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Lecture 1 – Theories of Financial Intermediaries Intro: -

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Economist (1999) – ‘Banks at heart of ec activity.’ Allen and Santomero (1998), paper ‘The theory of financial intermediation’ – banks have existed since ancient times, and now play major role in ‘transformation of savings from the household sector, into investments in real assets’. Fin markets expanded, transaction costs fallen, info now cheaper/more available. Bank (e.g. commercial/investment/saving/credit union) = FI – mechanism for transferring funds and allocating to most productive opps, allowing ec agents to smooth consumption. Insurance comps = FI. In news - City of Glasglow bank (CPG) collapsed – lending was concentrated with small number of enterprises (concentration risk). Management manipulated bank’s share price, and the f/s were falsified. Banks collect surplus funds from indiv (savers/lenders – hold fin claim, a FA), and allocate to firms (dissavers/borrowers – hold FL) with deficit funds, acting as intermediary doing unique form of asset transformation. This increases ec efficiency by creating credit and better allocation of resources, as shown below.

Alt is DIRECT FINANCE: -

No intermediary – borrows obtain funds directly from lenders in fin markets. Barriers: o Difficult/expensive match complex needs of indiv borrowers/lenders. o Incompatibility of fin needs. o Lenders want:  Minimise cost and risk of borrower not repaying.  Liquidity – prefer ST. o Borrowers want:  Funds at low cost.  Specified date/period of time.  Prefer LT – e.g. comp borrowing to buy equip, positive returns only in LT.

Asymmetric info: -

Info is central to fin transactions/contracts, asymmetric info needs FI. One party has better info that counterparty. 3 problems – not everyone has same info, imperfect info and insider info. E.g. borrower knows more about risks/returns of investment, than lender. Leland and Pyle (1977) - ‘entrepreneurs possess ‘inside’ info about their own projects for which they seek financing. E.g. investor buying equity in Apple – doesn’t know full details about operations/prospects. Regulators – to reduce mismatches in info.

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Mishkin and Eakins (2005) – Enron bankrupt Dec 2001 – complex set of transactions, kept substantial amounts of debt/fin contracts off b/s. Shows that even though gov regulation can reduce asymmetric info problems, can’t eliminate, as managers have big incentives to hide comp problems = hard for investors to know true value of firm.

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Distorts firm/user’s incentives = significant inefficiencies, esp cos info isn’t a free good, and acquisition of info isn’t costless.

Problems: Adverse Selection (AS) – before transaction: -

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Before buying firm’s debt/equity, indiv – search costs to investigate qual. Poorest (adverse) qual firms have most incentive to issue securities to unwary investors. Better informed ec agent = incentive exploit info adv/exaggerate qual of commodity being exchanged. Akerlof (1970) – ‘lemon’ problem, famous study ‘The market for ‘lemons’.’ Buyer opinion AFTER purchasing. E.g. second hand car market – seller knows if car is lemon (bad), but buyer only makes judgement after running. As buyer doesn’t know qual of car, all cars of same type sell at same p, even if lemons, therefore, buying lemon = lowers p that buyers preparing to pay for car, and as second-hand p low, non-lemon buyers = little incentive to put on market! FM – results in firms attracting wrong type clients. In banking – occurs as result of loan pricing. Relationship between return expected from certain loan and loan p, is increasing and positive, only up to certain point (e.g. IR of 12%), and any p above that level (shaded), will decrease expected return for bank, as shown.

Solutions to AS: o Signalling:  Informed party, e.g. warranty.  Leland and Pyle (1997) – intermediary can signal informed status, by investing in assets it has special knowledge. o Screening:  Less informed party, to determine info which informed party has.  E.g. insurance comp – health history info.  E.g. FIs – screen out/monitor customers by assessing risk profile, and adjust loan rates to reflect indiv risks.  HOWEVER, recent trends (IT) – reduced need screen qual/monitor large firm activities. o The Brokerage Function:  Resolves AS.  Act as broker – provide info to indiv about qual of security issues.  Therefore, only one entity (FI) incurs costs to screen qual of securities.  Merton (1989) – FI can transact at near zero cost, but surplus units would incur substantial transaction/search costs if seek borrowers directly, so this is efficient way to produce info. These include, obtaining info, negotiating contract, costs of monitoring borrower and eventual enforcement if doesn’t fulfil commitment.

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‘Without an intermediating info broker, there would be enormous duplication in info production as each investor attempts to screen the firm’ (Ramakrishnan and Thakor, 1984). E.g. if firm issue IPO – pot investors don’t know qual. Reputable inv bank underwriter researches firm, organises ‘road show’, informing of qual = willing purchase sec at fair offering p. broker ‘matches’ savers to qual firms that need funding.

Moral Hazard (MH) – after transaction: -

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Leland and Pyle (1977) – ‘MH prevents direct info transfer.’ After buying sec, indiv must monitor firm’s managers – incentive to spend excessively on risky projects, when control other people’s money – agency costs. o Principal-agent problem – agent superior info/expertise after contract. Can’t be eff/costlessly monitored/controlled by principal. o Solution - In banking - relationship banking – informal agreements btwn bank/borrowers, build future relationships/improve info flow = lower screening/monitoring costs for bank compared new customers, borrower – future loans at lower IR. In banking – after loan granted – risk borrowers may engage undesirable act = repayment less likely. o Solution – Screening - screen out excessively high risk, and monitor perf borrowers – look at periodic reports/credit rating agencies info.

