978-1259285295 Chapter 11 Lecture Note

Unlock access to all the studying documents.

View Full Document

Chapter 11 – The Economics of Financial Intermediation

Chapter 11

The Economics of Financial Intermediation

Chapter Overview

In theory, the market system may seem neat and simple, but in reality economic growth is

a messy, chaotic thing. Problems with the flow of information between parties in a

market system can derail economic growth unless they are addressed properly. This

chapter discusses some of those information problems and the ways that financial

intermediaries attempt to solve them.

Learning Objectives: Establish an understanding of:

1. How intermediaries promote efficiency

2. The central role of information costs

3. Incentive problems in finance

Important Points of the Chapter

Economic well-being is inextricably tied to the health of the financial intermediaries that

make up the financial system. These institutions pool funds from people and firms who

save and lend them to people and firms that need to borrow, and when they do their job

correctly, investment and economic growth increase at the same time that investment risk

and economic volatility decrease. There is a strong link between financial development

and economic development; without a stable, well-functioning financial system, no

country can prosper.

Application of Core Principles

Principle #4: Markets. Financial intermediaries provide access to the payments system

and so facilitate the exchange of goods and services, promoting specialization.

Moreover, reducing the cost of financial transactions also promotes more trade and

specialization.

Principle #2: Risk. Banks mitigate risk by taking deposits from a large number of

individuals and make thousands of loans with them, thus giving each depositor a small

stake in each of the loans.

Principle #2: Risk. Risk requires compensation, and in the bond market this means that

the higher the risk, the greater the risk premium. If a lender can’t tell whether a borrower

is a good or bad credit risk, the lender will demand a risk premium based on the average

risk. The good borrowers are likely to withdraw from the market rather than pay the high

rate, and only the bad borrowers will be left.

11-1

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

Teaching Tips/Student Stumbling Blocks

To emphasize the five functions performed by financial intermediaries (i.e., they

pool the resources of small savers; they provide safekeeping and accounting

services as well as access to the payments system; they supply liquidity; they

provide ways to diversify small investments (reducing their risk); and they collect

and process information in ways that reduce information costs) have students list

the various financial intermediaries with which they do business. Which

function(s) are performed by each?

Have students consider the factors that might affect their credit scores. Students

may not realize that a credit card with no balance but which has a credit amount is

treated exactly as if that amount was owed; this is a good example of how a lender

deals with moral hazard (i.e., the borrower could go out tomorrow and charge that

amount to the credit card). On the other hand, lenders also look at how much of

the total credit a person has is “available.”

Features in this Chapter

Your Financial World: Your First Credit Card

The interest rate on your first credit card is likely to be very high because you have no

credit history, and the company issuing the card will assume the worst. This is adverse

selection at its worst. After a while, when you establish a track record, you should be

able to get a card at a lower rate.

Applying the Concept: The Madoff Scandal

The fraud perpetrated by Bernard Madoff stands out as extraordinary, though it was an

ordinary Ponzi scheme. Why do such schemes work? They work for a number of

reasons, including investors failing to screen and monitor the managers of their

investments, and public respectability of those managers. Further, sometimes the

government agencies responsible for overseeing the managers fail to detect the scheme.

Your Financial World: Private Mortgage Insurance

If you try to buy a house with a down payment of less than 20 percent of the purchase

price, the lender may require you to buy private mortgage insurance (PMI), which insures

the lender in the event that the borrower defaults on the mortgage. You can cancel the

insurance when the amount you owe on your mortgage falls to less than 80 percent of the

value of your home; this can happen as a result of your making payments to reduce the

principal on the loan or as a result of increases in home values.

11-2

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

Applying the Concept: Deflation, Net Worth, and Information Costs

Deflation is bad because it aggravates information problems in ways that inflation does

not. It means that a firm’s net worth goes down as a result of drops in asset values,

making it less trustworthy as a borrower. This is what occurs at the start of a recession:

the value of the firm falls, lenders become more reluctant to lend, and the availability of

investment funds falls, pushing the economy further into the recession.

Lessons from the Crisis: Information Asymmetry and Securitization

A key source of the financial crisis of 2007-2009 was insufficient screening and

monitoring in the securitization of mortgages. These problems began with the loan

originators who eased standards and reduced screening to increase the volume of lending

and their own profitability. The distributors—the next stage of lending that assembled

these loans into securities—did little to forestall the decreased standards although they

could have had higher requirements. The securitization then resulted in frequent trading

to get rid of the security before it defaulted. Rating agencies continued the problem by

awarding high ratings to MBSs and investors relied on others opinions of the securities.

