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Lecture 1 – Theories of Financial Intermediation Chapter 1 – What is special about banks? Intro: -

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A bank = financial intermediary that offers loans, deposits and payment services. Insurance comps also = fin intermediaries. Monetary policy = central bank – determines size and rate of growth of money supply, which in turn affects int rates. i.e. modifying int rates/buying or selling gov bonds, and changing amount of money that banks keep as reserves. UK banking structure – 2003-2012 – total number of all types of banks in Western world has been decreasing, decline in number of financial institutions. US banking structure: 2004 v 2013, total number of all types of banks has been decreasing. Why are banks special? o Act as intermediaries between borrowers and lenders – unique form of asset transformation. o Provide liquidity to customers – payment systems. o Important role in macro economy- lending process creates credit.

The nature of financial intermediation: -

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FI and fin markets (FM), provide a mechanism by which funds are transferred and allocated to their most productive opps. Banks = FI – core activity = provide loans to borrowers, and collect deposits from savers. Act as intermediaries between borrowers and savers. Banks collect surplus funds from individuals (savers), and allocate them to firms (dis-savers or borrowers), with deficit funds. This increases ec efficiency, by promoting a better allocation of resources. A financial claim = claim to the payment of a future sum of money/or a periodic payment of money. Obligation on issuer to pay interest periodically, and to redeem the claim at a stated value in one of three ways:  On demand  After giving a stated period of notice  On a definite date, or within a range of dates. o Whenever borrowing takes place – when an economic unit’s (indiv, households, comp, gov etc) total expenditure > total receipts. o Can take form of any financial asset – money, bank deposit accounts, bonds, shares, loans etc. o Lender of funds holds borrower’s financial claim = holds fin asset. o Issuer of claim (borrower), holds financial liability. Direct finance: o No intermediary – borrowers obtain funds directly from lenders in fin markets. o Barriers:  Difficulty and expense of matching the complex needs of individual borrowers and lenders.  Incompatibility of financial needs of borrowers and lenders.  Lenders look for safety and liquidity, which borrowers may find difficult to promise. Lenders’ requirements:

Minimisation of risk – minimising risk of borrower not meeting repayment obligations, and risk of assets dropping in value. o Minimisation of cost o Liquidity – lenders prefer holding assets that can be more easily converted into cash – because of lack of knowledge of future events = lenders prefer ST to LT lending. Borrower’s requirements: o Funds at particular specified date. o Funds for specific period of time – pref LT. e.g. comp borrowing to purchase capital equipment, which will only have positive returns in LT! o Funds at lowest poss cost. Role of FI: o Bridge between borrowers and lenders – settle their incompatible needs and obj. o Offer suppliers of funds safety and liquidity, by using funds deposited for loans and investments. o Minimise transaction costs and information asymmetries – from direct lending. o Transaction costs = costs of searching for a counterparty to a financial transaction, costs of obtaining info about them, negotiating the contract, the costs of monitoring the borrowers, and the eventual enforcements if the borrower doesn’t fulfil its commitments. o Asymmetric info – one party has better info than counterparty. E.g. borrower has better info about risks and returns of investment, than lender. o Roles of banks:  Brokerage services (buying and selling stocks and bonds for clients)  Leasing and factoring  Before 2007 – securitisation – pooling and repackaging illiquid fin assets into marketable securities. o Shadow banking – in the decade before financial crisis of 2007 – credit intermediation involving entities and activities outside the regular banking system. o

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Functions of FI/Role of banks: -

Deposits = small-size, low-risk and highly liquid. Loans = larger size, higher risk and illiquid.

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The Brokerage Function: o FI can act as a broker, and provide info to individuals about quality of security issues. Only one entity – the FI broker, incurs costs to screen the quality of firm’s securities = resolves adverse selection problem. o E.g. firm wants to issue initial public offering (IPO) of securities. Firm’s quality is unknown to potential individual investors, so a reputable investment bank underwriter, researches firm, and organises a ‘road show’, to inform potential investors of firm’s quality = now willing to purchase at fair offering price. o Broker ‘matches’ savers to quality firms that need funding.

