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The Nature of Financial Intermediation

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Presentation on theme: "The Nature of Financial Intermediation"— Presentation transcript:

1 The Nature of Financial Intermediation
Chapter 11 The Nature of Financial Intermediation

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

3 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

4 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

5 Reason of Financial Intermediation
Gathering of Information Through 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

6 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

7 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

8 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

9 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

10 Asymmetric Information in Banking
Asymmetric information in lending leads to two distinct problems for lenders; Adverse Selection 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

11 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

12 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

13 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

14 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

15 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

16 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

17 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

18 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

19 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

20 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)

21 Financial Intermediary Assets in the United States, 1960–2007 (Billions of dollars)

22 Share of Financial Intermediary Assets in the United States, 1960–2007 (Percent)

23 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

24 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

25 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.

26 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

27 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

28 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

29 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)

30 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

31 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

32 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

33 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

34 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

35 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

36 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)

37 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

38 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

39 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

40 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

41 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

42 Commercial bank failures

43 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

44 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

45 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

46 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

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