Asymmetric information, financial intermediation and basic banking

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Asymmetric information, financial intermediation
and basic banking

• Chap 8 and 10, Mishkin

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• Corporate financial structures across developed
  nations reveal some common features
• The methods of financing in order of importance
  are bank loans and non-bank loans (56), bonds
  (32) and stocks (11)
• Only a few large corporations have access to
  securities markets.
• Collaterals are a common feature in debt
  contracts. These contracts also place substantial
  restrictions on activities
• Financial systems are heavily regulated

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• Facts point towards big role played by financial
  intermediaries in financial markets.
• In chap 8 we study two reasons why financial
  intermediaries play a big role
• Financial intermediation and transactions costs
• economies of scale
• expertise

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• 2. Financial intermediation and Lemons (adverse
  selection) problem
• When a lender cannot distinguish between
  good stocks (bonds) and bad stocks (bonds),
  he/she is willing to pay only a price
• As a result good stocks (bonds)
• Ways to reduce adverse selection problems are,
• private production and sale of information by
  specialized firms
• this arrangement however can cause its own
  problem -
• A free rider is
• Govt. regulation to increase information
• example SEC requiring

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• financial intermediation
• collateral and net worth
• net worth firms assets liabilities

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3. Financial intermediaries and moral
hazard principal-agent problem in financial
markets tools to solve principal-agent
problem monitoring government regulation
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Financial intermediation debt vs. equity
contracts
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Reducing moral hazard problems in equity
contracts net worth and collateral restrictive
covenants
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4. Banks are by far the most important category
of financial intermediaries and merit special
study. The Banks Capital Account Checkable
deposits Bank reserves Discount loans,
Repos Bank capital The building/equipment
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T-bonds, notes, bills Municipal bonds, Federal
govt. agency bonds Non-transaction
deposits Federal funds Commercial loans Real
estate loans Consumer loans
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5. Basic Banking T-account analysis

• 1. You deposit 100 cash into your account with
  the First National Bank (FNB)
• (FNB) Assets (FNB) Liabilities
• _______________
  ___________________
• 2.You deposit a 100 check into your account with
  the FNB. The check is drawn on Second National
  Bank (SNB).
• FNB (Initial) Assets FNB (Initial) Liabilities
• ____________________
  _____________________
• FNB (Final) SNB
  (Final)
• Assets Liabilities Assets Liabilities
• Conclusion

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• 6. Principles of bank management
• Bank manager manages these four
• Liquidity
• Assets
• Liability
• 4. Capital

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7. Liquidity management The following bank
maintains only the required amount of reserves at
any point of time. Is it a wise decision?
Assets Reserves 10m Liabilities Deposits 100 m
Loans 90 m Securities 10 m Bank capital 10 m

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• What can the bank do to acquire reserves at a
  short notice? Note the costs
• Borrow from other banks (__________) /from
  corporations (_______)
• Sell securities such as _______
• Borrowing from the FED (________ loans)
• Calling in loans/selling of loans in secondary
  markets
• Conclusion

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• 8. Asset management
• basic principle of asset management banks have
  high need of liquidity compared to other
  financial intermediaries, hence
• find borrowers with ________
• these risks are compounded by
  
  Usual strategies to managing credit risks
• (ii) find securities with ________

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(iii) diversify besides
the other most important type of risk banks face
is ________. Managing ___________risk
Assets
Liabilities Rate sensitive assets 20m Rate
sensitive liabilities 50m i. variable-rate
loans i. variable rate
CDs ii short-term loans ii. money
market accounts Iii short term securities Fixed
rate assets 80m Fixed rate liabilities
50m i.reserves
i.checkable deposits ii.long-term loans
ii.savings deposits iii.long-term
securities iii.long-term
CDs Conclusion If interest sensitive assets are
less than interest sensitive liabilities banks
can _________ if interest rates _________.
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• 9. Capital management
• Bank capital
• is a cushion against __________
• (ii) determines the rate of return for owners
• Net profit after tax / equity capital
• (___________/ _________) x (_________/
  ___________)
• (iii) required by law