Lecture 8
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
An Economic Analysis of Financial Structure
(Mishkin, chapter 8)
A definition of “financial intermediaries”
By bank-like financial intermediaries, we mean firms that
1 borrow from one group of agents and lend to another, where
2 both the borrowing and lending groups are large, suggesting diversification on each side of the balance sheet,
3 the claims issued to borrowers and to lenders have different state contingent payoffs, i.e.,
the maturity of the loan contracts is typically longer than the maturity of the debt on the liability side of the balance sheet.
Financial intermediaries with those characteristics correspond most closely to commercial banks, savings/loans, and similar institutions.
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“Borrowing” and “Lending”
The terms “borrowing” and “lending” mean that the contracts involved are debt contracts.
Financial intermediaries use debt contracts
• to lend to large numbers of consumers and firms (basically bank loans, which are not the same as corporate bonds)
• and borrow from large numbers of agents (in the form of demand deposits)
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The importance of financial intermediaries
In all the countries,
bank loans are the predominant source of external funding; and capital markets are not a significant source of financing.
Banks
play important roles in corporate governance, especially during periods of firm distress and bankruptcy,
“monitor” firms, and
are also important in producing liquidity.
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The importance of financial intermediaries
Bank loan legal contracts imply that banks can and should intervene into the affairs of the firm.
Unlike bonds, bank loans tend not to be dispersed across many investors.
This facilitates intervention and renegotiation of capital structures.
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Sources of External Funds for Non-financial Businesses
External funds financing American businesses’ activities in the period 1970-2000 in comparison to Germany, Japan, and Canada .
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Sources of External Funds for Non-financial Businesses
The numbers are percentages, so in the United States for example, 24.4% of firm investment was financed with bank loans during the 1970 – 1985 period.
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Business operations finance: Basic facts
1 Stocks are not the most important sources of external financing.
2 Issuing marketable debt and equity securities is not the primary
source of finance.
3 Indirect finance is a lot more important than direct finance.
4 Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.
5 The financial system is among the most heavily regulated sectors of the economy.
6 Only large, well-established corporations have easy access to securities markets to finance their activities.
7 Collateral is a prevalent feature of debt contracts for both households and businesses.
8 Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers.
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Asymmetric information
There are two types of asymmetric information problems, adverse selection and moral hazard.
Adverse selection occurs before the transaction. Moral hazard arises after the transaction.
Agency theory analyses how asymmetric information problems affect economic behavior.
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The Lemons Problem: How Adverse Selection Influences Financial Structure
“The Market for Lemons: Quality Uncertainty and the Market Mechanism” is a 1970 paper by the economist George Akerlof.
Suppose consumers cannot tell the quality of a product.
Then, they would be willing to pay a price reflecting average quality. But this price is more attractive for sellers who have bad products. High quality good owners won’t want to sell at this price.
This implies that more bad products will be offered than good products.
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The Lemons Problem: How Adverse Selection Influences Financial Structure
Rational consumers anticipate this adverse selection and expect that at any given price, a randomly chosen product is more likely to be a lemon than a good product.
These expectations imply that consumer will be willing to pay a price that is lower than the average.
Then, the proportion of good products that is actually offered falls further, while buyers don’t buy.
This process may lead to a complete break down of the market!
This problem explains fact 2 and partially explains fact 1.
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Tools that help solve Adverse Selection Problems
Private production and sale of information.
Free-rider problem
Government regulation to increase information.
Not always effective, explains Fact 5.
Financial intermediation.
Explains facts 3, 4, & 6.
Collateral and net worth.
Explains fact 7.
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Banks as Information Producers
If information about investment opportunities is not free, then economic agents may find it worthwhile to produce such information.
There will be an inefficient duplication of information production costs if multiple agents choose to produce the same information.
The returns to producing the information could not all be captured by the information producer, possibly hurting the incentives to produce information (Grossman and Stiglitz, 1980).
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Banks as Information Producers
The resale and appropriability problems in information production can motivate the existence of an intermediary.
