The Role of Financial Intermediation in Banking

Financial intermediaries exist to solve or reduce market imperfections such as differences in preferences of lenders and borrowers, transaction cost, shocks in consumers’ consumption and asymmetric information. Theories developed to explain how financial intermediaries reduce market imperfection:

Asset transformation

Transaction cost reduction

Liquidity insurance

Informational economies of scale and delegated monitoring

Asset Transformation

Asset transformation is a process performed by financial intermediaries to transform particular types of assets into to others. This is to satisfy the need of borrowers for long term capital and the need of lender for high degree of liquidity in their asset. Financial intermediaries transform the primary securities issued by firms into indirect securities by lenders. They issue liabilities (deposit claims) which are short term, low risk and high liquidity, and use parts of these funds to acquire larger, high risk and illiquid claims.

3 Main Transformations

Maturity Transformation

As the liabilities of financial intermediaries mature faster than their assets, financial intermediaries mismatch the maturity of the assets will maturity of the liabilities by making long-term loans and fund them by issuing short-term deposit.

Size Transformation

The amount required by borrowers are much more than the amount made available by lenders. Financial intermediaries will then collect and combine the funders from lenders as required by the borrowers.

Liquidity Transformation

Financial intermediaries provide financial or secondary claims or loans. Deposits which are held under liabilities of banks’ balance are low risk and high liquidity, while loans which are held under the assets of banks’ balance are riskier and illiquid. To hold liabilities and assets of different degree of liquidity, financial intermediaries will diversify their portfolios. More diversification will lower the default probability.

Risk Transformation

Financial intermediaries must be seen by the lenders as a safe place to make deposits. However, the loans made by the intermediaries to the borrower bear some default risk. Therefore, financial intermediaries have to transform risk to reconcile the preferences of borrowers and lenders.

Firstly, banks use credit scoring to select good borrowers with good repaying loans history to minimize the risk of loss of each loan.

Second is to diversify risk by lending to different types of borrowers. Banks try to avoid heavy concentration on an economic activity or on a particular area. They also limit the amount that can be loan out.

Example: From 1985-1989, 400 Texan banks failed which are resulted from heavy concentration on their loan portfolio in real estate dependent on the oil businesses.

Third is by pooling risks. Variability of losses can be reduced by making loans to many borrowers. Although by making out many loans does not reduce the loss in the portfolio of loans overall, but it increase the bank accuracy of prediction and limits maximum loss for which the intermediaries has to allow.

How financial intermediaries reduce transaction costs?

Financial intermediaries reduce transaction costs by internalizing them. They make network and information system available to lenders and borrowers. As such, lenders and borrowers do not have to find a suitable counterpart each time they want to make a transaction with the other party. Financial intermediaries also provide standardized products which help to reduce the information cost related with scrutinizing individual financial instruments. They also use tested procedures and routines.

Theory of transaction costs

Economies of scale refer to the transaction costs per dollar of output is reduced as the number of financial transactions increase.

Example: When using loan contract for many loans, the unit cost of a contract per loan is lower than a loan contract drawn up individually when undertaking direct lending.

Economies of cost refer to the cost of producing at least 2 products together is lower that producing them individually. It is concerned with deposit and payment services, because deposits are legal financial claims which allow banks to collect funds to sustain their lending activities and satisfy the request of making payments.

Expertise

They developed expertise to lower transaction cost. Financial intermediaries such as banks and mutual funds develop in information technology such as ATM to provide liquidity service.

Asymmetric Information

Adverse Selection

It arises when borrowers who are likely to produce undesirable results are the one who are actively seeking loans, because they know that they are unlikely to pay it back. Adverse selection increases the probability that the loan might become a bad credit risk. Hence, lenders may decide not to loan out, even when there is good credit risk.

Moral Hazard

It is the risk that occurs after the transaction has been made. It is the risk that the borrower may engage in activities which is undesirable from the lenders’ point of view because there a likelihood that the loan will not be repaid. Therefore, lenders may decide not to make loan.

How adverse selection influence financial structure?

