Chapter 11. The Economics of Financial Intermediation

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Chapter 11. The Economics of Financial
Intermediation

• The role of financial intermediaries
• Asymmetric Information

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The role of financial intermediaries

• Depository institutions
• Banks, SLs, credit unions
• Nondepository institutions
• Mutual funds, pension funds, insurance companies,
  finance companies

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• Indirect finance (through intermediary) is most
  important source of funds
• Larger than stocks/bonds combined
• Why?
• Intermediaries perform important functions

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5 functions

• Pooling savings
• Payments services
• Liquidity
• Diversification
• Information

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Pooling 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

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Payments system

• Funds are kept safe
• Funds are easily accessed for payments
• Checks, ATM, debit cards, online banking
• Tracks our finances

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

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Liquidity

• Ease/cost of converting assets to cash
• ATMs, checks, etc. to depositors
• Lines of credit to borrowers

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Diversification of risk

• Small savers cannot diversify on their own
• Pooled savings mean large, diversified investment
  portfolios
• Loan portfolios
• Stock/bond portfolios
• Money market accounts

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Information

• 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

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Asymmetric 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

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

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2 problems

• adverse selection
• occurs before the transaction
• moral hazard
• occurs after the transaction

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Adverse 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

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• why a problem?
• uninformed party may leave market
• beneficial transactions do not occur

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Solutions 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

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example 1 life insurance

• adverse selection
• sick/dying people more likely to want life
  insurance
• solution
• health history, blood work, etc.
• or group membership

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example 2 bank loan

• adverse selection
• riskier people more likely to need money
• solution
• credit history, references, collateral.

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Moral Hazard

• after transaction, people likely to engage in
  risky behavior or not do the right thing.
• hazard of lack of moral conduct

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• why a problem?
• uninformed party may leave market
• beneficial transactions do not occur

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Solutions to moral hazard

• Monitoring behavior
• Restrictive convenants on behavior
• Aligning incentives to both parties
• Collateral
• Stock options

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example 1 auto insurance

• moral hazard
• given coverage, drive less carefully or do not
  lock up
• solution
• monitor for tickets
• discount for anti-theft device

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example 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

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Example 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

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Costs of Information

• Screening/monitoring is costly
• But financial intermediaries minimize costs
• Specialization/expertise
• Economies of scale