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Copyright © 2015 McGraw-Hill Education. All rights resered. !o reproduction or distri"ution without the prior written consent o# McGraw-Hill Education.

The Economics of Financial

Intermediation

Chapter Eleven


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Learning Objectives

an understanding of

1. How intermediaries promoteeciency.

2. The central role of informationcosts.

3. Incentive prolems in !nance.


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Introduction•

Financial institutions serve asintermediaries etween savers andorrowers"

• These institutions pool funds from people

and !rms who saves and lend to orrowers.• Intermediaries investigate the !nancial

condition and the est investmentopportunities.

• Intermediaries they reduce investment ris#and economic volatility.


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Introduction• a common measure of !nancial activity$$the

ratio of credit e%tended to real &'( per capita.• not any rich countries with very low levels of

!nancial development.

• the )ow of information prolems and learnhow !nancial intermediaries attempt to solvethem.


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The Role of FinancialIntermediaries

• Financial mar#ets are importantecause they price economicresources and allocate them to their

most productive uses.

• Intermediaries" including an#s andsecurities !rms" continue to play a

#ey role in oth direct and indirect!nance.

• Tale 11.1 illustrates the importance

of di*erent channels of !nance.


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• From the tale we can see+ – To ma#e comparisons across countries of

vastly di*erent si,e" we measure everythingrelative to &'(.

– There is no reason that the value of acountry-s stoc# mar#et" onds outstanding"or an# loans cannot e igger than its &'(.

• hen you add up all the types of

!nancing" direct and indirect" as apercentage of &'(" the numers willgenerally sum to more than 1// in anadvanced economy.


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The Role of FinancialIntermediaries• These data highlight the importance of

intermediaries.

– 0an#s are still critical providers of !nancingaround the world.

– Intermediaries determine which !rms canaccess the stoc# and ond mar#ets.

– 0an#s decide the si,e of a loan and interest

rate to e charged. – ecurities !rms set the volume and price of

new stoc#s and ond issues when theypurchase them for sale to investors.


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• Financial intermediaries areimportant ecause of information.

• ending and orrowing involves othtransactions costs and informationcosts.

• Financial institutions e%ist to reducethese costs.


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In their role as !nancialintermediaries" !nancial institutionsperform !ve functions+1.(ooling the resources of small savers"

2.(roviding safe#eeping and accountingservices" as well as access to paymentssystem"

3.upplying liuidity y converting savers4

alances directly into a means of paymentwhenever needed"

5.(roviding ways to diversify ris#" and

6.7ollecting and processing information inways that reduce information costs.


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Pooling Savings•

The most straightforward economicfunction of a !nancial intermediary is topool the resources of many small savers.

$$ 0y accepting many small deposits"

•

0an#s+ – 8re a place for safe#eeping.

– 8ccess to the payments system $$ thenetwor# that transfers funds

–

peciali,e in handing payments• the intermediary+

– 9ust attract sustantial numers of savers"

– 9ust convince potential depositors

–

reduce the costs of !nancial transactions.


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Safeeeping! Pa"ments S"stem#ccess! and #ccounting

• facilitate the e%change of goods andservices.

• This principal of comparative advantage leads to speciali,ation

• y providing us with a reliale andine%pensive payments system"

• also help us manage our !nances.

• They provide us with oo##eeping andaccounting services"

• to write legal contracts

• do ta#es advantage of economies of scale"


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Providing Li$uidit"

1. Liquidity is a measure of the ease and costthat an asset can e turned

2. Financial intermediaries o*er us the ailityto transform assets into money

3. #eep enough funds in short$term" liuid!nancial instruments to satisfy

5. the an# can reduce the cost of theinvestment" o*ering each individualinvestor liuidity and

6. o*er oth individuals and usinesses linesof credit" which provides liuidity.

:. must speciali,e in liuidity management.

;. it can sustain sudden withdrawals


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%iversif"ing Ris

• enale us to diversify ourinvestments and reduce ris#.

• 0an#s ta#e deposits from

thousands of individuals andma#e loans.

