chapter 11. the economics of financial intermediation the role of financial intermediaries...

Chapter 11. The Economics of Chapter 11. The Economics of Financial IntermediationFinancial IntermediationChapter 11. The Economics of Chapter 11. The Economics of Financial IntermediationFinancial Intermediation

• The role of financial intermediaries

• Asymmetric Information

• The role of financial intermediaries

• Asymmetric Information

The role of financial intermediariesThe role of financial intermediariesThe role of financial intermediariesThe role of financial intermediaries

• Depository institutions Banks, S&Ls, credit unions

• Nondepository institutions Mutual funds, pension funds,

insurance companies, finance companies

• Depository institutions Banks, S&Ls, credit unions

• Nondepository institutions Mutual funds, pension funds,

insurance companies, finance companies

• Indirect finance (through intermediary) is most important source of funds Larger than stocks/bonds

combined

• Why? Intermediaries perform important

functions

• Indirect finance (through intermediary) is most important source of funds Larger than stocks/bonds

combined

• Why? Intermediaries perform important

functions

5 functions5 functions5 functions5 functions

• Pooling savings

• Payments services

• Liquidity

• Diversification

• Information

• Pooling savings

• Payments services

• Liquidity

• Diversification

• Information

Pooling savingsPooling savingsPooling savingsPooling savings

• Many small savers…

• Pooled together to make large loans or investments 100 savers with $1000 becomes a• $100,000 loan by a bank OR• $100,000 stock portfolio with a mutual

fund

• Many small savers…

• Pooled together to make large loans or investments 100 savers with $1000 becomes a• $100,000 loan by a bank OR• $100,000 stock portfolio with a mutual

fund

Payments systemPayments systemPayments systemPayments system

• Funds are kept safe

• Funds are easily accessed for payments Checks, ATM, debit cards, online

banking

• Tracks our finances

• Funds are kept safe

• Funds are easily accessed for payments Checks, ATM, debit cards, online

banking

• Tracks our finances

• This function has large economies of scale As output rises, per unit cost falls Very true for financial services

• This function has large economies of scale As output rises, per unit cost falls Very true for financial services

LiquidityLiquidityLiquidityLiquidity

• Ease/cost of converting assets to cash

• ATMs, checks, etc. to depositors

• Lines of credit to borrowers

• Ease/cost of converting assets to cash

• ATMs, checks, etc. to depositors

• Lines of credit to borrowers

Diversification of riskDiversification of riskDiversification of riskDiversification of risk

• Small savers cannot diversify on their own

• Pooled savings mean large, diversified investment portfolios Loan portfolios Stock/bond portfolios Money market accounts

• Small savers cannot diversify on their own

• Pooled savings mean large, diversified investment portfolios Loan portfolios Stock/bond portfolios Money market accounts

InformationInformationInformationInformation

• Collecting it and using it Info about borrowers Info about investments

• By doing this on a large scale become experts at it Do it for a lower per unit cost

• Collecting it and using it Info about borrowers Info about investments

• By doing this on a large scale become experts at it Do it for a lower per unit cost

Asymmetric InformationAsymmetric InformationAsymmetric InformationAsymmetric Information

• 2 parties in a transaction

• one has better info than the other could exploit this for advantage

• if not controlled, this leads to markets breaking down

• 2 parties in a transaction

• one has better info than the other could exploit this for advantage

• if not controlled, this leads to markets breaking down

• Asym. info affects buy/sell goods• eBay, used cars

insurance market lending market

• Asym. info affects buy/sell goods• eBay, used cars

insurance market lending market

2 problems:2 problems:2 problems:2 problems:

• adverse selection occurs before the transaction

• moral hazard occurs after the transaction

• adverse selection occurs before the transaction

• moral hazard occurs after the transaction

Adverse selectionAdverse selectionAdverse selectionAdverse selection

• people most who are most risky are more likely to seek insurance borrow money sell their crappy stuff

• the adverse are more likely to be selected

• people most who are most risky are more likely to seek insurance borrow money sell their crappy stuff

• the adverse are more likely to be selected

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

Solutions to adverse selectionSolutions to adverse selectionSolutions to adverse selectionSolutions to adverse selection

• Screening (banks, insurance)

• Disclosure of info Public companies required by SEC to

produce public financial statements

• Collateral & Net Worth Bad borrowers less likely to have

collateral

• Screening (banks, insurance)

• Disclosure of info Public companies required by SEC to

produce public financial statements

• Collateral & Net Worth Bad borrowers less likely to have

collateral

example 1: life insuranceexample 1: life insuranceexample 1: life insuranceexample 1: life insurance

• adverse selection: sick/dying people more likely to

want life insurance

• solution health history, blood work, etc. or group membership

• adverse selection: sick/dying people more likely to

want life insurance

• solution health history, blood work, etc. or group membership

example 2: bank loanexample 2: bank loanexample 2: bank loanexample 2: bank loan

• adverse selection: riskier people more likely to need

money

• solution credit history, references,

collateral….

• adverse selection: riskier people more likely to need

money

• solution credit history, references,

collateral….

Moral HazardMoral HazardMoral HazardMoral Hazard

• after transaction, people likely to engage in risky behavior or not “do the right thing.”

• hazard of lack of moral conduct

• after transaction, people likely to engage in risky behavior or not “do the right thing.”

• hazard of lack of moral conduct

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

Solutions to moral hazardSolutions to moral hazardSolutions to moral hazardSolutions to moral hazard

• Monitoring behavior

• Restrictive convenants on behavior

• Aligning incentives to both parties Collateral Stock options

• Monitoring behavior

• Restrictive convenants on behavior

• Aligning incentives to both parties Collateral Stock options

example 1: auto insuranceexample 1: auto insuranceexample 1: auto insuranceexample 1: auto insurance

• moral hazard given coverage, drive less

carefully or do not lock up

• solution monitor for tickets discount for anti-theft device

• moral hazard given coverage, drive less

carefully or do not lock up

• solution monitor for tickets discount for anti-theft device

example 2: bank loanexample 2: bank loanexample 2: bank loanexample 2: bank loan

• moral hazard get the loan and “blow the money” so

cannot pay it back

• solution collateral insurance to protect collateral consequences on credit report Restrictions on how money is used

• moral hazard get the loan and “blow the money” so

cannot pay it back

• solution collateral insurance to protect collateral consequences on credit report Restrictions on how money is used

Example 3: equity financingExample 3: equity financingExample 3: equity financingExample 3: equity financing

• How will funds be used? Better equipment? Corporate jet? Principal-agent problem• Do corporate officers act in

shareholders’ best interest?

• Solution: stock options

• How will funds be used? Better equipment? Corporate jet? Principal-agent problem• Do corporate officers act in

shareholders’ best interest?

• Solution: stock options

Costs of InformationCosts of InformationCosts of InformationCosts of Information

• Screening/monitoring is costly But financial intermediaries

minimize costs• Specialization/expertise• Economies of scale

• Screening/monitoring is costly But financial intermediaries

minimize costs• Specialization/expertise• Economies of scale