Why Do Banks Exist?
Economics 639 / American University / Fall 2015
Why Does It Matter?
• Federal Reserve and Federal government
provided unprecedented support for banks
during financial crisis-cum-recession on
assumption banks are “special.”
• Are they really?
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Intermediaries Minimize
Transactions Costs
•
Financial intermediaries like savings & loans,
mutual funds, and banks link borrowers
(especially firms) and savers (households).
•
In theory, borrowers and savers could seek
each other out and strike deals without
intermediaries, but in real world, process is
groping/inefficient.
Example:
Consider what typical saver must
do without using intermediary.
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Intermediaries Minimize
Transactions Costs
• Saver must locate firm needing funds and assess
creditworthiness.
• Then, saver and firm must bargain over how much will be
invested, for how long, and at what rate of return.
– Saver want securities with small denominations that pay off soon.
– Firm prefers selling large-denomination securities with long maturities.
• If saver and firm overcome these problems and strike deal,
saver must still monitor firm until repaid.
TAKE AWAY
Intermediaries minimize transactions costs
serving as barriers between savers and borrowers.
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Intermediaries Minimize
Transactions Costs
Intermediaries provide these specific transactions
services to link borrowers and savers:
1. Size transformation: Buying large securities and offering
savers small accounts.
2. Liquidity transformation: Holding illiquid “securities” like
bank loans – which can be hard to sell because of lemon’s
problems – and offering liquid “securities” (deposits).
3. Diversification: Holding large portfolio of securities with
imperfectly correlated returns to reduce saver risk.
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Intermediaries Minimize
Transactions Costs
Problem
• Nonbank financial intermediaries like mutual funds
can provide transactions services.
• Explaining why banks exist apart from other
intermediaries requires another angle.
That Angle:
Asymmetric Information!
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Banks Solve Information Problems
Moral Hazard
Banks lower costs arising from moral hazard and
adverse selection. First, moral hazard.
• As noted, manager has inside information about
payoffs from firm capital projects, so monitoring is
costly for bondholders* who provide funding.
• Moreover, information about bonds used to fund
projects has public good dimension, thereby
weakening incentives for bondholders* to monitor.
*Issue for stockholders, too. But, as noted, our focus is on bonds
because banks debt is a substitute for public debt.
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Banks Solve Information Problems
Moral Hazard
Free-Rider Problem: Information in securities markets has
public good dimension.
• When one investor monitors firm, others investors benefit
whether they monitor or not.
• But each investor ignores benefits to others when deciding
whether to monitor. So, each investor will decline to monitor
because personal is too small, even though total return to all
investors can be quite large.
• Everyone better off if someone monitored, yet no one does so,
hence, “too little” monitoring.
RESULT
More difficult for firms to issue bonds, which
complicates pursuit of attractive capital projects!
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Banks Solve Information Problems
Moral Hazard
To combat problem, firms add features to bonds to contain
moral hazard – such as covenants. But, inflexible nature of
these features can create other problems.
Bond Covenant Example
• Covenant requires minimum level of net worth, with violation
causing technical default.
‒ Pro: Threat of default successfully disciplines management.
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Banks Solve Information Problems
Moral Hazard
Bond Covenant Example (continued)
• Covenant requires minimum level of net worth, with violation
causing technical default.
‒ Con: Firm with healthy prospects might break covenant
because of temporary factor beyond management control, like
recession. Everyone benefits if manager had breathing space to
recover and respond. But, transactions costs and information
asymmetries make renegotiation difficult.
WORST CASE SCENARIO
Bankruptcy from severe, but temporary, shock
causes everyone to lose from failure to re-negotiate.
Bank lending has flexibility to avoid this!
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Banks Solve Information Problems
Moral Hazard
SOLUTION: Banks as delegated monitors!
• Bank loan enable firm to replace bondholders with single
lender, thus providing more flexibility. Large investment in
firm also makes bank more willing to monitor and
renegotiate contracts than individual bondholders.
• Replacing bondholders with one lender also reduces
duplication and, hence, total monitoring costs.
• Bank monitoring also preserves borrower confidentiality
that might be compromised if project details were shared
with capital market (particularly important for easily copied
projects, like new marketing campaign).
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Banks Solve Information Problems
Moral Hazard
BUT…delegating monitoring to bank does not
eliminate information asymmetry!
When households lend to firms indirectly through banks
(rather than directly through bonds), they have not found
magic wand to eliminate information problems.
• Bank itself is agent of depositors, delegated to
monitor on their behalf.
• Bank insiders know more than depositors about
bank’s current revenues, problem areas in loan
portfolio, competence of bank management, etc.
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Banks Solve Information Problems
Moral Hazard
Paradox:
If households use banks to avoid monitoring problems
associated with direct lending, but simply end up with
another difficult-to-monitor agent, how do bank loans
improve over buying bonds?