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The Asset transformation function: o FIs hold LT, high risk and large denomination (a classification for the face value of fin instruments) claims, and issue ST, low risk and small denomination deposit claims. Some have capacity to issue large loans.

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FIs process risk = change nature of the assets – can invest time/energy to ascertain risk in the firm they wish to lend.  Asset diversification:  Transformation of large-denomination FA, into smaller units. E.g. insurance comp pools together the risks of accidents or life faced by many individuals. In return for contributing an insurance premium (cash), each individual obtains a claim on the insurance comp, that pays off when an accident occurs. Kind like portf theory – pools risks and diversifies. 

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Asset Evaluation:  Banks act as evaluators of credit risk for the depositor.  Banks exploit asymmetric info between agents, for profit.  Bank can profit from the info it produces, by making private loans (i.e. avoiding free-rider problems) – need to monitor firms, but assumes there’s one person who’ll do something right = means there isn’t proper monitoring going on- if you put FI between investors and firm, they monitor efficiently over time = eliminates free-rider problem.

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FIs can provide maturity intermediation:  The maturities of banks’ assets, may be diff from maturities of it liab = creates liquidity.  E.g. a bank makes LT loans using ST funding (demandable) deposits – more liquid than underlying loans, as they can be withdrawn for cash at depositor’s discretion.

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Liquidity Creation and Monetary Policy:  The liquid (demandable) nature of bank deposits, makes them close substitutes for cash.  Outside money = created by gov, consists of currency held by public, or banks as reserves at central banks.  Inside money = created by FIs, substitute for currency in making transactions (includes bank deposits and even credit cards).  Variation in demand for inside money, can affect demand for outside money. As prices are denominated in (outside money) currency units, changes in inside money can affect monetary policy.  Demand for some inside money, e.g. bank deposits, can be unstable.  E.g. early 1930s US – depositors feared loses if their banks failed. Withdrew deposits (demand for inside money fell), for currency (demand for outside money increased). Federal Reserve failed to increase supply of outside money to offset this increased demand = led to severely contractionary monetary policy deflation, and widespread unemployment.

Transformation function: o Size transformation:  Banks collect funds from savers in small-size deposits, and repackage them into larger-size loans.

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Exploit econs of scale associated with lending/borrowing, as they have access to large number of depositors, than any individual borrowers Maturity transformation:  Transform funds lent for short period of time, into medium and LT loans.  E.g. convert demand deposits (can be withdrawn on demand), into 25-year residential mortgages.  Banks’ liabilities (i.e. funds collected from savers), are mainly repayable on demand, or at relatively short notice.  Banks’ assets (funds lend to borrowers), are repayable in the medium to LT.  ‘Borrow short and lend long’ – mismatch their assets and liab – liquidity risk problems (not having enough liquid funds to meet liab). Risk transformation:  Individual borrowers = default (credit risk) – may not be able to repay amount of money borrowed.  Banks minimise risk of individual risks, by diversifying investments, pooling risks, screening and monitoring borrowers and holding capital and reserves as a buffer for unexpected losses.

Information economies: -

Transaction costs: o Bank liab (i.e. deposits), are accepted as a means of exchange, and banks are the only intermediaries that can vary the level of deposits and can create and destroy credit. o Banks transform primary securities issued by firms (deficit units) into secondary securities – more attractive to surplus units. o They reduce transaction costs – secondary securities will be less risky, more convenient and more liquid than primary securities (because banks benefit from econs of scale in transaction tech, and can diversify risks) = can offer lower loan rates compared to direct financing.

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Economies of scale and economies of scope: o FI exploit econs of scale – increasing vol of transactions = decreases cost per unit of transactions. o Train high-quality staff in process of finding and monitoring suitable deficit units (borrowers) – would be time-consuming and costly for individual to do it! o FI reduce risk by pooling or aggregating individual risks, so that surplus units will be depositing money, as deficit units make withdrawals = banks can collect relatively liquid deposits, and invest most of them in LT assets. o Econs of scope = joint costs of producing two complementary outputs < combined costs of producing the two outputs separately e.g. selling both mortgages and life insurance policies– production processes of both outputs might have the same inputs, e.g. capital (the building that the bank occupies), and labour (bank management).

