Why Banks Exist

Why Do Banks Exist?
Minimize Transactions Costs
Depository intermediaries like savings
and loans, mutual funds, and banks link
ultimate borrowers (especially firms)
and ultimate savers (households).
Minimize Transactions Costs
While borrowers and savers might seek
each other out and strike deals without
going through intermediaries, traditional
intermediation theory says process will be
groping and inefficient.
Consider what typical saver must do to
invest money without using intermediary.
Minimize Transactions Costs
• First, saver must locate a firm needing funds and determine
• Then, saver and firm must bargain over how much will be invested,
for how long, and at what rate of return.
– Saver prefers buying securities with small denominations that pay off quickly.
– Firm prefers selling a few large securities with long maturities (because project
may not pay off for a while).
• Suppose saver and firm overcome these problems and strike a deal.
Then, saver must keep close watch on firm until repaid.
Intermediaries minimize transactions
costs (search costs, negotiation costs,
and enforcement costs) that serve as
barriers between savers and borrowers.
Minimize Transactions Costs
Transactions services provide by intermediaries to
match borrowers and savers include:
1. Size transformation: Buying large securities and offering savers
small accounts.
2. Liquidity transformation: Holding securities (like bank loans) that
are illiquid (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.
Minimize Transactions Costs
• Nonbank financial intermediaries like mutual
funds can provide transactions services.
• Explaining why banks exist apart from other
financial institutions requires another angle:
Asymmetric Information!
Banks as Solutions to
Information Asymmetries
Moral Hazard
Solving Information Problems
Moral Hazard
Agency Problems
• Managers have inside information about payoffs from
investment projects for their firms. This information
problem makes it difficult for bondholders and
stockholders to monitor.
Solving Information Problems
Moral Hazard
Holders of marketable securities have weak
incentives to monitor.
Information is costly to collect.
Free-Rider Problem: Monitoring is a public good.
- When one investor monitors a firm, other investors benefit whether
they monitor or not.
- But each investor ignores benefits others receive when he decides
whether to monitor. Thus, each investor may decide personal gains
from monitoring are too small, even when total gains to all investors
are quite large.
- Everyone would be better off if someone else monitored, yet no one
may be willing to do so. Hence, “too little” monitoring occurs in
securities markets.
Solving Information Problems
Moral Hazard
Managerial incentive schemes and bond
covenants reduce, but do not eliminate,
agency problems.
WHY? Bond contracts are inflexible.
- Bond contracts with possibility of costly default discipline
- But firm (especially new firm in new market) with healthy
prospects might miss a payment or break a covenant due to
temporary factors beyond management control (a recession).
- Both managers and investors would benefit if managers had
breathing space to recover and respond.
Solving Information Problems
Moral Hazard
Bond contracts are inflexible (cont.):
But, when no investor is willing to monitor, firm’s managers cannot easily
convince investors a reprieve will not be used merely to delay day of
Thus, opportunities for timely renegotiation of contract will be lost.
Instead, with threat of default in mind, managers will attempt to fulfill
terms of contract, even when this means dumping profitable projects.
Bankruptcy due to severe but temporary shock.
Everybody loses from failure to negotiate. Bank
lending has the flexibility to avoid this outcome!
Solving Information Problems
Moral Hazard
SOLUTION: Banks act as delegated monitors!
– Borrowing from bank enables firm to replace many small lenders with
single lender, thus providing more flexibility. Since 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.
– Replacing many small lenders with one lender also reduces duplication
and, hence, total monitoring costs, particularly if economies of scale
exist in monitoring.
– Bank monitoring will also preserve borrower confidentiality that might
be compromised if borrower had to share details of project with capital
market. Confidentiality is especially important if project is easily copied,
like a new marketing campaign.
Solving Information Problems
Moral Hazard
Delegating monitoring to bank does not
eliminate agency problem!
– When households lend to firms indirectly through a bank, they have
not found a magic wand to make agency problems disappear.
– Bank itself is an agent of its depositors, delegated to monitor on
their behalf.
– Bank insiders know more than depositors about bank’s current
revenues, about problem areas in the loan portfolio, about
efficiency of bank management, etc.
