Chapter 11

The Nature of Financial Intermediation

Economics of Financial Intermediation

Reasons for Financial Intermediation Reduction of Transaction Costs Portfolio Diversification Gathering of Information

Reason of Financial Intermediation

Reduction of Transaction Costs Transaction Cost implies the cost of bringing lenders and borrowers together

This cost can be substantial when an individual savers (lenders) want to find out the right (creditworthy) borrowers

This is especially true for small savers and small borrowers

Financial intermediary can minimize this transaction cost by specializing and being efficient in loan production

Reason of Financial Intermediation

Portfolio Diversification Diversification suggests that spreading investment over a large number of negatively correlated securities reduces the portfolio risk

However, this option requires a large amount of investment and therefore not available to small saver or lenders

Intermediaries can achieve this by pooling assets from large number of small savers and investing in a well diversified portfolio

Reason of Financial Intermediation

Gathering of InformationThrough specialization and economies of scale Intermediaries become efficient at

collecting and processing information Evaluating credit risks Generating of information to reduce the

impact of asymmetric information

Asymmetric Information

Exists when buyers and sellers not equally informed about the product under transaction

Specifically, seller knows more about quality of the product than buyers

In extreme situation this may lead to market failure where no exchange can take place

Example: Market of Lemons (used cars) Assume there are two types of used cars in the market: Good cars and Bad cars

Every seller knows the exact type of his/her car

However, buyers only knows distribution of each type

Market for Lemons

In particular, buyers know that 50% of the cars for sale are good 50% are lemons

Assume, Good cars worth 10,000 and Bad cars worth 6,000

In this situation, what should a buyer offer for a car of unknown type?

A risk neutral buyer will offer expected value of the car

Expected value here is the probability weighted average value:

(1/2)*(10,000) + (1/2)*(6,000) = 8,000

Market for Lemons

At this offer price, which type of cars do you think would be bought and sold in the market place?

Yes, only the lemons All good car sellers will pull out the market characterized by asymmetric information

This is an example of market failure for good cars

Market for Lemons

Can you suggest some ways to reduce the extent of asymmetric information so the market is restored? 3 months warranty of power-train or buy back policy (lemon laws)

Independent inspection by a mechanic Third party insurance for repairs Disclosure laws requiring sellers to disclose all known defects

Asymmetric Information in Banking

Asymmetric information in lending leads to two distinct problems for lenders;

1. Adverse Selection2. Moral Hazard This two major concepts will visit

us over and over again throughout the book

It is important to understand and differentiate them clearly and carefully

Adverse Selection

In Banking context, Asymmetric Information takes the following forms: Borrower knows more about the project (risk,

cash flow, costs and future performance) than lender

To obtain credit at a favorable rate, borrowers have an incentive to understate risk and overstate the positive aspects of the project

For this reason, lenders faces a risk of financing risky projects or borrowers

This is known as Adverse Selection Note, this problem occurs even before the loan

is made

Adverse Selection and Market Failure

Note, lenders know the distribution of low and high risk borrowers. But do not know the exact type of any given borrower

If lenders charge a low interest, losses to high risk borrowers will be more than profits from low risks

To compensate the loss of default if lenders charge a high interest, low risk borrowers look elsewhere —leaves just the high risk borrowers

Adverse Selection and Market Failure

Only high risk borrowers will be willing to accept a high interest rate for their risky projects (high return, but low probability of success)

These borrowers will have no problem defaulting on loans in case of failures

In adverse selection, borrowers who are most likely to cause an undesirable outcome are also the most likely to apply for loans

Adverse Selection and Market Failure

In such situation, lenders may decide not to lend money at all to any small businesses (information-opaque borrowers)

This leads to classic market failure due to adverse selection similar to markets for lemons

Moral Hazard

Moral Hazard is another problem that results from Information Asymmetry

In moral hazard, Borrowers know more about his/her true risk type than lenders

Monitoring is imperfect (or costly) Borrowers have incentive to engage in a more risky projects than normal after the loan is made

There are two reasons for moral hazard: Risk shifting Imperfect or costly monitoring

Risk Shifting

Risk shifting means disproportionate sharing of risk In the event of success, borrower keeps full reward

However, in the event of failure, borrower shifts the loss onto lender by defaulting on the loan

Therefore, taking risks works to borrowers advantage

This provides incentive to borrowers to assume more risk than normal

Risk Shifting

Whenever one party does not share the full burden of their action and passes the risk onto other party, risk taking becomes excessive

