Why do Banks Exist_Fall 2013

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 (the households of the economy).
Minimize Transactions Costs
While borrowers and savers might seek each other
out and strike deals without going through
intermediaries, traditional banking theory says this
will be a groping, inefficient process.
Minimize Transactions Costs
Consider what a typical saver
would have to do to invest her
money in some firm without
using an intermediary.
Minimize Transactions Costs
• 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 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.
Minimize Transactions Costs
Intermediaries minimize transactions costs (search
costs, negotiation costs, and enforcement costs)
that serve as barriers between savers and
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:
information problems.
Solve Information Problems
Solve Moral
Hazard Problems
Solve 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.
Solve Information Problems
Moral Hazard
Holders of marketable securities have little incentive to
• Information is costly to collect.
• Free rider problem: monitoring is a public good.
- When an investor supervises a firm, all other investors benefit
whether they monitor or not.
- But each investor will ignore the benefits he provides others when he
decides whether monitoring is worth her time and the trouble. Thus,
every investor may decide her 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.
Solve 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 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 beyond the control of management (a recession).
- Both managers and investors would benefit if managers could request some
breathing space to recover and respond.
Solve Information Problems
Moral Hazard
Bond contracts are inflexible (cont.):
But, when no investor is willing to monitor the firm, the firm’s managers
cannot easily convince investors 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.
Worst case scenario: bankruptcy due to severe but temporary
shock. Everybody loses from failure to negotiate. Bank lending
has the flexibility to avoid this outcome!
Solve Information Problems
Moral Hazard
Banks act as delegated monitors.
– By borrowing from a bank, a firm replaces many small lenders with 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.
– 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.
– 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.
Solve Information Problems
Moral Hazard
And banks also have agency problems…
– When households lend to firms indirectly through a bank, they have
not found a magic wand to make 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.
Solve Information Problems
Moral Hazard
Solutions to bank agency problems:
• Debt contracts with costly default, incentives schemes
to align managers and stockholders interests, and bank
regulation. As previously noted, these don’t do that
much to lower overall agency costs.
Solve Information Problems
Moral Hazard
Solution – 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?
Solve Information Problems
Moral Hazard
Diversification (cont.):
• 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.
Solve Information Problems
Moral Hazard
Diversification (cont.):
• 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
• And this probability falls as the bank’s portfolio grows larger
and more diversified.
Solve Information Problems
Moral Hazard
Diversification (cont.):
• 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 bad, and the
bank will be unable to pay its depositors.
Solve Information Problems
Moral Hazard
Diversification (cont.):
• But as long as the bank does monitor, the 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
• Thus, indirect lending through a delegated monitor that is
well-diversified actually reduces the wasted time and
effort of premature bankruptcy proceedings.
Solve Information Problems
Moral Hazard
Banks have a comparative advantage in
monitoring (uncollateralized loans) because:
• 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).
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.
Solve Information Problems
Moral Hazard
• History as lender: bank is better able to screen loans
because it has loaned to the same borrower in the past.
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
Solve Information Problems
Moral Hazard
• 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.
Solve Information Problems
Moral Hazard
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 Information Problems
Solve Information Problems
Adverse Selection
Bank “Seals of Approval”:
• Bank monitoring certifies to the market that the firm is behaving
• 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).
Solve Information Problems
Adverse Selection
The stock price of firm X rises when news a bank has
loaned money to firm X hits the market.
– The bank loan is a “signal” to the market 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).
Solve Information Problems
Adverse Selection
– In short, households and firms 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
obtained from banks.)
Solve Information Problems
Adverse Selection
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.
Solve Information Problems
Adverse Selection
Liquidity Insurance (cont.):
• Banks plug the hole in asset markets by pooling funds obtained from
depositors and investing principally in illiquid, high return projects.
• Banks also invest some funds in the liquid project so they have sufficient
funds to cover the needs of “liquidity shocked” agents.
Solve Information Problems
Adverse Selection
• This argument is a new and improved version of
the “liquidity transformation” transactions
service provided by intermediaries.
• This argument provides a “market failure”
justification for deposit insurance!