• provide a low$cost way for

individuals to diversify.


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Collecting and ProcessingInformation

• the lender faces sustantial costs to otainthat information" results in an informationasymmetry . –

0orrowers have information that lenders don4t.• reduce the prolems that information

asymmetries

• 9ar#ets reuire sophisticated information to

wor# well.• Issuers of !nancial instruments #now more

aout their usiness prospects andwillingness to wor#


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Information #s"mmetriesand Information Costs

• 8symmetric information is aserious hindrance

• It poses two important ostacles

1. 8dverse selection arises – enders need to #now how to

distinguish good credit ris#s from ad.

2. 9oral ha,ard occurs – ill orrowers use the money as they

claim<


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•

The 9ado* scandal was a classicPonzi scheme+

• Investors fail to screen and monitorthe managers

• 8 fa=ade of pulic respectailitycontriutes to the success of a (on,ischeme"

• Everyone acted as if someone elsewas monitoring" so they could en>oythe free ride.


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#dverse Selection• ?sed cars and the mar#et for lemons+

– ?sed car uyers can4t tell good cars from ad.

– ellers have a good car" won4t accept less thanthe true value.

– If uyers are only pay average value" good car

sellers will withdraw

– Then the mar#et has only the ad cars.

• solve the asymmetrical informationprolem. – 7onsumer @eports

– 9ore recently 78@F8A

– Bou can also hire a mechanic to loo# over

– eginning to o*er Ccerti!edD used cars"


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Solving the #dverseSelection Problem•

If you can4t tell good from ad companies – toc#s or onds of good companies are

undervalued" and

– wners will not want to sell them.

• the prolems of adverse selection are notgood.

– ome companies will pass up goodinvestments.

– Economy will not grow

• !nd ways for investors and lenders todistinguish good !rms from ad !rms.


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%isclosure of Information• to solve the prolem of asymmetric

information is to provide more information.

• public companies are reuired to disclosemore information.

• For e%ample" in the ?.." the ecurities andE%change 7ommission E7G reuires !rmsto produce pulic !nancial statements

•

with the help of some unethicalaccountants" found some cases tomanipulate the statements to disguisetheir !rms4 true !nancial condition


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%isclosure of Information

• there is private information collected andsold to investors. – To e credile" companies cannot pay for this

research"

– @esearch services li#e 9oody4s" alue ine" and'un and 0radstreet collect information directlyfrom !rms

•

(rivate information services face a free$rider prolem. – 8 free$rider is someone who doesn4t pay the

cost to get the ene!t of a good or service.(ulic liraries suscrie


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Collateral and &et 'orth•

8nother solution for adverse selection isto ma#e sure lenders are compensatedwith the coll. – If a loan is insured in some way" then the

orrower isn4t a ad credit ris#.• 7ollateral is something of value pledged

y a orrower to the lender.

• ?nsecured loans" li#e credit cards" areloans made without collateral. – 0ecause of this they generally have very high

interest rates.


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Collateral and &et 'orth•

The net worth is the owner4s sta#e ina !rm $ – et worth serves the same purpose as

collateral

– If a !rm defaults" the lender can claimfor the !rm4s net worth.

• From the perspective of themortgage lender" the homeowner4shouse serves the same function asnet worth

• 9ost small usiness owners must put

up their homes and other property as


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(oral )a*ard+ Problem andSolutions

• 9oral ha,ard arises when we cannotoserve people4s actions andtherefore cannot judge ,hether

a poor outcome was intentional or >ust a result of ad luc#.

• 8 second" information asymmetry

arises ecause the orrower #nowsmore than the lender aout the wayorrowed funds"


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(oral )a*ard+ Problem andSolutions• How do we solve the prolem<

• the manager will use the funds in a waythat is most advantageous to them" notyou.

•

The separation of your ownership fromtheir control creates what is called a principal-agent problem.

• to align managers4 interests with those of

stoc#holders. – there is no foolproof way of ensuring managers

will ehave in the owner4s est interest

– E%ecutives were given stoc# options


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(oral )a*ard in %ebtFinance

• hen the managers are the owners"moral ha,ard in euity !nancedisappears.