Had housing prices continued to increase, this collateral system would have worked.

In the News: China Shadow Bankers Go Online as Peer-to-Peer Sites Boom

Peer-to-peer lending is increasing in China as traditional methods of private lending

among family and friends moves online. China’s peer-to-peer lenders let individuals

invest a minimum of 50 yuan in projects for as much as 23 percent interest, the highest

rate allowed by law.

Lessons of the Article: Will peer‐to‐peer lending sites grow enough to offer

serious competition to banks and other financial intermediaries? Not unless they

can likewise expand lenders’ ability to screen and monitor borrowers to

minimize the problems of adverse selection and moral hazard. With only

rudimentary screening by peer‐to‐peer lenders, only the borrowers know the

risks of the loans.

Additional Teaching Tools

In an article from the Wall Street Journal, Jane Kim discusses the appealing switch from

banks to credit unions. Benefits include higher interest rates on deposits, lower fees, and

lower rates on borrowing.

11-3

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

Virtual Tools

Give students an overview of the different aspects of financial intermediaries by visiting

the Citigroup website. Students can click on logos to find out more about the different

components of that corporation. Among other interesting facts: Banamex, Mexico’s

largest commercial bank, is part of Citigroup. http://www.citigroup.com/citi/

Students can find out more about their state’s lemon laws by visiting the site of the

National Lemon Law Center. Use this as a jumping off point for a discussion of the role

of government in addressing information problems.

http://www.nationallemonlawcenter.com/

For more information on credit scores, students can visit this site from Wikipedia:

http://en.wikipedia.org/wiki/Credit_score

Credit reports can be obtained on this site set up by the big three credit-reporting agencies

to provide such reports for free:

https://www.annualcreditreport.com/cra/index.jsp

More and more states (25 at the time of writing) are allowing people to freeze their credit

reports. For a discussion of the pros and cons see this page from Bankrate.com:

http://www.bankrate.com/brm/news/cc/20030613c1.asp

For More Discussion

Have students consider a transaction like selling a car or a house; you may wish to do this

as a role-playing exercise. Students are likely to quickly discover that they need

information about whether a potential buyer actually has the resources to complete the

transaction.

Here’s another topic for discussion: have students consider whether they would buy a

used car from a person or from a dealership. What are the pros and cons of each and how

does that relate to the chapter material?

Chapter Outline

I. The Role of Financial Intermediaries

1. As a general rule, indirect finance through financial intermediaries is much

more important than direct finance through the stock and bond markets.

2. In virtually every country for which we have comprehensive data, credit

extended by financial intermediaries is larger as a percentage of GDP than

stocks and bonds combined.

11-4

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

3. Around the world, firms and individuals draw their financing primarily from

banks and other financial intermediaries.

4. The reason for this is information; financial intermediaries exist so that

individual lenders don’t have to worry about getting answers to all of the

important questions concerning a loan and a borrower.

5. Lending and borrowing involve transactions costs and information costs, and

financial intermediaries exist to reduce these costs.

6. Financial intermediaries perform five functions: they pool the resources of

small savers; they provide safekeeping and accounting services as well as

access to the payments system; they supply liquidity; they provide ways to

diversify small investments; and they collect and process information in ways

that reduce information costs.

7. The first four of these functions have to do with the reduction of transactions

costs.

8. International banks handle transactions that cross borders, which may mean

converting currencies.

Pooling Savings

1. The most straightforward economic function of a financial intermediary is to

pool the resources of many small savers.

2. To succeed in this endeavor the intermediary must attract substantial numbers

of savers.

3. This is the essence of indirect finance, and it means convincing potential

depositors of the soundness of the institution.

4. Banks rely on their reputations and government guarantees like deposit

insurance to make sure customers feel that their funds will be safe.

B. Safekeeping, Payments System Access, and Accounting

1. Goldsmiths were the original bankers; people asked the goldsmiths to store

gold in their vaults in return for a receipt to prove it was there.

2. People soon realized that trading the receipts was easier than trading the gold

itself.

3. Eventually the goldsmiths noticed that there was gold left in the vaults at the

end of the day, so it could safely be lent to others.

4. Today, banks are the places where we put things for safekeeping; we deposit

our paychecks and entrust our savings to a bank or other financial institution

because we believe it will keep our resources safe until we need them.

5. Banks also provide other services, like ATMs, checkbooks, and monthly

statements, giving people access to the payments system.