Solving Information Problems
Moral Hazard
Bank Agency Problems:
• While agency costs of indirect lending help explain why
bank loans don’t always replace direct securities, they also
pose a paradox.
• Namely, if depositors place funds with banks to avoid
agency costs of direct lending, but simply end up with
another difficult-to-monitor agent, how can bank loans ever
improve over direct lending?
Solving Information Problems
Moral Hazard
SOLUTION? Diversification!
• If a borrower has multiple projects spread across
multiple markets, it is unlikely all will go bad at once.
• Similarly, if bank faithfully monitors large portfolio of
loans including different firms in many different markets,
probability of many firms facing troubles at same time is
quite small.
• And this probability falls as bank’s portfolio grows larger
and more diversified.
Solving Information Problems
Moral Hazard
Diversification as Answer to Bank
Agency Problems:
• Even with diversification, threat of bankruptcy forces
bank to monitor.
• If bank is lackadaisical about soundness of its loan
portfolio, then many loans could go bad, and bank will be
unable to pay depositors.
Solving Information Problems
Moral Hazard
Diversification (continued):
• But as long as bank does monitor, the revenues from a
large loan portfolio will tend to be stable.
• By monitoring, bank reduces 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.
Solving Information Problems
Moral Hazard
Banks have a comparative advantage in
monitoring (uncollateralized loans) because:
Single Lender: As discussed, monitoring and renegotiation are more
efficient with a single lender than with multiple lenders (reduction in total
monitoring costs and greater ease of renegotiation).
If story is correct, banks will lose edge as lenders in financial markets
over time. Finance companies, stockbrokers, insurance companies
could perform single-lender function.
History as Lender: Bank is better able to screen loans because it has
loaned to same borrower before.
If story is correct, banks have an edge as lenders in financial markets
because of industry’s long history as commercial lenders, but they may
lose out to other financial institutions.
Solving Information Problems
Moral Hazard
Banks have comparative advantage in
monitoring (uncollateralized loans) because:
• Bank is better able to monitor because of an
informational economy of scope between lending and
checking (checking account hypothesis).
• Specifically, access to transactions of borrowers
through their checking accounts gives bank additional
information that makes it cheaper to monitor loans.
• If true, institutions legally permitted to issue checking
accounts have unique edge.
Solving Information Problems
Moral Hazard
Informational economies of scope in supply of checking and
lending services should be greatest for small-firm
borrowers/depositors doing business mostly in local markets.
– Checking accounts of such firms contain detailed history of cash
– Checking account of large firm with subsidiaries across country (and,
hence, many other checking accounts) contains less information.
Banks as Solutions to
Information Problems
Solving Information Problems
Adverse Selection
Banks provide “Seals of Approval”
• Hence, when firms obtain bank loans (or other services from
a bank), they receive a “seal of approval.”
• This seal makes other securities marketed by the firm more
attractive (i.e., lowering their costs).
Solving Information Problems
Adverse Selection
EXAMPLE: Stock price of firm X rises when news bank
has loaned money to firm X hits market.
• Bank loan “signals” market the firm is sound. Market values
signal because bank presumably has inside information.
• Hence, bank loan helps overcome information asymmetry
between market (outsiders) and firm management (insiders).
In short…
Households and firms value delegated monitoring by banks.
Households enjoy higher returns because of lower agency
costs in lending, and firms enjoy lower costs of selling
other securities because of “seal of approval.” (Not to
mention, value of the funds obtained from banks!)
Solving Information Problems
Adverse Selection
Liquidity Insurance…
Another Adverse Solution Angle:
• Economy offers illiquid projects with high returns and liquid projects with
low returns. Obtaining high returns means running risk of suffering a
“liquidity shock.”
• If probability of suffering liquidity shocks 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.
Solving Information Problems
Adverse Selection
• Banks plug hole in asset markets by pooling funds obtained from
depositors and investing principally in illiquid, high return projects.
• Banks also invest some funds in liquid project, so they have sufficient
funds to cover the needs of “liquidity shocked” agents.
Argument is new and improved version of
“liquidity transformation” transactions service
provided by intermediaries. It also provides a
“market failure” justification for deposit insurance!