CHAPTER 8
The Economics of Financial Intermediation
Direct vs. Indirect Finance
• Finance is the process of shifting excess funds from
savers to borrows.
• Savers and borrowers may connect directly in equity and
debt markets – issuance of stocks and bonds.
• Substantial amount of funds are intermediated through
institutions.
Link
Domestic Financing Profile
Total domestic financing equals the sum of total domestic credit provided by the banking
sector, total local currency (LCY) bonds outstanding, and total equity outstanding. Percentage
shares are computed to show the relative importance of each type of domestic financing.
Stock market capitalization is used as a proxy for total equity outstanding.
External vs. Internal Finance
• Internal finance is the retention & re-investment of profits
by firms. Perhaps the main source of finance for
commercial investment.
• External finance is raising funds through borrowing or
issuance of securities.
• Issuance of new equity of securities is a small part of
external finance…
But foregone dividends of shareholders is a
large part of internal finance.
Historical Growth of Asian LCY Bond Market
Link
This indicator shows the absolute amount of local currency (LCY) bonds outstanding in USD,
categorized as government and corporates. Government bonds include obligations of the
central government, local governments, and the central bank. Corporates comprise both public
and private companies including financial institutions and international organizations. Financial
institutions comprise both private and public sector banks and other financial institutions.
DEFAULT RISK
Uncertainty vs. Asymmetric Information
• Bond issuers and investors both face uncertainty about a
wide variety of factors that might impact likelihood of
repayment or value of repayment. This creates risk.
• Risk is a negative characteristic that might reduce the price
of bonds or increase the premium on bonds.
Default Risk: Bonds by Rating
• A bond is in default if the issuer misses a payment of
interest or principal.
• Though all bonds involve some risk, for all practical
purposes, are default-free. In the $US bond market, U.S.
Treasury bonds are the benchmark default free bond. In
HK, Exchange Fund bonds play this role. (Be careful, not
all government debt is risk-free).
• Bond rating agencies (Moody’s and Standard & Poor’s
assess default risk for bonds).
• A bond with a significant probability of default must pay a
higher return to compensate purchasers for the risk.
Market
CN
HK
ID
JP
KH
KR
MY
PH
SG
TH
VN
Rating
AAAAA
BB+
AAB+
A+
ABBB
AAA
BBB+
BB-
Date
12/16/2010
12/16/2010
4/28/2014
4/27/2011
2/19/2008
9/19/2014
7/26/2013
5/8/2014
5/3/2013
12/11/2012
6/6/2012
Default Risk and Asymmetric Information
• Key risk characteristic of bonds is default risk.
• Default – Bond issuer fails to make a required coupon or
face value payment.
• Default risk depends on conditions faced by bond issuer.
• Bond issuer almost certainly more knowledgable about
own conditions than potential buyer.
Asymmetric Information
•
•
Asymmetric Information A condition that
occurs when one party to a transaction has
more information about the good tha does
the other.
In bond/financial markets, borrowers have
some information about their opportunities
or activities that they do not disclose to
lenders, creditors or insurers.
Adverse Selection
• Asymmetric information causes least desirable counter-
parties to a transaction are most attracted to the
transaction.
• People with bad used cars are most likely to want to sell their cars.
• Sick people are the most likely to want to buy health insurance.
• Untrustworthy borrowers are most likely to want to borrow.
Lemon Problem: Bond Market
• Some firms have risky prospects (lemons) and
some firms have safe prospects (creampuffs).
• Bond buyers cannot distinguish between them.
They offer bond prices which are an average of the
price of creampuff bonds and lemon bonds.
[Another way of putting this is that interest rates are
an average of creampuff and lemon rates].
• Potential borrowers with creampuff prospects may
finance their own projects.
Raising Interest Rates May Not
Compensate for Risks in Bond Markets
• Only borrowers with lemon prospects will join
bond markets.
• Typically we think bond buyers might take riskier
assets if they were offered a higher interest rate.
• But if savers demand a higher interest rate under
asymmetric information this will only exacerbate
the lemon problem if higher interest rates drive
creampuff borrowers out of the market.