11-5

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

6. Financial intermediaries also reduce the cost of transactions and so promote

specialization and trade, helping the economy to function more efficiently.

7. The bookkeeping and accounting services that financial intermediaries

provide help us to manage our finances.

8. Providing safekeeping and accounting services as well as access to the

payments system forces financial intermediaries to write legal contracts,

which are standardized.

9. Much of what financial intermediaries do takes advantage of economies of

scale, which means that the average cost of producing a good or service falls

as the quantity produced increases.

10. Information is also subject to economies of scale.

C. Providing Liquidity

1. One function that is related to access to the payments system is the provision

of liquidity.

2. Liquidity is a measure of the ease and cost with which an asset can be turned

into a means of payment.

3. Financial intermediaries offer us the ability to transform assets into money at

relatively low cost (ATMs are an example).

4. Financial intermediaries provide liquidity in a way that is both efficient and

beneficial to all of us.

5. By collecting funds from a large number of small investors, a bank can reduce

the cost of their combined investment, offering the individual investor both

liquidity and high rates of return.

6. Financial intermediaries offer depositors something they can’t get from the

financial markets on their own.

7. Financial intermediaries offer both individuals and businesses lines of credit,

which are pre-approved loans that can be drawn on whenever a customer

needs funds.

D. Diversifying Risk

1. Financial intermediaries enable us to diversify our investments and reduce

risk.

2. Banks mitigate risk by taking deposits from a large number of individuals and

make thousands of loans with them, thus giving each depositor a small stake

in each of the loans.

3. Providing a low-cost way for individuals to diversify their investments is a

function all financial intermediaries perform.

11-6

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

E. Collecting Processing Information

1. One of the biggest problems individual savers face is figuring out which

potential borrowers are trustworthy and which are not.

2. There is an information asymmetry because the borrower knows whether or

not he or she is trustworthy, but the lender faces substantial costs to obtain the

same information.

3. Financial intermediaries reduce the problems created by information

asymmetries by collecting and processing standardized information.

II. Information Asymmetries and Information Costs

1. Information plays a central role in the structure of financial markets and

financial institutions.

2. Markets require sophisticated information in order to work well, and when the

cost of obtaining information is too high, markets cease to function.

3. Asymmetric information is a serious hindrance to the operation of financial

markets, and solving this problem is one key to making our financial system

work as well as it does.

4. Asymmetric information poses two obstacles to the smooth flow of funds

from savers to investors: adverse selection, which involves being able to

distinguish good credit risks from bad before the transaction; and moral

hazard, which arises after the transaction and involves finding out whether

borrowers will use the proceeds of a loan as they claim they will.

A. Adverse Selection

1. Used Cars and the Market for Lemons: In a market in which there are good

cars (“peaches”) and bad cars (“lemons”) for sale, buyers are willing to pay

only the average value of all the cars in the market. This is less than the

sellers of the “peaches” want, so those cars disappear from the markets and

only the “lemons” are left.

a. To solve this problem caused by asymmetric information, companies like

Consumer Reports provide information about the reliability and safety of

different models, and car dealers will certify the used cars they sell.

2. Adverse Selection in Financial Markets: Information asymmetries can drive

good stocks and bonds out of the financial market.

B. Solving the Adverse Selection Problem

1. Disclosure of Information: Generating more information is one obvious way

to solve the problem created by asymmetric information.

a. This can be done through government required disclosure and the private

collection and production of information.

11-7

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

b. However, the accounting scandals of 2001 and 2002 showed that in spite

of such requirements companies can distort the profits and debt levels

published in their financial statements.

c. Reports from private sources such as Moody’s and Value Line are often

expensive.

2. Collateral and Net Worth: Lenders can be compensated even if borrowers

default, and if the loan is so insured then the borrower is not a bad credit risk.

a. The importance of net worth in reducing adverse selection is the reason

owners of new businesses have so much difficulty borrowing money.

C. Moral Hazard: Problem and Solutions

1. An insurance policy changes the behavior of the person who is insured.

2. Moral hazard plagues both equity and bond financing.

3. Moral Hazard in Equity Financing: people who invest in a company by

buying its stock do not know that the funds will be invested in their best

interests.

a. The principal-agent problem, which occurs when owners and managers

are separate people with different interests, may result in the funds not

being used in the best interests of the owners.

4. Solving the Moral Hazard Problem in Equity Financing: The problem can be

solved by if owners can fire managers and by requiring managers to own a

significant stake in their own firm.