• 0ecause det contracts allow owners

encourage ris# ta#ing.• enders need to !nd ways to ma#e

sure orrowers don4t ta#e too manyris#s.

• det !nance ecause lenders get thefull ene!t of the upside" thedownside is limited to collateral.


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Solving the (oral )a*ardProblem in %ebt Finance

• egal contracts can solve themoral ha,ard prolem in det!nance.

– 0onds and loans carry restrictivecovenants

– to maintain a certain level of networth" a minimum credit rating"

– For e%ample+ home mortgagesreuire home insurance" !reinsurance" etc.


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&egative Conse$uences ofInformation Costs


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Financial Intermediaries andInformation Costs

• 9uch of the information is used to+ – @educe information costs" and

– 9inimi,e the e*ects of adverse selection andmoral ha,ard.

• To do this" intermediaries+ – creen loan applicants"

– 9onitor orrowers" and

– (enali,e orrowers y enforcing contracts.

• The lender uses a credit score.

• reuests a credit score" they have to pay"eliminating the free rider prolem.


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(onitoring to Reduce (oral)a*ard

•

Intermediaries insure against thistype of moral ha,ard y monitoring

– 9any hold signi!cant numer of

– They may place a representative

• For new companies" a !nancialintermediary called a venturecapital rm does the monitoring. – They speciali,e in investing – Finally" the threat of a ta#eover

helps to persuade managers to actin the interest


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)o, Companies Finance -ro,thand Investment

1.ealthy countries have high levels of!nancial development" and

2.Intermediaries play #ey roles oth in directand indirect !nance.

3. a !rm can also use its own pro!ts" can

reinvest the earnings into the !rm.

5. managers have superior information

aout running ma#es internal !nance


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)o, Companies Finance -ro,thand Investment


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)ome,or%ue date ne.t 'ee


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1. hat prolem associated withasymmetric information was central to

0ernard 9ado*4s success in cheatingso many investors for so long<

2. Financial intermediation is not con!nedto an# lending ut is also carried outy non$an# !rms such as mutual fundcompanies. How do mutual funds helpovercome information prolems in

!nancial mar#ets


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3. In some countries it is very dicult forshareholders to !re managers when theydo a poor >o. hat type of !nancing

would you e%pect to !nd in thosecountries


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6. ne of the solutions to the adverseselection prolem associated withasymmetric information is the pledging of

collateral. However" the collateral may eris#ier than initially thought.

8s an e%ample" e%plain why thecollateral did not wor# adeuately to

mitigate the mortgage securiti,ationprolems associated with the !nancialcrisis of 2//;$2//K<


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:. If a an# has 1"/// depositors" eachof whom deposits L1"/// in thean#" and the an# ma#es loans of

L1/"/// each" then each depositorhas contriuted+

1////M1///N1/

;. How are !nancial intermediariesale to reduce transactions costs<


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O. hich of the following is an e%ample of adverse selection<

• 8G 8 homeowner with a large !re insurance policy allows thewiring in her house to deteriorate.

• 0G 8 woman with a large life insurance policy ta#es up s#y diving.

• 7G Bour rother$in$law orrows L2/"/// from you to open a pi,,aparlor" ut spends it gamling at the racetrac# instead.

• 'G 8 man with a ad heart condition uys a large life insurancepolicy.

K. hy do higher interest rates increase adverse selectionprolems in the loan mar#et<

• 8G Higher interest rates reduce the gains from economies ofscale.

• 0G 8s interest rates rise" the creditworthiness of the average loan

applicant declines.• 7G Higher interest rates reduce information prolems in the loan

mar#et.

• 'G 8t higher interest rates fewer investment pro>ects arepro!tale.


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1/G 9oral ha,ard prolems arise when

• 8G lenders have diculty in distinguishingetween good and lemon !rms.

•0G when a downturn in economic activityma#es repaying loans dicult for orrowers.

• 7G orrowers default on loans.

• 'G orrowers have an incentive to conceal

information.

• 8nswer

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