Equity Market

When borrower wanted to make investment and yet is unable to distinguish between good and bad firms, he is only willing to pay the price the price that reflects the average quality of firms. However, the firms have more information than the investors and will know the quality of the projects. Good firms will not be willing to sell the securities because they know that their securities are undervalued. Only bad firms are willing to sell their securities at the average price because the price is higher than the value of bad firms’ securities. However, investors may not want to buy securities from bad firms and end up decides not to buy any.

Bond Market

A potential investor will only be willing to buy a bond if the interest rate is high enough to compensate him the average default risk between the good and bad firms. Good firms will not want to borrow funds because they know that they are less risk adverse and should not pay an interest that is higher than what they originally should pay for. Only bad firms are willing to pay for such interest rate. However, investor does not wish to buy bond from bad firms. Subsequently, there will be fewer bonds sold in the markets.

Tool used which helps to reduce or solve adverse selection problems

Private production and sales of information

Government regulation to increase information

Financial intermediaries

Private companies such as Standard and Poor’s, Moody’s and Value Line gather firms’ financial position and investment activities, and sell them to potential investor. Such information will help investors in making more accurate investment decisions. However, this does not completely solve the asymmetric problem because of the free-rider problem. The free-rider problem occurs when individual who do not pay for the information take advantage of the information of which others has paid for. An investor who has paid for the information knows which the are good firms. He decides to buy securities of good firms that are undervalued. The free-riding investors observe which securities is the investor who paid for information is buying, will buy the same securities. This leads to increase in demand of the securities and soon the price of that security will increase to reflect the true value. As a result, because of these free-riders, the investors who bought the information will not benefit. As such, he will realize that he should not buy the information in the first place. If other investors also realize this, private companies may not be able to make enough profit from producing the information, and less information is produced in the market and so adverse selection will interfere with the efficient function of securities markets.

Government regulation to increase information

Government could regulate financial markets to ensure that firms disclose all information so that investors could distinguish between good firms and bad firms. In United States, the Securities and Exchange Commission (SEC) is the government agency that requires firm selling securities to be certified in adhering to standard accounting principles and disclose honest information about their sales, assets and earnings. But, government intervention on disclosing information does not solve adverse selection completely because accounting principles can be manipulated. Also bad firms can slant information which is required to transmit public to make them look like good firms. By doing so, they can get higher price for their securities. Thus, investors will have problem again to identify which firms are the good ones.

Financial intermediaries

Financial intermediaries such as banks have developed expertise in the production of information so that they can evaluate the quality of firms better. Banks produce information through the transactions on the borrowers’ bank accounts. From the transactions, banks will be able to determine the suitability of credit and ability to repay the loan. Banks then acquire funds from depositors and lend them to good firms. By lending the money to good firms, banks will be able to earn a higher return than they pay to depositors. Banks will then earn profit and can continue in producing information. Also, banks can make profit because it can avoid free-rider problem. They make private loans which are not traded in open markets. As such, other investors cannot follow what the bank did and bid the price of loan where the bank does not get any gain for the information it produces.

Fact: Banks are important to developing countries. When banks produce information, the problem on asymmetric problem is less severe, and it will be easier for firms to issue securities. Information in developing countries is difficult to get as compared to developed countries. Therefore, banks have to play the role in producing information.

Collateral

Collateral which is property that promised to the lender if the lender default, reduces the adverse selection problem because it reduces the lender losses if the borrower goes into default.

How moral hazard influences financial markets

Moral hazard occurs after the transaction takes place. It is the risk that the borrower may engage in risky activities which is undesirable from the lender’s point of view, because the loan may be unpaid.

Because of the presence of moral hazard problems, firms find it easier to raise fund with debt instruments rather than with equity contracts.

Moral hazard in equity contracts

Equity contracts subject to a type of moral hazard known as principal-agent problem. In a firm, there are managers and stockholders. Usually, managers and stockholders are different people. Managers are the ones who have more information than the stockholders while the stockholders own most of the firm’s equity. The separation of ownership and control and with the presence of asymmetric information, managers may act in their own interest rather than the interest of the stockholder because managers have fewer incentives to maximize the profit that the stockholder do.

Tools to help reduce/solve moral hazard in equity markets

Production of information: monitoring

To reduce moral hazard problem, stockholders can engage in the monitoring of the firm activities by auditing the firm frequently and checking on what the management is doing. However, monitoring can be very costly. (Monitoring is a costly state verification). – This also explains in parts why equity is not an important element in the financial structure.

