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