶ Provide information
▶ Explains fact 8
▶ Financial intermediation
▶ Covenants must be monitored and enforced
▶ Free-rider problem for debt securities
▶ With loans no one can free-ride on bank’s monitoring
▶ Explains facts 3 & 4

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Moral hazard - example 1

Assume that the assets of ABC will be worth €7 million in one

year. ABC has debt with Banco Santander that matures in one
year and has face value equal to €9 million.
▶ Assume that ABC can invest all its assets in one project that
in one year
▶ will be worth €11 million with probability ½,
▶ will be worth €1 million with probability ½.
▶ Should ABC do this exchange? What do shareholder say?
Does the bank want ABC to do it?

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Moral hazard - example 2

Assume that the assets of ABC will be worth €7 million in one

year. ABC has debt with Banco Santander that matures in one
year and has face value equal to €9 million.
▶ Assume that ABC finds the following positive NPV
opportunity:
▶ Invest €2 million to buy a riskless asset that will be worth €3
million in one year
▶ It needs to raise €2 million to fund the project
▶ Should ABC implement this project? Will ABC be able to
raise €2million to finance the project?

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Summary: Asymmetric information problems and solutions

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Summary: Asymmetric information problems and solutions

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Financial systems and economic development

The financial systems in developing and transition countries face

several difficulties that often keep them from operating efficiently
▶ System of property rights (rule of law, constraints on
government expropriation, absence of corruption) functions
poorly
▶ Collateral and covenants cannot be used
▶ Makes it hard to use tools of financial intermediation
effectively
▶ Weak accounting standards (less reliable information)
▶ Directed credit programs and state-owned banks (less
incentive to properly channel funds to its most productive use)

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