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WHY DO BANKS EXIST?
OVERVIEW LECTURE
I.
Minimize Transactions Costs
A.
Depository intermediaries like savings and loans, mutual funds, and banks
link ultimate borrowers, especially firms, and ultimate savers, the households
of the economy.
1.
While borrowers and savers might seek each other out and strike deals
without going through intermediaries, traditional banking theory says that
this will be a groping and inefficient process.
a)
2.
B.
C.
II.
Example: Consider what a typical saver would have to do to
invest her money in some firm without using an intermediary.
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
that 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.
Intermediaries minimize transactions costs (search costs, negotiation costs,
and enforcement costs) that serve as barriers between savers and firms.
Transactions services provided by intermediaries to match borrowers and savers:
1.
Size transformation: buying large securities and offering savers small
accounts.
2.
Liquidity transformation: holding securities (like bank loans) that are
hard to sell (lemon’s problem) while offering securities that are highly
liquid (deposits).
3.
Diversification: holding a large portfolio of securities with returns that are
not perfectly correlated reduces risk for savers.
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
Solve Information Problems
A.
Solve Moral Hazard Problems (Delegated Monitoring)
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1.
Agency problems: managers have inside information about the payoffs
from investment projects for their firms. This information problem makes
it difficult for bondholders and stockholders to monitor.
2.
Holders of marketable securities have little incentive to monitor.
3.
a)
Information is costly to collect
b)
Free rider problem: monitoring is a public good. When an
investor supervises the firm, all other investors benefit whether the
monitor or not. But each investor will ignore the benefits he
provides others when he decides whether monitoring is worth the
time and the trouble. Thus, every investor may decide that his
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
Managerial incentive schemes and bond covenants reduce but do not
eliminate agency problems.
a)
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 due
to a temporary factor beyond the control of management (a
recession).
Both managers and investors would benefit if
managers could request some breathing space to recover and
respond. But, when no investor is willing to monitor the firm, the
firm’s managers cannot easily convince investors that 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.
i)
4.
Worst case scenario: bankruptcy due to severe but
temporary shock.
Everybody loses from failure to
negotiate.
Banks act as delegated monitors:
a)
By borrowing from a bank, the firm replaces many small lenders
with as 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.
b)
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.
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c)
5.
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.
But, bank loans do not replace all securities:
a)
bank monitoring certifies to the market that the firm is
behaving efficiently, thereby making other securities marketed by
the firm more attractive (i.e., lowering their costs).
b)
Banks have agency problems, as well. When savers lend to firms
indirectly through a bank, they have not found a magic wand that
makes 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.
c).
Solutions to bank agency problems
i)
Debt contracts with costly default, incentives schemes to
align managers and stockholders interests, bank
regulation. These don’t do that much to lower overall
agency costs.
ii)
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?
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. 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.
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 bank and the bank will be unable to pay its
depositors. But as long as the bank does monitor, the
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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.
6.
Banks have a comparative advantage in monitoring (uncollateralized
loans) because:
a)
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).
i)
b)
History as lender: bank is better able to screen loans because it
has loaned to the same borrower in the past.
i)
c)
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.
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.
i)
B.
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.
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.
Solve Adverse Selection Problems
1.
Bank “Seals of Approval”: As noted above, 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
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approval.” This seal makes other securities marketed by the firm more
attractive (i.e., lowering their costs).
2.
a)
As we shall see, the stock price of firm X rises when news that a
bank has loaned money to firm X hits the market. The bank loan is
a “signal” to the market that 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).
b)
In short, households and firm 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 obtain from banks.)
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. Banks plug the hole in asset markets by pooling
funds obtained from depositors and investing principally in the illiquid,
high return project. Banks also invest some funds in the liquid project so
that they have sufficient funds to cover the needs of “liquidity shocked”
agents. Because banks invest funds in the high return project, they can
offer depositors a higher return than that obtainable from direct investment
in the illiquid project.
a)
This argument is a new and improved version of the “liquidity
transformation”
transactions
service
provided
by
intermediaries.