Adverse Selection: The Bond Market
Consider a bond market with three types of bond
sellers.
1. Safe: Financing a safe, low-return project. Can
only pay 7.5% interest rate but will never default.
2. Speculative: Financing a high risk/high return
project will pay a 15% interest rate, but a high
probability of default.
3. Crooks: Will offer to pay any interest rate, but will
never repay.
Assume that 75% of bond issuers are safe, 20% of
bond issuers are speculative, and just 5% are
crooks.
Discount Bonds
• Investments are financed with discount bonds, in this
case, paper that will pay 100 after 1 year. Price of the
bond is PB.
• Gross interest rate is 1+i =100/PB .
• Bond buyers will pay:
• 97 for a discount bond issued by a borrower identified
as safe;
• 90 for a bond issued by a borrower identified as
speculative
• 0 for bond issued by a crook.
• If they cannot distinguish, they will pay a value
equal to the expected value of the pool.
Bond Buyers
• In this pool, the expected value is
(.75*97)+(.2*90)+(0.05*0) = 90.75 which implies a
yield to maturity of i = .102.
Expected Value
• We can use the statistical concept of expected value to
answer these questions.
• Expected payoff to a project with two possible outcomes
PayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2
Borrower
will Pay
Share
at Most
Safe
0.75
7.50%
Speculative
0.2
15%
Crook
0.05 Anything
Unknown Type
Investor
will pay
at Most
97
90
0
90.75
or get
at least
1.030928
3.09%
1.111111
11.11%
∞
1.101928
10.19%
Bond market breaks down!
• Rate of interest offered by uninformed investor is
attractive to speculative borrowers but to
expensive for safe borrowers.
• They will drop out of the market. As bond buyers
begin to realize the riskiness of pool is changing,
they will reassess price that they will pay for bonds.
• The pool will now be 80% speculative and 20%
crooks. The expected value of bonds in this pool is
(.8*90)+(.2*0)=72 implying a yield of i = .3889.
This is too much for speculative borrowers.
• Only crooks will stay in the market. Ultimately the
bond market will disappear.
Reducing Adverse Selection Through Information Gathering
1.
Information Gathering – Bond rating agencies perform the
function of analyzing possibility of repayment.
Free Rider Problem – Gathering information about firms is costly, but
once gathered it can be shared very cheaply. Information firms do not
receive funds from all who benefit from their services. Information may be
underprovided by markets.
2.
3.
Government Regulation – One solution to the free rider
problem is for the government to issue rules requiring
sellers of securities to provide honest information about their
firms.
Financial Intermediation – Banks specialize in acquiring
information and reducing monitoring costs. Typically, they do
not share information so do not face the free rider problem
as severely. Since financial intermediaries engage in
financial transactions repeatedly, their reputation is at stake
if they abuse asymmetric information.
Asymmetric Control and Moral Hazard
• Financial transactions are often characterized by
asymmetric control. Two parties to a transaction
may both have a stake in the outcome but one
party’s actions may have a disproportionate
impact on the outcome.
• Moral hazard is the temptation for the party with
disproportionate control to benefit themselves at
the expense of other party.
Debt
• Speculative Investments – Owners may get
upside benefits, share downside risks with
investors
Moral Hazard: One Example
•
Lender lends $100 to borrower at 5% interest.
Borrower can choose between two investment
projects each of which require an upfront pay-off of
$100.
Two Projects
• Project A is a risky project but potentially lucrative. With an
80% probability, project A will generate 0 payoff. With a
20% probability project A will generate a $205 payoff.
• Project B is a non-risky project which will generate a payoff of $110 with an 80% probability and a pay-off of $95
with an 20% probability.
Three Questions
1.
2.
3.
Which project will A choose if he is risk-neutral.
Which project would B choose if he is risk-neutral
Which project is most advantageous to a risk-neutral
society.
Which project is socially beneficial?
• Expected payoff to project A is
.8∙$0 +.2·$205 = $41
Since cost is $100, the expected payoff to project A
is less than the cost. To a risk neutral or risk averse
society this project will be bad.
