Chapter 11
The Nature of Financial
Intermediation
Economics of Financial Intermediation
Reasons for Financial Intermediation
 Reduction of Transaction Costs
 Portfolio Diversification
 Gathering of Information
Reason of Financial Intermediation
Reduction of Transaction Costs
 Transaction Cost implies the cost of bringing
lenders and borrowers together
 This cost can be substantial when an individual
savers (lenders) want to find out the right
(creditworthy) borrowers
 This is especially true for small savers and
small borrowers
 Financial intermediary can minimize this
transaction cost by specializing and being
efficient in loan production
Reason of Financial Intermediation
Portfolio Diversification
 Diversification suggests that spreading investment
over a large number of negatively correlated
securities reduces the portfolio risk
 However, this option requires a large amount of
investment and therefore not available to small
saver or lenders
 Intermediaries can achieve this by pooling assets
from large number of small savers and investing in a
well diversified portfolio
Reason of Financial Intermediation
Gathering of Information
Through specialization and economies of scale
 Intermediaries become efficient at collecting and
processing information
 Evaluating credit risks
 Generating of information to reduce the impact of
asymmetric information
Asymmetric Information
 Exists when buyers and sellers not equally informed
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about the product under transaction
Specifically, seller knows more about quality of the
product than buyers
In extreme situation this may lead to market failure
where no exchange can take place
Example: Market of Lemons (used cars)
Assume there are two types of used cars in the
market: Good cars and Bad cars
Every seller knows the exact type of his/her car
However, buyers only knows distribution of each type
Market for Lemons
 In particular, buyers know that
 50% of the cars for sale are good
 50% are lemons
 Assume, Good cars worth 10,000 and Bad cars worth
6,000
 In this situation, what should a buyer offer for a
car of unknown type?
 A risk neutral buyer will offer expected value of
the car
 Expected value here is the probability weighted
average value:
(1/2)*(10,000) + (1/2)*(6,000) = 8,000
Market for Lemons
 At this offer price, which type of cars do
you think would be bought and sold in the
market place?
 Yes, only the lemons
 All good car sellers will pull out the
market characterized by asymmetric
information
 This is an example of market failure for
good cars
Market for Lemons
 Can you suggest some ways to reduce the extent of
asymmetric information so the market is restored?
 3 months warranty of power-train or buy back
policy (lemon laws)
 Independent inspection by a mechanic
 Third party insurance for repairs
 Disclosure laws requiring sellers to disclose
all known defects
Asymmetric Information in Banking
 Asymmetric information in lending leads to two
distinct problems for lenders;
1. Adverse Selection
2. Moral Hazard
 This two major concepts will visit us over
and over again throughout the book
 It is important to understand and
differentiate them clearly and carefully
Adverse Selection
 In Banking context, Asymmetric Information
takes the following forms:
 Borrower knows more about the project (risk, cash
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flow, costs and future performance) than lender
To obtain credit at a favorable rate, borrowers
have an incentive to understate risk and
overstate the positive aspects of the project
For this reason, lenders faces a risk of
financing risky projects or borrowers
This is known as Adverse Selection
Note, this problem occurs even before the loan is
made
Adverse Selection and Market Failure
 Note, lenders know the distribution of low
and high risk borrowers. But do not know the
exact type of any given borrower
 If lenders charge a low interest, losses to
high risk borrowers will be more than
profits from low risks
 To compensate the loss of default if lenders
charge a high interest, low risk borrowers
look elsewhere —leaves just the high risk
borrowers
Adverse Selection and Market Failure
 Only high risk borrowers will be willing to
accept a high interest rate for their risky
projects (high return, but low probability
of success)
 These borrowers will have no problem
defaulting on loans in case of failures
 In adverse selection, borrowers who are most
likely to cause an undesirable outcome are
also the most likely to apply for loans
Adverse Selection and Market Failure
 In such situation, lenders may decide not to
lend money at all to any small businesses
(information-opaque borrowers)
 This leads to classic market failure due to
adverse selection similar to markets for
lemons
Moral Hazard
 Moral Hazard is another problem that results
from Information Asymmetry
 In moral hazard,
 Borrowers know more about his/her true risk type
than lenders
 Monitoring is imperfect (or costly)
 Borrowers have incentive to engage in a more
risky projects than normal after the loan is made
 There are two reasons for moral hazard:
 Risk shifting
 Imperfect or costly monitoring
Risk Shifting
 Risk shifting means disproportionate sharing
of risk
 In the event of success, borrower keeps full
reward
 However, in the event of failure, borrower shifts
the loss onto lender by defaulting on the loan
 Therefore, taking risks works to borrowers
advantage
 This provides incentive to borrowers to
assume more risk than normal
Risk Shifting
 Whenever one party does not share the full
burden of their action and passes the risk
onto other party, risk taking becomes
excessive
 Example: Too Big to Fail policy in which
large and systemic lenders know that they
will be saved (bailed out) if lose on their
bets
 This encourages excessive risk raking
 FDIC insurance may have the same effect
Moral Hazard
 In a moral hazard, behavior of one party
(borrower) changes after loan is made
 Classic example of moral hazard is how
driving habits changes after a driver
purchases auto insurance with no deductible
 Consider a simple example where borrower
borrows 100k at 3% interest rate for a
project that offers 5% sure return
 In this case, if the borrower sticks to his
proposed plan his payoff is:
5000 – 3000 = $2000
Moral Hazard
 However, after the loan is obtained borrower
has an incentive to engage in risky project
such as a project that pays following
return:
 Success: 20% return with 50% probability
 Failure: 0% return with 50% probability
 Clearly, this is a risky investment with
following payoff:
 Success: $20,000 with 50% probability
 Failure:
$0 with 50% probability
 Therefore, the average payoff would be
$10,000
Evolution of Financial Intermediaries
 Looking at the percentage share of
asset value, there are clear evidence
of winners and losers.
