Chapter 11. The Economics of Financial Intermediation

1. Chapter 11. The Economics of Financial Intermediation • 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

3. 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

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

6. Payments system • 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

8. Liquidity • 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

10. Information • 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

12. 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

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

15. 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

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

18. example 2: bank loan • 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

20. 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

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

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

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

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