Risk and Liquidity: -

Firm’s debt/eq had diff risk/mat/liq, might not attractive to certain indiv.

Role as Delegated Monitors: -

Efficiently produces info about borrower = reduces asymmetric info and MH. Monitoring: o Screening projects, preventing opp behaviour, acting policeman – punishing if fail meet contract oblig. o Monitoring credit risk (default) = costly/time, so efficient for dep to delegate to banks – expertise/econs of scale. Diamond (1996) states that ‘the cost of monitoring and enforcing debt contracts issued directly to investors, is a reason that raising funds through an intermediary can be superior.’ o E.g. instead of each indiv buying firm’s debt and incurring monitoring costs – give funds bank, which issues deposits to them. Bank mang also contrib bank eq, makes loan to purchase debt of firm. Bank mang = residual claimant = incentive to be deleg monitor of activities, and only party incurring costs, as shown.

Banks – comp adv in monitoring activ. Diamond (1984) – ‘Fin intermediation and deleg monitoring’ theoretical models, 3 assumptions: -

Scale econ in monitoring: o Lewis (1991) – internalised function means banks profit from info econ of scale. o Diversification increases with number of loans = delegated FIs = higher econs of scale in monitoring = low monitoring costs than indiv. o Risk transformation function – diversifying investments, pooling risks, screening/monitoring borrowers, whilst holding reserves as buffer to unexpected losses = minimise risk of indiv borrowers = lowers prob of bank default.

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Capacity of investors must be small, compared to size of investment: o Size transformation – collect funds from savers in small-size deposits, repackage larger-size loans, financing many borrowers.

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Low cost of delegation: o Cost monitoring/controlling FI < surplus gained from scale econs (inc vol of transactions = lower cost per unit) = cost-benefit analysis.

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HOWEVER, problem with info from monitor – reliable? Monitor needs incentives perform properly. HOWEVER, reputation effects – banks have developed lots of rep capital as monitors of credit risk. ALSO, regulators monitoring them!

Functions of FI: Asset transformation: FIs hold LT, high risk and large denomination claims, and issue ST, low risk and small denomination deposit claims. They process risk and change nature of assets: -

ADV: o

o o

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Asset diversification – transform large denom FA – smaller units. E.g. insurance comp pools risks of accidents by indiv. In return for contrib insurance prem (cash), indiv has claim on insurance comp, pays off when accident. Able to provide assets large size, while accepting small size dep at same time = size transformation. Asset evaluation – act evaluators of credit risk for dep, by exploting asymmetric info btwn agents, for profit.  Bank profits from info it produces, by private loans – avoids free rider (people who don’t pay for info, take adv info others paid – e.g. investors follow others buying sec).  Eval signals, build customer relationships = info adv = dep willing to place funds, knowing directed appropriate borrowers, without incurring costs.

DISADV: o Risk – if one large loan defaults = headache!

Liquidity transformation: -

Offer contracts that are highly liq, and low price-risk to savers, and held on liab side of b/s, which are financed by relatively illiquid and higher-risk assets (e.g. loans), on its asset side. i.e. hold assets/liab of diff liq on both sides of b/s. Benefits: o Bryant (1980) – improved liq and risk sharing for dep on liab side of b/s. o Diamond and Rajan (2001a and 2001b) – liquidity mismatched b/s = ‘fragile capital structure’ = central to ec role and rationale for bank. o Fragility of bank = driver!

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Risks: o o

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HOWEVER, financing LT assets (loans) using ST dep = bank fragile = if lots if depositors decide to withdraw funds. Vulnerable to runs (many depositors simultaneously seek to redeem their claims, due to concern bank will default if they wait). Diamond and Dybvig (1983) – theoretical model – run can cause bank default, that wouldn’t otherwise.  E.g. Northern Rock –Economist (2007) - This was the first bank run in Britain, since 1866. Stable bank, until liquidity crisis of 2007, where it couldn’t acquire backing from institutional lenders. After news broke, its stock fell to 32%. Dep ran - queues of formed outside its branches, to withdraw their money. Nationalised – 2008.  HOWEVER, deposit insurance = incentive to remove run. Economist (2013) – banks unstable, cos gamble people won’t withdraw all cash at same time = backed deposit insurance (gov, i.e. taxpayers cover losses of depositors), avoid run. To provide liq, banks = high leverage = bad!

Maturity Transformation: -

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Recent FI theory suggests banks with excessive maturity mismatches (e.g. Segura and Suarez, 2012) = vulnerable to liq shocks, e.g. fin crisis. Transform short-mat (demandable) dep into long-mat loans/assets. E.g. convert demand dep into 25-year mortgages. Dep = more liq than underlying loans (can withdraw for cash at dep discretion). Benefits: o Reduce risk through divers – better able to bear risk of mismatching mat of LT assets and ST liab. o Mat mismatching = incentive screen before issuing loan, and monitor borrowers after lending. Risks: o Risk transformation of relatively certain dep vs uncertain assets. o Mismatch of assets and liab, and inc mat gap to boost profits = incs exposure to int rate risk. o Borrowing short, lending long = liq risk probs.

Other: -

Econ of scope – joint cost producing two complementary outputs < combined cost producing separately. E.g. mortgages and life insurance policies (capital – building, labour – bank mang). HOWEVER – conflicts of interest.

Conclusion: -

In conclusion, this essay has highlighted the primary functions of FI. Main points = FI have comp adv over direct financing, e.g. economies of scale. It can be argued that FI have a vital role in the economy....