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Copyright © 2015 McGraw-Hill Education. All rights resered. !o reproduction or distri"ution without the prior written consent o# McGraw-Hill Education.
The Economics of Financial
Intermediation
Chapter Eleven
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Learning Objectives
an understanding of
1. How intermediaries promoteeciency.
2. The central role of informationcosts.
3. Incentive prolems in !nance.
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Introduction•
Financial institutions serve asintermediaries etween savers andorrowers"
• These institutions pool funds from people
and !rms who saves and lend to orrowers.• Intermediaries investigate the !nancial
condition and the est investmentopportunities.
• Intermediaries they reduce investment ris#and economic volatility.
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Introduction• a common measure of !nancial activity$$the
ratio of credit e%tended to real &'( per capita.• not any rich countries with very low levels of
!nancial development.
• the )ow of information prolems and learnhow !nancial intermediaries attempt to solvethem.
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The Role of FinancialIntermediaries
• Financial mar#ets are importantecause they price economicresources and allocate them to their
most productive uses.
• Intermediaries" including an#s andsecurities !rms" continue to play a
#ey role in oth direct and indirect!nance.
• Tale 11.1 illustrates the importance
of di*erent channels of !nance.
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The Role of FinancialIntermediaries
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The Role of FinancialIntermediaries
• From the tale we can see+ – To ma#e comparisons across countries of
vastly di*erent si,e" we measure everythingrelative to &'(.
– There is no reason that the value of acountry-s stoc# mar#et" onds outstanding"or an# loans cannot e igger than its &'(.
• hen you add up all the types of
!nancing" direct and indirect" as apercentage of &'(" the numers willgenerally sum to more than 1// in anadvanced economy.
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The Role of FinancialIntermediaries• These data highlight the importance of
intermediaries.
– 0an#s are still critical providers of !nancingaround the world.
– Intermediaries determine which !rms canaccess the stoc# and ond mar#ets.
– 0an#s decide the si,e of a loan and interest
rate to e charged. – ecurities !rms set the volume and price of
new stoc#s and ond issues when theypurchase them for sale to investors.
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The Role of FinancialIntermediaries
• Financial intermediaries areimportant ecause of information.
• ending and orrowing involves othtransactions costs and informationcosts.
• Financial institutions e%ist to reducethese costs.
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The Role of FinancialIntermediaries
In their role as !nancialintermediaries" !nancial institutionsperform !ve functions+1.(ooling the resources of small savers"
2.(roviding safe#eeping and accountingservices" as well as access to paymentssystem"
3.upplying liuidity y converting savers4
alances directly into a means of paymentwhenever needed"
5.(roviding ways to diversify ris#" and
6.7ollecting and processing information inways that reduce information costs.
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Pooling Savings•
The most straightforward economicfunction of a !nancial intermediary is topool the resources of many small savers.
$$ 0y accepting many small deposits"
•
0an#s+ – 8re a place for safe#eeping.
– 8ccess to the payments system $$ thenetwor# that transfers funds
–
peciali,e in handing payments• the intermediary+
– 9ust attract sustantial numers of savers"
– 9ust convince potential depositors
–
reduce the costs of !nancial transactions.
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Safeeeping! Pa"ments S"stem#ccess! and #ccounting
• facilitate the e%change of goods andservices.
• This principal of comparative advantage leads to speciali,ation
• y providing us with a reliale andine%pensive payments system"
• also help us manage our !nances.
• They provide us with oo##eeping andaccounting services"
• to write legal contracts
• do ta#es advantage of economies of scale"
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Providing Li$uidit"
1. Liquidity is a measure of the ease and costthat an asset can e turned
2. Financial intermediaries o*er us the ailityto transform assets into money
3. #eep enough funds in short$term" liuid!nancial instruments to satisfy
5. the an# can reduce the cost of theinvestment" o*ering each individualinvestor liuidity and
6. o*er oth individuals and usinesses linesof credit" which provides liuidity.
:. must speciali,e in liuidity management.
;. it can sustain sudden withdrawals
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%iversif"ing Ris
• enale us to diversify ourinvestments and reduce ris#.
