Why Do Banks Exist?

1. Why Do Banks Exist?

2. Minimize Transactions Costs

3. Minimize Transactions Costs While borrowers and savers might seek each other out and strike deals without going through intermediaries, traditional banking theory says this will be a groping, inefficient process.

4. Minimize Transactions Costs

5. Minimize Transactions Costs • First, she would have to locate a firm that needs money and determine whether it is creditworthy. • Then, she and the firm would have to bargain over how much money she will invest, for how long, and at what rate of return. She would probably prefer to buy securities with small denominations that pay off quickly so her money isn’t all tied up. • The firm, on the other hand, would most likely rather sell just a few large securities, and it may need money for a project that will not pay off until sometime far in the future. Suppose the firm and the saver overcome all of these problems and actually strike a deal. Then, she still has to keep a close watch on the firms until she is paid back.

6. Minimize Transactions Costs Take-away Intermediaries minimize transactions costs (search costs, negotiation costs, and enforcement costs) that serve as barriers between savers and borrowers.

7. Minimize Transactions Costs Transactions services provide by intermediaries to match borrowers and savers include: • Size transformation: buying large securities and offering savers small accounts. • Liquidity transformation: holding securities (like bank loans) that are illiquid (hard to sell, lemon’s problem) while offering securities that are highly liquid (deposits). • Diversification: holding a large portfolio of securities with returns that are not perfectly correlated reduces risk for savers.

8. Minimize Transactions Costs Problem: • Nonbank financial intermediaries like mutual funds can provide transactions services. • Explaining why banks exist apart from other financial institutions requires another angle: information problems.

9. Solve Information Problems

10. Solve Information ProblemsMoral Hazard Agency problems • Managers have inside information about payoffs from investment projects for their firms. This information problem makes it difficult for bondholders and stockholders to monitor.

11. Solve Information ProblemsMoral Hazard Holders of marketable securities have little incentive to monitor. • Information is costly to collect. • Free rider problem:monitoring is a public good. • When an investor supervises a firm, all other investors benefit whether they monitor or not. • But each investor will ignore the benefits he provides others when he decides whether monitoring is worth her time and the trouble. Thus, every investor may decide her personal gains from monitoring are too small, even when the total gains to all investors are quite large. • Everyone would be better off if someone else chose to monitor, yet no one may be willing to do so. In this sense, too little monitoring occurs in securities markets.

12. Solve Information ProblemsMoral Hazard Managerial incentive schemes and bond covenants reduce but do not eliminate agency problems. Why? Bond contracts are inflexible. • Bond contracts with the possibility of costly default discipline management. • But a firm (especially a new firm in a new market) with healthy future prospects might miss a payment or break a covenant due to temporary factors beyond the control of management (a recession). • Both managers and investors would benefit if managers could request some breathing space to recover and respond.

13. Solve Information ProblemsMoral Hazard Bond contracts are inflexible (cont.): • But, when no investor is willing to monitor the firm, the firm’s managers cannot easily convince investors a reprieve is not being used merely to delay the day of reckoning. • Thus, opportunities for timely renegotiation of the contract will be lost. Instead, with the threat of default in mind, managers will attempt to fulfill the terms of the contract, even when this means cutting back on projects that are fundamentally profitable. Worst case scenario: bankruptcy due to severe but temporary shock. Everybody loses from failure to negotiate. Bank lending has the flexibility to avoid this outcome!

14. Solve Information ProblemsMoral Hazard Banks act as delegated monitors. • By borrowing from a bank, a firm replaces many small lenders with a single lender thus providing more flexibility. Since a bank, for example, makes large investments in firms, it will be more willing to monitor and renegotiate contracts than would a group of individual investors. • Replacing many small lenders with one lender also reduces duplication and, hence, total monitoring costs. This is especially true if economies of scale exist in monitoring. • Bank monitoring will also preserve borrower confidentiality, confidentiality that would be compromised if the borrower had to share the details of his project with the capital market. Confidentiality is especially important if the project is easily copied, like a new marketing campaign.

15. Solve Information ProblemsMoral Hazard And banks also have agency problems… • When households lend to firms indirectly through a bank, they have not found a magic wand to make agency problems disappear. • The bank itself is an agent of its depositors, delegated to monitor on their behalf. • Bank insiders know more than depositors about the bank’s current revenues, about problem areas in the loan portfolio, about the efficiency of bank management, etc.

16. Solve Information ProblemsMoral Hazard Solutions to bank agency problems: • Debt contractswith costly default, incentives schemes to align managers and stockholders interests, and bank regulation. As previously noted, these don’t do that much to lower overall agency costs.

17. Solve Information ProblemsMoral Hazard Solution – Diversification! • While the agency costs of indirect lending help to explain why bank loans don’t always replace direct securities, they also seem to pose a paradox. • If depositors place their funds with banks to avoid the agency costs of direct lending, but simply end up with another agent who is difficult to monitor, how can bank loans ever be an improvement over direct lending?