5. Moral Hazard in Debt Finance: Debt goes a long way toward eliminating the

moral hazard problem, but it doesn’t finish the job; debt contracts allow

owners to keep all the profits in excess of the loan payments and so encourage

risk taking.

6. Solving the Moral Hazard Problem in Debt Finance: To some degree, a good

legal contract with restrictive covenants can solve the moral hazard problem

in debt finance.

III. Financial Intermediaries and Information Costs

A. Screening and Certifying to Reduce Adverse Selection

1. Borrowers must fill out a loan application that includes information that can

be provided to a company that collects and analyzes credit information and

which provides a summary in the form of a credit score.

2. Your personal credit score tells a lender how likely you are to repay a loan; the

higher your score the more likely you are to get a loan.

3. Banks collect additional information about borrowers because they can

observe the pattern of deposits and withdrawals, as well as the use of credit

and debit cards.

11-8

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

4. Financial intermediaries’ superior ability to screen and certify borrowers

extends beyond loan making to the issuance of bonds and equity.

5. Underwriting represents screening and certifying because investors feel that if

a well-known investment bank is willing to sell a bond or stock then it must

be a high-quality investment.

B. Monitoring to Reduce Moral Hazard

1. Intermediaries monitor both the firms that issue bonds and those that issue

stocks.

2. Banks will monitor borrowers to make sure that the funds are being used as

intended.

3. Financial intermediaries that hold shares in individual firms monitor their

activities, in some cases placing a representative on a company’s board of

directors.

4. In the case of new firms, a financial intermediary called a venture capital firm

does the monitoring.

5. The threat of a takeover helps to persuade managers to act in the interest of

the stock and bondholders.

6. In the end, the vast majority of firm finance comes from internal sources,

suggesting that information problems are problems too big for even financial

intermediaries to solve.

Terms Introduced in Chapter 11

adverse selection

asymmetric information

collateral

deflation

free rider

moral hazard

net worth

unsecured loan

11-9

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Total credit market debt owed TCMDO

Total credit market debt owed by household sector HSTCMDODNS

Total credit market debt owed by nonfinancial corporate

business

NCBTCMDODNS

Total credit market debt owed by domestic financial sector TCMDODFS

Market value of equities (nonfarm nonfinancial corporate

business)

MVEONWMVSNNC

Bank loans owed (nonfarm nonfinancial corporate business) BLNECLBSNNCB

Bank loans owed (nonfarm noncorporate business) BLNECLBSNNB

Other loans and advances owed (nonfarm nonfinancial

corporate business)

OLALBSNNCB

Other loans and advances owed (nonfarm noncorporate

business)

OLALBSNNB

Total debt to equity ratio (US) TOTDTEUSQ163N

Total debt to equity ratio (Germany) TOTDTEDEQ163N

11-10

McGraw-Hill Education.

Chapter 11 – The Economics of Financial Intermediation

Lessons of Chapter 11

1. Financial intermediaries specialize in reducing costs by

a. Pooling the resources of small savers and lending them to large borrowers.

b. Providing safekeeping, accounting services, and access to the payments system.

c. Providing liquidity services.

d. Providing the ability to diversify small investments.

e. Providing information services.

2. For potential lenders, investigating a borrower’s trustworthiness is costly. This

problem, known as asymmetric information, occurs both before and after a

transaction.

a. Before a transaction, the least creditworthy borrowers are the ones most likely to

apply for funds. This problem is known as adverse selection.

b. Lenders and investors can reduce adverse selection by

i. Collecting and disclosing information on borrowers.

ii. Requiring borrowers to post collateral and show sufficient net worth.

c. After a transaction, a borrower may not use the borrowed funds as productively as

possible. This problem is known as moral hazard.

i. In equity markets, moral hazard exists when the managers’ interests

diverge from the owners’ interests.

ii. Finding solutions to the moral hazard problem in equity financing is

difficult.

iii. In debt markets, moral hazard exists because borrowers have limited

liability. They get the benefits when a risky bet pays off, but they don’t

suffer a loss when it doesn’t.

iv. The fact that debt financing gives managers/borrowers an incentive to take

too many risks gives rise to restrictive covenants, which require borrowers

to use funds in specific ways.

3. Financial intermediaries can solve the problems of adverse selection and moral

hazard.

a. They can reduce adverse selection by collecting information on borrowers and

screening them to check their creditworthiness.

b. They can reduce moral hazard by monitoring what borrowers are doing with

borrowed funds.

c. In the end, the vast majority of firms’ finance comes from internal sources,

suggesting that information problems are too big for even financial intermediaries

to solve.

11-11

McGraw-Hill Education.