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Asymmetric info: o Not everyone has same info. o Everyone has less than perfect info. o Some parties to a transaction have inside info, that isn’t available to both sides of the transaction = difficult for two parties to do business together = regulators introduced in order to reduce mismatches in info.

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E.g. a gov selling a bond doesn’t know what buyers are prepared to pay, a bank doesn’t know how likely a borrower is to repay, an investor buying equity in Apple doesn’t know full details of comp’s operations and prospects. Info asymmetry can distort firm and users’ incentives = significant inefficiencies. Full and complete info isn’t uniformly available to all interested parties, and not all parties have same ability to utilise the info available to them. Parties have more info about themselves (e.g. intentions and abilities), than others do. These problems occur because info isn’t a free good, and the acquisition of info isn’t costless. Problems when FI are absent:  Things that can be assisted with by introducing a bank.  These are the problems when there is no bank or FI. 

Adverse selection:  Before buying a firm’s debt/equity, individual incurs costs to investigate its quality. The poorest (adverse) quality firms, have the most incentive to issue securities to unwary investors – investors who don’t know things.  The better informed economic agent has incentive to exploit his informational adv.  A problem at the search/verification stage of the transaction – only buyer, not seller, knows quality of commodity being exchanged – they know they’re the only one who know the true characteristics of the commodity, so they exaggerate the quality.  Buyer can only form an opinion on the commodity after buying it. If there are lots of bad commodities in the market, it will function poorly.  E.g. second hand car market – seller knows if car is bad, but buyer can only make judgement after running it. All cars of same type, will sell at same price, regardless of whether or not they are bad. Risk of purchasing a ‘lemon’, will lower the price that buyers are prepared to pay for the car, and because second-hand prices are low, people with non-lemon cars will have little incentive to put them on the market.  Signalling = the actions of the informed party. E.g. offering a warranty- signal of quality.  Screening = action by less informed party to determine the info which the informed party possesses – e.g. action by insurance company to gather info about healthy history of potential customers.  Those who take out bank loans, have better idea of risks they face, than bank.  Adverse selection in FM results in firms attracting the wrong type of clients = pushes up insurance premiums and loan rates to the detriment of lower-risk customers.

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Financial firms, i.e. banks/insurers, screen out/monitor customers by assessing risk profile, and adjust insurance premiums and loan rates to reflect the risks of individual clients. In banking, adverse selection can occur as a result of loan pricing.

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Moral hazard:  After buying a firm’s securities, individual must monitor the firm’s managers. When they have control of other people’s money = incentive to spend on excessively risky projects/perquisite consumption, resulting in agency costs.  Once you’ve engaged in transaction with firm (lent them money), must monitor then, or they may become reckless with your money!  Hidden action.  Arises when contract of fin arrangement, creates incentives for parties to behave against interest of others.  Risk that borrowers may engage in activities that are undesirable – make loan repayment less likely, and harm interest of lender.  E.g. funds originally borrowed for ‘safe’ investment project – e.g. car purchase/home improvement, but are then gambled in high-risk projects- e.g. invested in ‘get rich quick’ schemes.  For banks, moral hazard occurs after loan has been granted, and is associated with monitoring and enforcement changes.  Those who get insurance, might take greater risks than they would without it, as they know that they’re protected, so insurer might get larger claims than expected.  Bank loans – lenders screen out excessively high risks, and regularly monitor performance of borrowers, by obtaining various types of fin info. E.g. comps submit periodic reports on performance of their bus.  For loans to large comps – credit rating agencies provide info on their performance and credit ratings – est of amount of credit that can be extended to a comp/person, without undue risk.  Banks send inspectors to firms to monitor their progress.

