1. Chapter 11. The Economics of Financial Intermediation The role of financial intermediaries Asymmetric Information The role of financial intermediaries Asymmetric Information

2. The role of financial intermediaries Depository institutions  Banks, S&Ls, credit unions Nondepository institutions  Mutual funds, pension funds, insurance companies, finance companies Depository institutions  Banks, S&Ls, credit unions Nondepository institutions  Mutual funds, pension funds, insurance companies, finance companies

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

4. 5 functions Pooling savings Payments services Liquidity Diversification Information Pooling savings Payments services Liquidity Diversification Information

5. 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 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

6. Payments system Funds are kept safe Funds are easily accessed for payments  Checks, ATM, debit cards, online banking Tracks our finances Funds are kept safe Funds are easily accessed for payments  Checks, ATM, debit cards, online banking Tracks our finances

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

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

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

10. InformationInformation 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 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

11. 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 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

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

13. 2 problems: adverse selection  occurs before the transaction moral hazard  occurs after the transaction adverse selection  occurs before the transaction moral hazard  occurs after the transaction

14. 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 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

15. why a problem?  uninformed party may leave market  beneficial transactions do not occur why a problem?  uninformed party may leave market  beneficial transactions do not occur

16. 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 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

17. example 1: life insurance adverse selection:  sick/dying people more likely to want life insurance solution  health history, blood work, etc.  or group membership adverse selection:  sick/dying people more likely to want life insurance solution  health history, blood work, etc.  or group membership

18. example 2: bank loan adverse selection:  riskier people more likely to need money solution  credit history, references, collateral…. adverse selection:  riskier people more likely to need money solution  credit history, references, collateral….

19. Moral Hazard after transaction, people likely to engage in risky behavior or not “do the right thing.” hazard of lack of moral conduct after transaction, people likely to engage in risky behavior or not “do the right thing.” hazard of lack of moral conduct

20. why a problem?  uninformed party may leave market  beneficial transactions do not occur why a problem?  uninformed party may leave market  beneficial transactions do not occur

21. Solutions to moral hazard Monitoring behavior Restrictive convenants on behavior Aligning incentives to both parties  Collateral  Stock options Monitoring behavior Restrictive convenants on behavior Aligning incentives to both parties  Collateral  Stock options

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

23. 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 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

24. 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 How will funds be used?  Better equipment?  Corporate jet?  Principal-agent problem Do corporate officers act in shareholders’ best interest? Solution: stock options

25. Costs of Information Screening/monitoring is costly  But financial intermediaries minimize costs Specialization/expertise Economies of scale Screening/monitoring is costly  But financial intermediaries minimize costs Specialization/expertise Economies of scale