• 0an#s ta#e deposits from
thousands of individuals andma#e loans.
• provide a low$cost way for
individuals to diversify.
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Collecting and ProcessingInformation
• the lender faces sustantial costs to otainthat information" results in an informationasymmetry . –
0orrowers have information that lenders don4t.• reduce the prolems that information
asymmetries
• 9ar#ets reuire sophisticated information to
wor# well.• Issuers of !nancial instruments #now more
aout their usiness prospects andwillingness to wor#
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Information #s"mmetriesand Information Costs
• 8symmetric information is aserious hindrance
• It poses two important ostacles
1. 8dverse selection arises – enders need to #now how to
distinguish good credit ris#s from ad.
2. 9oral ha,ard occurs – ill orrowers use the money as they
claim<
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•
The 9ado* scandal was a classicPonzi scheme+
• Investors fail to screen and monitorthe managers
• 8 fa=ade of pulic respectailitycontriutes to the success of a (on,ischeme"
• Everyone acted as if someone elsewas monitoring" so they could en>oythe free ride.
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#dverse Selection• ?sed cars and the mar#et for lemons+
– ?sed car uyers can4t tell good cars from ad.
– ellers have a good car" won4t accept less thanthe true value.
– If uyers are only pay average value" good car
sellers will withdraw
– Then the mar#et has only the ad cars.
• solve the asymmetrical informationprolem. – 7onsumer @eports
– 9ore recently 78@F8A
– Bou can also hire a mechanic to loo# over
– eginning to o*er Ccerti!edD used cars"
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Solving the #dverseSelection Problem•
If you can4t tell good from ad companies – toc#s or onds of good companies are
undervalued" and
– wners will not want to sell them.
• the prolems of adverse selection are notgood.
– ome companies will pass up goodinvestments.
– Economy will not grow
• !nd ways for investors and lenders todistinguish good !rms from ad !rms.
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%isclosure of Information• to solve the prolem of asymmetric
information is to provide more information.
• public companies are reuired to disclosemore information.
• For e%ample" in the ?.." the ecurities andE%change 7ommission E7G reuires !rmsto produce pulic !nancial statements
•
with the help of some unethicalaccountants" found some cases tomanipulate the statements to disguisetheir !rms4 true !nancial condition
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%isclosure of Information
• there is private information collected andsold to investors. – To e credile" companies cannot pay for this
research"
– @esearch services li#e 9oody4s" alue ine" and'un and 0radstreet collect information directlyfrom !rms
•
(rivate information services face a free$rider prolem. – 8 free$rider is someone who doesn4t pay the
cost to get the ene!t of a good or service.(ulic liraries suscrie
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Collateral and &et 'orth•
8nother solution for adverse selection isto ma#e sure lenders are compensatedwith the coll. – If a loan is insured in some way" then the
orrower isn4t a ad credit ris#.• 7ollateral is something of value pledged
y a orrower to the lender.
• ?nsecured loans" li#e credit cards" areloans made without collateral. – 0ecause of this they generally have very high
interest rates.
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Collateral and &et 'orth•
The net worth is the owner4s sta#e ina !rm $ – et worth serves the same purpose as
collateral
– If a !rm defaults" the lender can claimfor the !rm4s net worth.
• From the perspective of themortgage lender" the homeowner4shouse serves the same function asnet worth
• 9ost small usiness owners must put
up their homes and other property as
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(oral )a*ard+ Problem andSolutions
• 9oral ha,ard arises when we cannotoserve people4s actions andtherefore cannot judge ,hether
a poor outcome was intentional or >ust a result of ad luc#.
• 8 second" information asymmetry
arises ecause the orrower #nowsmore than the lender aout the wayorrowed funds"
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(oral )a*ard+ Problem andSolutions• How do we solve the prolem<
• the manager will use the funds in a waythat is most advantageous to them" notyou.
•
The separation of your ownership fromtheir control creates what is called a principal-agent problem.
• to align managers4 interests with those of
stoc#holders. – there is no foolproof way of ensuring managers
will ehave in the owner4s est interest
– E%ecutives were given stoc# options
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(oral )a*ard in %ebtFinance
• hen the managers are the owners"moral ha,ard in euity !nancedisappears.