Example: Too Big to Fail policy in which large and systemic lenders know that they will be saved (bailed out) if lose on their bets

This encourages excessive risk raking FDIC insurance may have the same effect

Moral Hazard

In a moral hazard, behavior of one party (borrower) changes after loan is made

Classic example of moral hazard is how driving habits changes after a driver purchases auto insurance with no deductible

Consider a simple example where borrower borrows 100k at 3% interest rate for a project that offers 5% sure return

In this case, if the borrower sticks to his proposed plan his payoff is:

5000 – 3000 = $2000

Moral Hazard

However, after the loan is obtained borrower has an incentive to engage in risky project such as a project that pays following return: Success: 20% return with 50% probability Failure: 0% return with 50% probability

Clearly, this is a risky investment with following payoff: Success: $20,000 with 50% probability Failure: $0 with 50% probability

Therefore, the average payoff would be $10,000

Evolution of Financial Intermediaries

Looking at the percentage share of asset value, there are clear evidence of winners and losers.

Winners Pension funds Mutual funds

Losers Savings and loan associations (S&Ls) Mutual savings banks Life insurance companies Depository institutions (except credit unions)

Financial Intermediary Assets in the United States, 1960–2007

(Billions of dollars)

Share of Financial Intermediary Assets in the United States, 1960–

2007 (Percent)

Evolution of Financial Intermediaries

The Cause Changes in Financial regulations Financial Innovations Technological Innovations

This Evolution can be categorized under three major themes: Interest Rate Volatility Institutionalization of Financial Markets Transformation of Traditional Banking

Interest Rate Volatility

1950s and early 1960s Stable interest rates Fed imposed Regulation Q on depository institution A ceilings on deposit rates a lender can pay to its depositors

Depositories faced no competition to attract short term funds.

Many present day competitors were not even in existence.

Therefore, depositories had a large supply of cheap money

Why Regulation Q Imposed a ceiling (maximum limit) on

deposit rate that depositories can pay to their depositors

Without a ceiling banks would compete against each other for deposits causing deposit rates to increase without a limit

To be profitable these banks would be forced to engage in projects with high return (risky investment)

Higher cost of fund and risky investment would cause higher bank failures

To promote stability, Fed wanted reduced competition through Regulation Q.

Interest Rate Volatility However economy continued to grow through the mid-1960s

Growing economy meant increased demand for loans

Challenge for banks was to find enough deposits to satisfy loan demand.

Increased loan demand meant higher interest rate

However, depository institutions still fell under protection of Regulation Q

Consequences of Regulation Q

Depository institutions could not match higher rates offered by money market instruments such as T-bills and Commercial Paper.

Depositors started to shift their deposits from their savings account to money market instruments

However, this option was not opened to small savers because money market instruments were not sold in small denominations

Wealthy investors and corporations took money from depository institutions and placed in money market instruments – a phenomenon known as Financial Disintermediation

Consequences of Regulation Q

To prevent this exodus, depository came up with ways to undermine Regulation Q. Large denomination (over 100,000) Negotiable Certificate of Deposits (CDs)

Commercial paper through their holding companies

Attracting funds (Eurodollar) from abroad In mid-1960s short-term rates became more volatile and wealthy investors switched from savings accounts to large CDs

Invention of Money Market Mutual Funds in 1971 finally killed Regulation Q

Birth of Money Market Mutual Fund

Increased technological sophistication and financial innovation In 1971 gave rise to Money Market mutual Funds

Small investors pooled their funds to buy a claim on a diversified portfolio of money market instruments

Unlike passbook savings, some mutual funds offered limited checking withdrawals

Small investors now had access to money market interest rates which were much higher than rates permitted by Regulation Q

Finally, the Regulation Q was repealed in 1980 by Depository Institution Deregulation and Monetary Control Act (DIDMCA)

Interest Rate Volatility

Interest rate volatility was also associated with another crisis in the US financial system known as The Savings and Loan (S&L) Crisis

interest rates continued to rise in late 1970s

Large and now small investors moved funds out of banks and thrifts

This was particularly devastating for S&Ls since they were dependent on small savers for their source funding

The Savings and Loan (S&L) Crisis

Rising interest rate reduced the asset values of the S&Ls.

Most of their assets (fixed-rate residential mortgages, 30 year) which can be compared to Bonds.