The intermediary can credibly produce information by investing its wealth in assets about which it claims to have produced valuable information.
A bank-like intermediary does not sell information that it produces. Rather it uses the information internally.
This is very different from the case of a firm that sells information to investors, like a rating agency. Firms selling information face problems of reliability and appropriability.
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How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Called the Principal-Agent Problem:
• Principal: less information (stockholder) • Agent: more information (manager)
Separation of ownership and control of the firm:
• Managers pursue personal benefits and power rather than the profitability of the firm.
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Tools that help solve Principal-Agent Problems
Monitoring (Costly State Verification)
Free-rider problem, Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation
Fact 3
Debt Contracts
Fact 1
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How Moral Hazard Influences Financial Structure in Debt Markets
Borrowers have incentives to take on projects that are riskier than the lenders would like.
This prevents the borrower from paying back the loan.
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Tools to Help Solve Moral Hazard in Debt Contracts
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior Encourage desirable behavior Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4
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Why Financial Intermediaries?
Diamond (1984) offered the first coherent explanation for the existence of financial intermediaries.
Intermediaries “monitor” borrowers.
Since monitoring is costly, it is efficient to delegate the task to a specialized agent, the bank.
The intermediary “monitors” borrowers on behalf of investors who lend to the intermediary.
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Bonds versus Loans
If banks monitor borrowers in ways that cannot be accomplished by dispersed bondholders, or produce information that capital markets investors cannot produce, then how can bonds and loans coexist?
Diamond (1989, 1991):
• New borrowers, i.e., young firms, borrow from banks initially.
• Later, based on the credit record established while being monitored by a bank, the firm can issue bonds.
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Bonds versus Loans
Suppose there are three types of borrowers.
Two of these types are fixed at either Good (G) or Bad (B) while the third can choose between Bad and Good (BG).
Type refers to the value of the firm’s project.
If investors knew a firm’s type, its debt would be priced accordingly.
Over time, investors or the bank can learn the type of the firms with a fixed type by observing whether there has been a default.
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Bonds versus Loans
The reputation of a surviving BG type is consistent with a G type. The cost of funding is so low that it always chooses the Good project.
Reputation effects eliminate the need for future monitoring so G types can issue bonds.
B types cannot benefit from monitoring, so they issue bonds that are appropriately priced.
The BG types borrow from banks, which then monitor them.
This result explains the coexistence of bonds and loans, but not for the same firm.
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Bonds versus Loans
Bolton and Freixas (2000) bank loans are valuable to firms because, unlike bonds, bank loans can be renegotiated.
But bank capital is costly, so bank loans are costly relative to bonds. Firms trade off the benefits of bank loans against their cost.
Hence, bonds and loans coexist.
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Banks versus Stock Markets
Allen (1993) and Allen and Gale (1999) argue that banks and stock markets are fundamentally different in the way that they process information.
Stock markets can aggregate diverse opinions, particularly about new technologies, while banks are inherently conservative.
The prediction is that stock market-based economies will embrace new technologies, while bank-based economies will be less dynamic.
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Banks versus Stock Markets
This finding is consistent with casual observations about venture capital.
Empirical literature, Levine (2000) and Levine and Zervos (1998), finds that the level of financial development is more critical than the relative dominance of banks or stock markets.
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Tools to Solve Asymmetric Information Problems
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Asymmetric Information in Transition and Developing Countries
“Financial repression” created by an institutional environment characterized by:
• insecure property rights (unable to use collateral efficiently);
• a poor legal system (restrictive covenants are difficult to enforce);
• weak accounting standards (less access to good information);
• government intervention (directed credit programs and state owned banks hurt incentives to proper channel funds to its most productive use).
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Application: Financial Development and Economic Growth
The financial systems in developing and transition countries face several difficulties that keep them from operating efficiently.
In many developing countries, the system that enforces property rights
i.e., the rule of law, constraints on government expropriation, absence of corruption,
functions poorly, making it hard to use these tools effectively.
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