• 0ecause det contracts allow owners
encourage ris# ta#ing.• enders need to !nd ways to ma#e
sure orrowers don4t ta#e too manyris#s.
• det !nance ecause lenders get thefull ene!t of the upside" thedownside is limited to collateral.
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Solving the (oral )a*ardProblem in %ebt Finance
• egal contracts can solve themoral ha,ard prolem in det!nance.
– 0onds and loans carry restrictivecovenants
– to maintain a certain level of networth" a minimum credit rating"
– For e%ample+ home mortgagesreuire home insurance" !reinsurance" etc.
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&egative Conse$uences ofInformation Costs
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Financial Intermediaries andInformation Costs
• 9uch of the information is used to+ – @educe information costs" and
– 9inimi,e the e*ects of adverse selection andmoral ha,ard.
• To do this" intermediaries+ – creen loan applicants"
– 9onitor orrowers" and
– (enali,e orrowers y enforcing contracts.
• The lender uses a credit score.
• reuests a credit score" they have to pay"eliminating the free rider prolem.
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(onitoring to Reduce (oral)a*ard
•
Intermediaries insure against thistype of moral ha,ard y monitoring
– 9any hold signi!cant numer of
– They may place a representative
• For new companies" a !nancialintermediary called a venturecapital rm does the monitoring. – They speciali,e in investing – Finally" the threat of a ta#eover
helps to persuade managers to actin the interest
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)o, Companies Finance -ro,thand Investment
1.ealthy countries have high levels of!nancial development" and
2.Intermediaries play #ey roles oth in directand indirect !nance.
3. a !rm can also use its own pro!ts" can
reinvest the earnings into the !rm.
5. managers have superior information
aout running ma#es internal !nance
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)o, Companies Finance -ro,thand Investment
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)ome,or%ue date ne.t 'ee
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1. hat prolem associated withasymmetric information was central to
0ernard 9ado*4s success in cheatingso many investors for so long<
2. Financial intermediation is not con!nedto an# lending ut is also carried outy non$an# !rms such as mutual fundcompanies. How do mutual funds helpovercome information prolems in
!nancial mar#ets
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3. In some countries it is very dicult forshareholders to !re managers when theydo a poor >o. hat type of !nancing
would you e%pect to !nd in thosecountries
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6. ne of the solutions to the adverseselection prolem associated withasymmetric information is the pledging of
collateral. However" the collateral may eris#ier than initially thought.
8s an e%ample" e%plain why thecollateral did not wor# adeuately to
mitigate the mortgage securiti,ationprolems associated with the !nancialcrisis of 2//;$2//K<
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:. If a an# has 1"/// depositors" eachof whom deposits L1"/// in thean#" and the an# ma#es loans of
L1/"/// each" then each depositorhas contriuted+
1////M1///N1/
;. How are !nancial intermediariesale to reduce transactions costs<
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O. hich of the following is an e%ample of adverse selection<
• 8G 8 homeowner with a large !re insurance policy allows thewiring in her house to deteriorate.
• 0G 8 woman with a large life insurance policy ta#es up s#y diving.
• 7G Bour rother$in$law orrows L2/"/// from you to open a pi,,aparlor" ut spends it gamling at the racetrac# instead.
• 'G 8 man with a ad heart condition uys a large life insurancepolicy.
K. hy do higher interest rates increase adverse selectionprolems in the loan mar#et<
• 8G Higher interest rates reduce the gains from economies ofscale.
• 0G 8s interest rates rise" the creditworthiness of the average loan
applicant declines.• 7G Higher interest rates reduce information prolems in the loan
mar#et.
• 'G 8t higher interest rates fewer investment pro>ects arepro!tale.
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1/G 9oral ha,ard prolems arise when
• 8G lenders have diculty in distinguishingetween good and lemon !rms.
•0G when a downturn in economic activityma#es repaying loans dicult for orrowers.
• 7G orrowers default on loans.
• 'G orrowers have an incentive to conceal
information.
• 8nswer
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