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Banks Solve Information Problems
Moral Hazard
SOLUTION? Diversification!
• If bank faithfully monitors large portfolio of loans to
different firms in different markets, probability of all
borrowing firms simultaneously defaulting is small.
• And probability falls as bank’s loan portfolio grows
larger and more diversified.
IMPLICATION
Bank cannot credibly claim it cannot honor depositor
claims because so many borrowers defaulted (i.e.,
depositor monitoring costs significantly lower).
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Banks Solve Information Problems
Moral Hazard
Diversification Solves Bank Agency Problem:
• Note: Even with diversification, bank must monitor loans.
– If bank neglects loan portfolio, many loans could go bad,
thereby making it impossible to pay off depositors.
• Upshot: By monitoring, bank reduces bankruptcy
probability for borrowing firms, and by holding diversified
loan portfolio, lowers its own bankruptcy probability.
Bank comparative advantage in lending traceable
to lower monitoring and renegotiation costs!
Diamond (1984)
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Banks Solve Information Problems
Adverse Selection
On top of serving as delegated monitors,
banks solve adverse-selection problems:
• Long history gives banks comparative advantage
screening loan applicants.
• So bank lending decisions act as “seals of approval” that
make firm’s marketable securities more attractive.
Empirical Regularity: Stock price of firm X rises when
news bank lent money to firm X becomes public.
‒ Bank loan “certifies” firm soundness; market values signal
because banks can sort credit risks. (If bank already has
relationship with firm, market values signal because bank
has inside information from ongoing relationship with firm.)
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Banks Solve Information Problems
Adverse Selection
Liquidity Insurance…
…Another Adverse-Selection Angle
Economy offers two types of capital projects:
1. Liquid projects with low returns.
2. Illiquid projects with high returns Early liquidation
leaves zero salvage value, so investment in
illiquid/high return project risks of big losses from
“liquidity shocks.”
Were probability of liquidity shocks publicly observable,
households could invest in illiquid projects to get high
returns and buy liquidity-insurance policies.
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Banks Solve Information Problems
Adverse Selection
Liquidity Insurance…
…Another Adverse-Selection Angle (continued)
• PROBLEM: But liquidity risk is privately observable, so
conventional insurance companies do not offer policies.
• SOLUTION: Banks sell liquidity insurance, offering savers
return above liquid project as well as liquidity on demand.
– Banks take deposits and invest bulk in high-return, illiquid projects
and small residual in liquid projects to cover routine withdrawals.
– Approach works as long as withdrawals uncorrelated.
Diamond-Dybvig 1983
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Why Banks Exist?
Application
Traditional Justification for Deposit Insurance:
• “Demandable at par on first come, first served basis”
(DPFCFS) nature of deposits contains different type of
moral hazard, but creates exposure to banks.
– Banks can transform risk profile quickly
(“asset shifting”), imposing losses on claimholders.
– Threat of massive depositor withdrawals disciplines bank.
• But DPFCFS nature of deposits exposes banks to runs.
• Runs generate macroeconomic externalities by causing
collapse of money supply (→ AD and real output↓).
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Why Banks Exist?
Application
New Twist on Justification for Deposit Insurance:
Adverse Selection a la Diamond-Dybvig
• Event persuades households massive deposit withdrawals from
banking system possible.
• Collective household response – correlated withdrawals – could
cause solvent but illiquid banks to fail (by forcing sale of illiquid
projects at big losses).
• Threat of losses from bank failures causes households to start
withdrawing deposits in case runs start, but household reaction,
ironically, sparks runs.
• Runs cause massive sale of illiquid projects with huge
losses. So, on top of fall in real output (from money-stock
decline), economy loses value of illiquid projects.
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Why Banks Exist?
Application
New Twist on Justification for Deposit Insurance:
Adverse Selection a la Diamond-Dybvig (continued)
RESULT: Households rationally react to event that could
cause bank runs/failures by withdrawing deposits en masse
and causing failures (self-fulfilling prophecy).
• Banks plug hole in asset markets (i.e., sell liquidity insurance)
but expose economy to “run risk” because DPFCFS nature of
deposits necessary to prevent asset shifting.
• To preserve value of illiquid projects, liquidity access, and
stable macro-economy, government must somehow convince
households deposits are safe, no matter what.
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Why Banks Exist?
Application
Justification for Deposit Insurance:
Adverse Selection a la Diamond-Dybvig (continued)
SOLUTION: Federal deposit insurance
Successful policy must convince households deposits are
risk-free, thereby removing incentive to run.
• State-underwritten deposit insurance won’t work because every
such system in U.S. history imploded.
• Discount Window won’t because Fed has discretion (i.e., might
not insulate households from losses on deposits).
• Federal deposit insurance credible because of power to
(i) tax large diversified economy, and (ii) print money.
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