18. Solve Information ProblemsMoral Hazard Diversification (cont.): • The problems of debt finance arise when a borrower with basically healthy prospects cannot make current payments. • If the borrower has many separate projects in different market, however, it is very unlikely that all projects will go bad at once, unless the borrower is particularly inefficient or inept.

19. Solve Information ProblemsMoral Hazard Diversification (cont.): • Similarly, if a bank faithfully monitors a large portfolio of loans that includes different firms in many different markets, the probability of many firms facing troubles at once is quite small. • And this probability falls as the bank’s portfolio grows larger and more diversified.

20. Solve Information ProblemsMoral Hazard Diversification (cont.): • Even with diversification, the threat of bankruptcy forces the bank to monitor. • If a bank is lackadaisical about the soundness of its loan portfolio, then many loans are likely to go bad, and the bank will be unable to pay its depositors.

21. Solve Information ProblemsMoral Hazard Diversification (cont.): • But as long as the bank does monitor, the revenues from a large loan portfolio will tend to be stable. • By monitoring, the bank reduces the likelihood of bankruptcy for its borrowing firms, and by holding a diversified portfolio, it lowers its own probability of bankruptcy. • Thus, indirect lending through a delegated monitor that is well-diversified actually reduces the wasted time and effort of premature bankruptcy proceedings.

22. Solve Information ProblemsMoral Hazard Banks have a comparative advantage in monitoring (uncollateralized loans) because: • Single lender: as discussed before, monitoring and renegotiation are likely to be more efficient with a single lender than with multiple lenders (reduction in total monitoring costs and greater ease of renegotiation). • If this story is correct, banks will not have an edge as lenders in financial markets for long. Finance companies, stockbrokers, insurance companies could perform the single lender function.

23. Solve Information ProblemsMoral Hazard • History as lender: bank is better able to screen loans because it has loaned to the same borrower in the past. • If this story is correct, banks have an edge as lenders in financial markets because of the industry’s long history as commercial lenders, but they may lose this edge gradually to alternative institutions.

24. Solve Information ProblemsMoral Hazard • Informational economies of scope with lending (checking account hypothesis). • Bank is better able to monitor because of an informational economy of scope between lending and checking. • Specifically, access to transactions of borrowers through their checking accounts gives the bank additional information that enables it to monitor the loan. • If this is the case, then institutions that are legally permitted to issue checking accounts would have a unique edge.

25. Solve Information ProblemsMoral Hazard Informational economies of scope between checking and loan monitoring are greatest for small firms doing business exclusively in local markets. • The checking accounts of such firms contain a detailed history of firm cash flows. • The checking account of a large firm with subsidiaries across the country (and, hence, many other checking accounts) contains a great deal less information.

26. Solve Information Problems

27. Solve Information ProblemsAdverse Selection Bank “Seals of Approval”: • Bank monitoring certifies to the market that the firm is behaving efficiently. • Hence, when firms obtain bank loans (or other services from a bank), they receive a “seal of approval.” • This seal makes other securities marketed by the firm more attractive (i.e., lowering their costs).

28. Solve Information ProblemsAdverse Selection The stock price of firm X rises when news a bank has loaned money to firm X hits the market. • The bank loan is a “signal” to the market the firm is sound. The market values the signal because the bank presumably has inside information about the firm. • Hence, the bank loan helps overcome the information asymmetry between the market (outsiders) and the firm’s management (insiders).

29. Solve Information ProblemsAdverse Selection • In short, households and firms value the delegated monitoring services provided by banks. • Households enjoy higher returns because of lower agency costs in lending and firms enjoy lower costs of marketing other securities because of the “seal of approval” that comes with bank monitoring. (Not to mention, the value of the funds obtained from banks.)

30. Solve Information ProblemsAdverse Selection Liquidity Insurance: • The economy offers illiquid projects with high returns and liquid projects with low returns. Obtaining high returns means running the risk of suffering a “liquidity shock.” • If the probability of suffering a liquidity risk were publicly observable, it would be insurable. Agents could invest in illiquid projects and take out “liquidity insurance policies.” • Because liquidity risk is privately observable, however, such policies are not available.

31. Solve Information ProblemsAdverse Selection Liquidity Insurance (cont.): • Banks plug the hole in asset markets by pooling funds obtained from depositors and investing principally in illiquid, high return projects. • Banks also invest some funds in the liquid project so they have sufficient funds to cover the needs of “liquidity shocked” agents.

32. Solve Information ProblemsAdverse Selection • This argument is a new and improved version of the “liquidity transformation” transactions service provided by intermediaries. • This argument provides a “market failure” justification for deposit insurance!

33. Questions?