However, this could also cause free-rider problem. Free-rider problem reduces the moral hazard problem. Because, when stockholder knows that other stockholders are paying for the monitoring activities, he can free ride on their activities. If all stockholders share the same mentality, no stockholders will be willing to pay for the monitoring activities.

Government regulation to increase information

Governments enforce laws to ensure that firms are adhering to accounting standards which can verify the profit easier, and impose penalties on people who committed fraud in hiding or stealing the profit. However, this measure is not very effective because managers have the incentive to make fraud difficult to be proven.

Financial intermediaries active in the equity market

An example of financial intermediaries is the venture capital firm which cans helps to reduce moral hazard arising from the principal-agent problem. They use fund of their partners to help entrepreneurs in setting up new businesses. In exchange for the use of funds provided by venture capital firm, venture capital firm get an equity shares in the new business. Because verifying profit is important in eliminating moral hazard, venture capital firms usually insist on having several of their own people to participate in the management of the firm. Also, the equity in the firm cannot be sold to anyone but to the venture capital firm. Therefore, other investors are unable to free-ride on the venture capital firm’s activities on verifying profit.

Debt Contracts

Debt contract is a contractual agreement by which the borrower promised to pay lender fixed amount at regular intervals. The amount of profit made by firm will not affect how much will the lender be receiving. Therefore, whether did the managers have been hiding or stealing profit or engaging in activities which do not increase the level of profit earned, it is of no concern to the lenders, so long as the firm is able to make payment. Only when the firm is unable to make payment as promised, then will the lenders have to know how much profit is the firm getting. As such, less monitoring is required for debt contracts and therefore, lowering the cost of state verification. This also explains why debt contracts are used more often than equity contracts to raise funds.

The concept of moral hazard explains why stocks are not the most important source of financing for businesses.

How moral hazard influences financial structure in debt markets

Although debt contracts has lower moral hazard as compared to equity contracts, but debt contracts are still subjected to moral hazard. Because debt contracts only require firms to pay a fixed amount and allow them to keep profit above this amount, firms have an incentive to take on risky investment projects

Tools to help reduce/solve moral hazard in debt markets

Making debt contract incentive-compatible

High net worth makes the debt contract incentive-compatible; it aligns the incentive of the borrower with that of the lender. Firms with higher net worth are more likely to act in the way that are desirable form the lender’s point of view, and thus reducing moral hazard problem, and it will be easier for firms to borrow.

Monitoring and enforcement of restrictive covenants

By introducing restrictive covenants into debt contracts, moral hazard problems are be reduced, as restrictive covenants is a provision which restricts firms activities by either ruling out undesirable behavior or encouraging desirable behavior.

There are mainly four types of covenants/

Covenants to discourage undesirable behaviors

Such covenants restrict firms to use the debt contracts to finance on fixed assets or inventories. Others may restrict firms to engage in risky activities such as acquiring other businesses. Covenants may also disallow firm to issue new debt or dispose it asset, and may also restrict dividend payments if ratios such as leverage ratio, ratio of debt to equity has up to a certain level.

Covenants that encourage desirable behavior

Such covenants require the borrower to have a life insurance that pays off the loan upon the death of the borrower. Such covenants may also encourage firms to keep it net worth high because firms with high net worth reduce the moral hazard problem. Hence, it minimizes the chance that the lenders may be making losses. These covenants require firms to maintain minimum holding of asset relative to the size of the firm.

Covenant to keep collateral valuable

Such covenants encourage borrower to keep the collateral in good condition and it must be in the possession of the borrower.

Covenants to provide information

Such covenants provide information about its activities periodically in the form of quarterly accounting and income reports. Such covenants may also allow the lender to audit the firms anytime.

This explains why debt contracts are complicated legal documents with restrictions on borrowers’ behavior.

Covenants reduce moral hazard but do not eliminate them, as it not difficult to rule out every risky activity. Also, to ensure that firms are complying with the covenants, monitoring must be enforced. However, monitoring is very costly. Investors may free-ride on the monitoring activities undertaken by other investors.

Financial intermediaries, particularly banks are able to avoid the free-riders problems