 Winners
 Pension funds
 Mutual funds
 Losers
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Savings and loan associations (S&Ls)
Mutual savings banks
Life insurance companies
Depository institutions (except credit
unions)
Financial Intermediary Assets in the United
States, 1960–2007 (Billions of dollars)
Share of Financial Intermediary Assets in
the United States, 1960–2007 (Percent)
Evolution of Financial Intermediaries
 The Cause
 Changes in Financial regulations
 Financial Innovations
 Technological Innovations
 This Evolution can be categorized under
three major themes:
 Interest Rate Volatility
 Institutionalization of Financial Markets
 Transformation of Traditional Banking
Interest Rate Volatility
1950s and early 1960s
 Stable interest rates
 Fed imposed Regulation Q on depository
institution
 A ceilings on deposit rates a lender can
pay to its depositors
 Depositories faced no competition to attract
short term funds.
 Many present day competitors were not even
in existence.
 Therefore, depositories had a large supply
of cheap money
Why Regulation Q
 Imposed a ceiling (maximum limit) on deposit
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rate that depositories can pay to their
depositors
Without a ceiling banks would compete against
each other for deposits causing deposit rates
to increase without a limit
To be profitable these banks would be forced to
engage in projects with high return (risky
investment)
Higher cost of fund and risky investment would
cause higher bank failures
To promote stability, Fed wanted reduced
competition through Regulation Q.
Interest Rate Volatility
 However economy continued to grow through
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the mid-1960s
Growing economy meant increased demand for
loans
Challenge for banks was to find enough
deposits to satisfy loan demand.
Increased loan demand meant higher interest
rate
However, depository institutions still fell
under protection of Regulation Q
Consequences of Regulation Q
 Depository institutions could not match higher
rates offered by money market instruments such as
T-bills and Commercial Paper.
 Depositors started to shift their deposits from
their savings account to money market instruments
 However, this option was not opened to small savers
because money market instruments were not sold in
small denominations
 Wealthy investors and corporations took money from
depository institutions and placed in money market
instruments – a phenomenon known as Financial
Disintermediation
Consequences of Regulation Q
 To prevent this exodus, depository came up
with ways to undermine Regulation Q.
 Large denomination (over 100,000) Negotiable
Certificate of Deposits (CDs)
 Commercial paper through their holding companies
 Attracting funds (Eurodollar) from abroad
 In mid-1960s short-term rates became more
volatile and wealthy investors switched from
savings accounts to large CDs
 Invention of Money Market Mutual Funds in
1971 finally killed Regulation Q
Birth of Money Market Mutual Fund
 Increased technological sophistication and
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financial innovation In 1971 gave rise to Money
Market mutual Funds
Small investors pooled their funds to buy a claim
on a diversified portfolio of money market
instruments
Unlike passbook savings, some mutual funds
offered limited checking withdrawals
Small investors now had access to money market
interest rates which were much higher than rates
permitted by Regulation Q
Finally, the Regulation Q was repealed in 1980 by
Depository Institution Deregulation and Monetary
Control Act (DIDMCA)
Interest Rate Volatility
 Interest rate volatility was also associated
with another crisis in the US financial
system known as The Savings and Loan (S&L)
Crisis
 interest rates continued to rise in late
1970s
 Large and now small investors moved funds
out of banks and thrifts
 This was particularly devastating for S&Ls
since they were dependent on small savers
for their source funding
The Savings and Loan (S&L) Crisis
 Rising interest rate reduced the asset values of the
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S&Ls.
Most of their assets (fixed-rate residential
mortgages, 30 year) which can be compared to Bonds.