• Expected payoff to project B is
.8∙$110 +.2·$95 = $107
Since cost is $100, the expected payoff to project B
is more than cost. To a risk neutral society this
project is good (though the risk might be to large
for a sufficiently risk-averse society).
Pay-offs, Project A
• With 80% probability, the payoff to the project will be $0
so both the borrower and lender get $0.
• With 20% probability, the pay-off to the project will be
$205, so the lender will be repaid $105 and the borrower
will keep $205-$105 = $100.
• The expected payoff to the project for the lender
will be .2∙$105+.8∙0=$21.* The expected payoff to
project A for the borrower is .2∙$100+.8∙0=$21.
*The lender would not lend if they believed the borrower would conduct
project A.
Payoffs, Project B
• With 20% probability, the payoff to the project will be $95,
so the lender will only be repaid $95 and the borrower
keeps $0.
• With 80% probability, the payoff to the project will be $110,
so the lender is repaid $105 and the borrower keeps $5.
• The expected payoff to the project for the lender will
be .2∙$95+.8∙$105 =$103*. The expected payoff to
project A for the borrower is .2∙$0+.8∙$5=$4
*Note that this is greater than the money
lent, the lender makes positive returns.
Which project will be undertaken?
• If the borrower has control of the funds, then he will
choose project A. The expected value of the payment to
him is higher for the riskier project. This is because the
lender takes all of the downside of a risky investment and
none of the upside.
• The lender of course prefers the reverse. He would
choose the socially beneficial project B.
• This example demonstrates the problem of moral hazard
in debt markets. Because he shares none of the downside,
the borrower will choose inefficiently risky projects once
he has control of the funds.
Restrictive Covenants
•
Debt agreements place restrictions on activities of
borrowers.
•
•
•
•
Restrict spending of funds
Require maintenance of minimum net worth
Require maintenance of value of collateral
Free Rider Problem: For a bond with many owners, it
may not be worth the trouble for any one of them to
ensure contracts are enforced.
Collateral/Net Worth
•
•
Most debt is backed by some sort of collateral. In the
case of default, lender takes possession of some
physical or financial asset of relatively clear value.
Lenders will only lend to firms with a high net worth. This
means lenders can make claims on the outstanding
assets of companies in the case of debt default.
Net Worth Example
• If borrowers have their own capital invested as well as
borrowed funds, they are much less likely to engage in
risky behavior.
• Go back to 1st Moral hazard example. Assume that the
lender is only willing to lend $50 and the borrower must
kick in $50 on their own.
Pay-offs, Plan A (Pt. 2)
• With 80% probability, the payoff to the
project will be $0 so both the borrower
and lender get $0.
• With 20% probability, the pay-off to the
project will be $205, so the lender will be
repaid $52.5 and the borrower will keep
$205- $52.5 = $152.5
• Expected pay-off to the borrower is $30.5, less
than the $50 that they must kick in.
Payoffs, Project B
• With 20% probability, the payoff to the project will be $95,
so the lender will be repaid $52.5 and the borrower keeps
$42.5.
• With 80% probability, the payoff to the project will be $110,
so the lender is repaid $52.5 and the borrower keeps
$57.5.
• The expected payoff to the project for the lender will
be =$52.5*. The expected payoff to project Afor the
borrower is .2∙$42.5+.8∙$57.5=$54.5
Financial Intermediaries and …
• Adverse Selection: Banks specialize in evaluating
borrowers and avoid the free rider problem by holding
their own loans.
• Moral Hazard: Banks use their economies of scale to act
as delegated monitors for their depositors.
Bank Dominance in Asia
300%
250%
% of GDP
200%
150%
100%
50%
0%
CN
HK
ID
JP
KR
Corporate Local Currency Bond Market
MY
PH
Bank Credit
SG
TH
Conclusion
• A key role for banks is to solve problems associated with
asymmetric information by evaluating borrowers and
monitoring them.
• Solutions to moral hazard problems rely on effective legal
foundations.
• Banks are especially important for emerging markets.