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