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Risk and liquidity:  Firm’s debt/equity may have risk characteristics, maturities and liquidity that may not be attractive to particular individuals. i.e. desired maturities may be diff- firm might want to borrow for LT, you might want to lend for ST = mismatch!

Principal-agent problems:  Agent has superior info/expertise, and can choose how to behave after contract has been established, and is able to hide its outcome.  Agent can’t be efficiently/costlessly monitored.  Agency costs = serious deterrent to financial contracting, can lead to losses.  Challenge is to create fin contracts/arrangements that align the interests of principal and agent.  Principal can’t completely control the agent’s behaviour.

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The free-rider problem:  When people who don’t pay for info, take adv of the info that other people have paid for.  E.g. you buy info that tells you which firms are good, and which are bad. You believe the purchase is worthwhile, cos you can buy securities of good firms that are undervalued, so you’ll gain extra profits, but free-rider investors see that you’re buying certain securities, so they do the same.  By encouraging bank lending, a bank can profit from the info it produces, by making private loans (i.e. avoiding free-rider problems).

Relationship and transaction banking: o In credit markets, to overcome agency and adverse selection problems, parties can enter a relational contract = informal agreements between bank and borrowers, sustained by value of future relationships. o Role of banks as relationship lenders = banks invest in developing close and LT relationships with customers = improves info flow between bank and borrow = benefits both parties. o If customers has ‘history’- e.g. have borrowed previously from bank over long period of time, then bank’s screening and monitoring costs will be much lower compared with those for new customers, and borrowers get future loans at lower rates of interest. o Relationship banking:  Helps minimise principal agent and adverse selection problems.  Relationship evolves over time between borrower and lender. e.g. Hausbak relationship in Germany – customer obtains variety of services from bank (current account, loans, credit cards etc).  Relationship banking improves upon information flow= gets rid of info asymmetries, and allows for flexibility.  Relationship banking can be sustained even with significant competitive pressures.  The informational savings from relationship lending is a primary compet adv for existing banks over new market participants – because by drawing relational contracts, banks can ‘isolate’ themselves from competition from other banks and non-bank fin intermediaries. o Transaction banking:  Characterised by arms-length relationship between bank and customers.  Banks compete for customers on ‘hard facts’ and customers ‘shop around’.  Counterparties bargain over terms and conditions, transactional banking limits the exchange of info.  Involves a pure funding transaction, where bank acts as a ‘broker’. E.g. mortgage loan made by a bank, and then sold on to an investor in the form of a security = securitisation.  No relationship between parties, and no flexibility in contract terms.

Why do banks exist? Theories of financial intermediation: -

Financial intermediation and delegated monitoring: o Role of banks as ‘monitors’ of borrowing.

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Because monitoring credit risk (likelihood that borrowers default) is costly, more efficient for surplus units (depositors), to delegate task of monitoring, to specialised agents – banks. They have expertise, and econs of scale in processing info on risks of borrowers. Diamond’s study:  Theoretical model, in which a FI (bank or insurance comp), has net cost savings, relative to direct lending and borrowing. Developed around two interconnected factors:  Diversification among diff investment projects – crucial in explaining why there is a benefit from delegating monitoring to an intermediary that isn’t monitored by its depositors.  The size of the delegated intermediary that can finance a large number of borrowers. Diversification increases with the number of bank loans = larger delegated intermediaries will generate higher econs of scale in monitoring = greater portfolio diversification than any lender could achieve. But who is monitoring the monitor? FIs as Delegated Monitors:  By acting as an asset transformer, a FI acts as delegated monitor = efficiently produces info on the activities of a borrowing firm = reduces moral hazard.  E.g. instead of each individual buying the firm’s debt and incurring monitoring costs, the indiv give their funds to a bank, which issues deposits to them. Bank manager (loan officer) also contributes their own funds (bank equity), and makes a loan to (purchase debt of) firm. Bank manager – residual claimant = incentive to be a delegated monitor of the borrowing firm’s activities. Therefore, only manager incurs the cost of monitoring.  Delegated m...