Interest rate and Bond value are inversely related
Market value of mortgages held by S&Ls fell as
interest rates rose making the value of assets less
than value of liabilities
Banks could not sell their long term assets at high
price
However, their insolvency was not detected or
reported because in their financial statement assets
were measured at the historic value (not current
market value) showing positive networth
The Savings and Loan (S&L) Crisis
 Depository Institutions Deregulation and
Monetary Control Act of 1980 and the Garn-St.
Germain Depository Institutions Act of 1982
 Dismantled Regulation Q
 Permitted S&Ls (as well as other depository institutions)
to compete for funds at the money market rates
 Interest paid on short-term money (competing
with mutual funds) was generally double the
rate of return on their mortgages – a
problem known as Mismatch of Maturity
The Savings and Loan (S&L) Crisis
 Regulators thought the problem was temporary.
As soon as the interest rate falls, everything
will be alright.
 Instead of strong regulations, the Garn-St.
Germain Act, permitted S&Ls to invest in high
yielding assets in which they had little
expertise (specifically junk bonds, real
estate equity and oil loans)
 S&L took the gamble expecting big payoff,
which will keep them alive for a while
 They had every incentive to do so. They were
not going to share downside risks – Moral
Hazard
The Savings and Loan (S&L) Crisis
 Investors were not concerned because
their deposits were insured by Federal
Savings and Loan Insurance Corporation
(FSLIC)
 Result is an approximate $150 billion
bail-out—paid for by taxpayers
 Another event associated with rising
interest rate was the growth of
Commercial Paper Markets
Growth of Commercial Paper Markets
 Recall everyone rushed to Money Market Mutual Funds
creating a large pool of funds looking for short
term investment
 Managers of these funds purchased Commercial Paper
(short term bonds) issued directly by large
Corporations and Finance companies
 Date suggests a money market mutual funds and
commercial paper market grew in a parallel way
Growth of Commercial Paper Markets
 Commercial banks suffered from this growth. They
lost their highest quality clients (corporate
borrower)
 Growth of money market mutual funds not only hurt
S&L by destroying their source of fund (depositors),
but cause disaster to commercial banks by taking
away their client base (borrowers)
Technological Innovation
 The Rise of Commercial Paper was possible
because of technological innovation
 Computers and communication technology
permitted transactions at very low costs
competing with commercial banks
 Complicated modeling permitted financial
institutions to more accurately evaluate
borrowers quality – addressing the
asymmetric problem
Technological Innovation
 Permitted banks to more effectively monitor
inventory and accounts receivable used as
collateral for loans – addressing moral
hazard problem
 Banks were losing their competitive
advantage
 Non depositories including mutual funds and
pension funds benefitted from technological
advancement and were able compete with
depositories
Institutionalization
 Institutionalization
 More and more funds flew indirectly into
financial markets through financial
intermediaries or institutional investors like
pension funds and mutual funds
 These “institutional investors” have
become more important in financial markets
relative to individual investors
 Easier for companies to distribute newly
issued securities via their investment
bankers
Institutionalization
 Reasons for Institutionalization
 Growth of pension funds and mutual funds
 Technological innovations
 Tax laws encourage additional pensions and
benefits rather than increased wages
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Employee deferred taxes on their income.
New defined contribution plan gave limited flexibility
to employee on how much to save for their retirement
 Mutual funds gained from these plans because many
of these defined contribution plans invested in
mutual funds
Transformation of Traditional
Banking
 During 1970s & 80s banks faced increased
competition from other financial
institutions
 Extended loans to riskier borrowers and
projects
 Many of these projects were vulnerable to
international debt crisis during 1980s
 Bank failures of banks during late 1980s &
early 1990s reached its peak
Commercial bank failures
Evolution of Financial
Intermediaries
 Predictions of demise of banks are
probably exaggerated
 Although banks’ share of the market has
declined, bank assets continued to
increase
 New innovation activities of banks are not
reflected on balance sheet
 Trading in interest rates and currency swaps
 Selling credit derivatives
 Issuing credit guarantees
Evolution of Financial
Intermediaries
 Banks still have a strong comparative
advantage in lending to individuals and
small businesses
 Banks offer wide menu of services
 Develop comprehensive relationships—easier
to monitor borrowers and address information
asymmetry problems
Assets, Liabilities, and
Management
 Unlike a manufacturing company with real
assets, banks have only financial assets
 Therefore, banks have financial claims on
both sides of the balance sheet
 Credit Risks
 Banks tend to hold assets to maturity and
expect a certain cash flow
 Do not want borrowers to default on loans
 Need to monitor borrowers continuously
 Charge quality customers lower interest rate on
loans
 Detect possible default problems
Assets, Liabilities, and
Management
 Interest Rate risks
 Vulnerable to change in interest rates
 Want a positive spread between
interest earned on assets and interest
paid on liabilities
 Attempt to maintain an equal balance
between maturities of assets and
liabilities
 Adjustable rate on loans, mortgages,
etc. minimizes interest rate risks