Financial Intermediation

1
Financial Intermediation

• Lecture 3
• Nature of Financial Intermediation

2
Definition

• Financial institution processor of risk and
  information
• Financial intermediary buy and sell financial
  assets at the same time
• Two functions (1) brokerage matching
  transactions, (2) qualitative asset
  transformation risk management and
  transformation of the nature of claims

3
Brokerage examples

• Transactions services
• Financial advise
• Screening e.g. bond rating
• Origination initiating a loan
• Issuance IPO
• Funding bank making a loan
• Trust activities

4
Qualitative asset transformation

• Monitoring compliance with loan covenants
• Management expertise venture capitalist running
  a firm
• Guaranteeing providing insurance
• Liquidity creation
• Claims transformation

5
Brokerage

• Essential difference does a trader buy goods or
  assets himself? A typical broker does not. Core
  reusability of information
• If we have x agents who pay c costs to get
  informed about a randomly chosen other agent
  total information costs are 2cx2
• A broker pays 2cx, so brokerage saving is S
  2cx (x-1) and dS/dx gt 0

6
Qualitative Asset Transformation

• Transformation of mismatches
• Time, place, owner transformation
• Examples liquidity creation, claims
  transformation
• There is risk exposure in all cases

7
Intermediated vs non-intermediated in The
Netherlands end of 2000

• Financial Assets (intermediated vs
  non-intermediated GDP)
• Households 220.5 vs 71.6
• Firms 33.8 vs 44.4
• Government 3.4 vs 12.4
• Non-residents 74.4 vs 193.4

• Liabilities
• Households 91.0 vs 0
• Firms 94.2 vs 174.9
• Government 11.7 vs 46.0
• Non-residents 63.3 vs 177.4

8
Number of monetary FIs in The Netherlands (2000)

• Universal banks 104
• Cooperatives (RABO) 397
• Savings banks 4
• Branches of foreign institutions 35
• Other credit institutions 16
• Money market funds 25

9
Balance sheet MFIs (balance sheet total, 2000)

• Assets
• Cash 0.2
• Loans 81.8
• Securities (non-shares) 10.1
• Shares 4.0
• Fixed assets 0.5

• Liabilities
• Deposits 73.1
• Securities 15.0
• Capital 0.4
• Money market funds 5.1

10
Balance sheet Pension Funds (balance sheet
total, 2000)

• Assets
• Deposits 1.5
• Securities (non-shares) 35.3
• Shares 50.0
• Other 13.3

• Liabilities
• Technical reserves 97.9
• Other 2.1
• 1019 pension funds!

11
Balance sheet Insurance Companies (BT, 2000)

• Assets
• Deposits 5.2
• Securities (non-shares) 28.5
• Shares 30.6
• Other 35.7

• Liabilities
• Technical reserves 76.7
• Other 23.4
• 376 insurance companies

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Banks are special

• Banks trade private contracts instead of easy to
  handle claims
• Banks have liabilities (deposits) that have a
  typical other character than their assets (loan
  contracts)
• Banks have a systematic risk

13
The basic question why do FIs exist ?

• Old-fashioned explanations transaction costs,
  transformation of risk, time and place,
  diversification and insurance
• Modern explanations information problems like
  adverse selection, moral hazard, costly state
  verification

14
Old-fashioned views

• FIs transform risk, maturity, indivisibilities,
  place, etc. Example from deposits to long-term
  loans
• Why do borrowers not do the job themselves?
• Economies of scope banking and insurance
• Economies of scale lower costs

15
New insights

• Liquidity insurance (Diamond-Dybvig, 1983) we
  will return to this model in discussing
  depositing
• Information sharing coalitions
• Delegated monitoring (Diamond, 1984)

16
Liquidity insurance

• Idea consumers are uncertain about the timing of
  consumption and invest their funds at the bank in
  a deposit as an insurance
• FIs are a pool of liquidity
• If households vary in risk profiles FIs do not
  need to hold full cash for the deposits

17
Information sharing coalitions

• Idea if a group of firms can credibly
  communicate the quality of investment projects,
  borrowing costs will decrease with the number of
  members of the group
• A FI is a coalition of firms
• Scale economies are generated in lender-borrower
  relationships if firms are better informed on the
  quality of the investment project

18
Diamond (1984) delegated monitoring

• Idea banks are good in monitoring projects
  increasing returns to scale
• n firms, 1 unit investment
• cash flow y uncertain, unobservable to FI
• K monitoring costs
• C costs of a debt contract K lt C if the firm
  had a unique financier, it would be optimal to
  choose the monitoring

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Diamond (2)

• Per project m investors are needed
• Direct financing of n projects costs nmK in
  monitoring
• Let the FI do the job nK monitoring costs plus
  costs of monitoring the bank by the depositors
  Cn
• When does Cn nK lt nmK hold?

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Delegated monitoring direct finance
Lender 1
Borrower 1
Lender m
Lender (n - 1)m 1
Borrower n
Lender m
Total cost nmK
21
Delegated monitoring Intermediate finance
Lender 1
Borrower 1
Bank
Lender m
Borrower n
Lender nm
Total cost nK Cn
22
Diamond (3)

• FI is cheaper if
• I Monitoring is efficient K lt C
• II Investors are relatively small m gt 1
• III Investment is profitable Ey gt K R

23
Proof of Diamond monitoring

• Definition of Cn. Bank offers a debt contract
  for a deposit 1/m it offers a repayment Rd / m
• If the announce cash flow of the bank
  z lt nRd, the bank is liquidated z ?yi - nK
• Depositors are risk neutral and have an outside
  investment technology yielding a gross return R

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Proof Diamond (2)

• What is the equilibrium repayment by the bank?
• The depositor must be indifferent between getting
  R on the outside technology or getting the
  minimum of the after cost result (?yi - nK)/n or
  Rd, the deposit rate.
• The cost of delegation are equal to the expected
  nonpecuniary penalty in case of bankruptcy
  Cn E max(nRd nK - ?yi, 0)

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Costs of delegation

• Penalty is designed in such a way that the total
  return to the bank is equal to nRd, which is
  independent of the cash flow ?yi, so that the
  bank has no incentive to misreport earnings
• min(?yi - nK, nRd) Cn nRd, so
• Cn E max(nRd nK - ?yi,0)

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Proof Diamond (3)

• When is nK Cn lt nmK, or K Cn/n lt mK? So it is
  sufficient to prove that Cn / n tends toward 0 if
  n goes to infinity.
• ?yi/n goes to Ey gt K R, so lim Rd R
  deposits are asymptotically riskless
• So Cn/n max (R K -Ey, 0) 0

27
Depository Financial Intermediaries

• Commercial banks payment system and supply of
  deposits, credit supply role for monetary
  transmission issues
• Savings banks
• Credit Unions in one organization (RABObank)

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Nondepository intermediaries

• Venture capitalists supply of equity and debt.
  There is no de novo capital, but performance
  requirements, buyout options
• Finance companies
• Insurance companies
• Pension funds
• Mutuals investment trusts
• Investment banks (Kempen)

29
Background reading

• Greenbaum and Thakor, Contemporary Financial
  Intermediation, Chapter 2.
• Freixas and Rochet, Microeconomics of Banking,
  Chapter 2.
• European Central Bank, Report on financial
  structures