Interest rate and Bond value are inversely related Market value of mortgages held by S&Ls fell as interest rates rose making the value of assets less than value of liabilities

Banks could not sell their long term assets at high price

However, their insolvency was not detected or reported because in their financial statement assets were measured at the historic value (not current market value) showing positive networth

The Savings and Loan (S&L) Crisis Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Depository Institutions Act of 1982 Dismantled Regulation Q Permitted S&Ls (as well as other depository institutions) to compete for funds at the money market rates

Interest paid on short-term money (competing with mutual funds) was generally double the rate of return on their mortgages – a problem known as Mismatch of Maturity

The Savings and Loan (S&L) Crisis Regulators thought the problem was

temporary. As soon as the interest rate falls, everything will be alright.

Instead of strong regulations, the Garn-St. Germain Act, permitted S&Ls to invest in high yielding assets in which they had little expertise (specifically junk bonds, real estate equity and oil loans)

S&L took the gamble expecting big payoff, which will keep them alive for a while

They had every incentive to do so. They were not going to share downside risks – Moral Hazard

The Savings and Loan (S&L) Crisis

Investors were not concerned because their deposits were insured by Federal Savings and Loan Insurance Corporation (FSLIC)

Result is an approximate $150 billion bail-out—paid for by taxpayers

Another event associated with rising interest rate was the growth of Commercial Paper Markets

Growth of Commercial Paper Markets

Recall everyone rushed to Money Market Mutual Funds creating a large pool of funds looking for short term investment

Managers of these funds purchased Commercial Paper (short term bonds) issued directly by large Corporations and Finance companies

Date suggests a money market mutual funds and commercial paper market grew in a parallel way

Growth of Commercial Paper Markets

Commercial banks suffered from this growth. They lost their highest quality clients (corporate borrower)

Growth of money market mutual funds not only hurt S&L by destroying their source of fund (depositors), but cause disaster to commercial banks by taking away their client base (borrowers)

Technological Innovation The Rise of Commercial Paper was possible because of technological innovation

Computers and communication technology permitted transactions at very low costs competing with commercial banks

Complicated modeling permitted financial institutions to more accurately evaluate borrowers quality – addressing the asymmetric problem

Technological Innovation Permitted banks to more effectively monitor inventory and accounts receivable used as collateral for loans – addressing moral hazard problem

Banks were losing their competitive advantage

Non depositories including mutual funds and pension funds benefitted from technological advancement and were able compete with depositories

Institutionalization

Institutionalization More and more funds flew indirectly into financial markets through financial intermediaries or institutional investors like pension funds and mutual funds

These “institutional investors” have become more important in financial markets relative to individual investors

Easier for companies to distribute newly issued securities via their investment bankers

Institutionalization

Reasons for Institutionalization Growth of pension funds and mutual funds Technological innovations Tax laws encourage additional pensions and

benefits rather than increased wages Employee deferred taxes on their income. New defined contribution plan gave limited

flexibility to employee on how much to save for their retirement

Mutual funds gained from these plans because many of these defined contribution plans invested in mutual funds

Transformation of Traditional Banking

During 1970s & 80s banks faced increased competition from other financial institutions

Extended loans to riskier borrowers and projects

Many of these projects were vulnerable to international debt crisis during 1980s

Bank failures of banks during late 1980s & early 1990s reached its peak

Commercial bank failures

Evolution of Financial Intermediaries

Predictions of demise of banks are probably exaggerated Although banks’ share of the market has declined, bank assets continued to increase

New innovation activities of banks are not reflected on balance sheet Trading in interest rates and currency swaps

Selling credit derivatives Issuing credit guarantees

Evolution of Financial Intermediaries

Banks still have a strong comparative advantage in lending to individuals and small businesses Banks offer wide menu of services Develop comprehensive relationships—easier to monitor borrowers and address information asymmetry problems

Assets, Liabilities, and Management

Unlike a manufacturing company with real assets, banks have only financial assets

Therefore, banks have financial claims on both sides of the balance sheet Credit Risks Banks tend to hold assets to maturity and expect a certain cash flow

Do not want borrowers to default on loans

Need to monitor borrowers continuously Charge quality customers lower interest rate on loans

Detect possible default problems

Assets, Liabilities, and Management

Interest Rate risks Vulnerable to change in interest rates

Want a positive spread between interest earned on assets and interest paid on liabilities

Attempt to maintain an equal balance between maturities of assets and liabilities

Adjustable rate on loans, mortgages, etc. minimizes interest rate risks