The Economics of Financial Intermediation Chapter 11 The Economics of Financial Intermediation

Economics of Financial Intermediation: The Big Questions What are financial intermediaries and what do they do? What information problems exist in financial relationships and how do intermediaries help solve them?

Economics of Financial Intermediation: Roadmap Role of Financial Intermediaries Information Asymmetries and Information Costs Financial Intermediaries and Information Costs

Financial Intermediaries Businesses whose assets and liabilities are primarily financial instruments Economic growth requires a well-functioning financial system.

Financial and Economic Development

40% of world’s population lives on less than $2/day Most people have no access to traditional banking Microfinance offers small loans, often to groups who are collectively responsible for repayment

Role of Financial Intermediaries: Importance of Indirect Finance

Preliminaries: eBay Roughly 15 million items for sale 100 million registered users No one is auctioning checking account services or mortgages.

Preliminaries: eBay Imagine someone wants $100,000 mortgage. Could offer 1000 shares of $100 each on eBay But Is the borrower accurately representing their ability to repay? Will the borrower really take the funds and purchase a house?

Role of Financial Intermediaries: Problems They Solve Lower transactions costs Reduce information costs

Role of Financial Intermediaries Pool the resources of small savers Put together the 100 savers with $1000 each and create a $100,000 mortgage

Role of Financial Intermediaries 1. Pool savings 2. Accounting, Safekeeping, and Access to the Payments System Hold funds safely Monthly Statements, keep track of deposits and withdrawals and help us manage our financial lives ATMs – way to get cash

Role of Financial Intermediaries 1. Pool savings 2. Accounting, Safekeeping and Access to the Payments System 3. Liquidity Pay interest at the same time that they give you emergency access. Can do it because not everyone will need it at the same time.

Role of Financial Intermediaries 1. Pool savings 2. Accounting, Safekeeping and Access to the Payments System 3. Liquidity 4. Risk sharing Your deposit is distributed into small share of many loans Access to standard portfolio diversification

Role of Financial Intermediaries 1. Pool savings 2. Accounting, Safekeeping and Access to the Payments System 3. Liquidity 4. Risk sharing 5. Information services Bank is an information warehouse. Collecting and processing standardized financial information.

Role of Financial Intermediaries: Summary

Credit card interest rates are often very high? People who use them often have bad credit or no credit history at all, so lenders assume the worst about borrower. This is adverse selection.

Information Asymmetries and Information Costs Asymmetric Information: Borrowers know more about themselves than lenders do Why does eBay work? Have to trust seller’s representation of the item in order to bid Winning bidder has to trust that seller will send the item once payment is received.

Information Asymmetries: eBay (again) Solution to the information problem Feedback forum Buyer’s insurance

eBay’s feedback rating system awards The Star Chart Stars are awarded to eBay members for achieving 10 or more feedback points. Here's what the different stars mean: Yellow Star (         ) = 10 to 49 points Blue Star (         ) = 50 to 99 points Turquoise Star (         ) = 100 to 499 points Purple Star (         ) = 500 to 999 points Red Star (         ) = 1,000 to 4,999 points Green Star (         ) = 5,000 to 9,999 points Yellow Shooting Star (         ) = 10,000 to 24,999 points Turquoise Shooting Star (         ) = 25,000 to 49,999 points Purple Shooting Star (         ) = 50,000 to 99,999 points Red Shooting Star (         ) = 100,000 or more points eBay’s feedback rating system awards +1 point for each positive comment 0 points for each neutral comment -1 point for each negative comment

Information Asymmetries: Two Problems Adverse selection: Can’t distinguish good borrowers from bad ones before making a loan. Moral hazard: Can’t monitor whether borrower is doing what they claimed once they receive the funds.

Information Asymmetries: Adverse Selection The market for lemons: Used car buyers can’t tell good from bad cars. Will at most pay the expected value of good and bad cars. Sellers know if they have a good car, and won’t accept less than the value. Good car sellers will withdraw cars from the market. Market has only the bad cars.

Adverse Selection in Financial Transactions If you can’t tell good from bad companies stocks of good companies are undervalued, owners will not want to sell them. If you can’t tell good from bad bonds owners of good companies will have to sell bonds for too low a price owners won’t want to do it.

Solving the Adverse Selection Problem Used cars Consumers reports, car dealers with reputations, warranties and mechanics Financial Markets Information disclosure Collateral and Net worth

If you can’t make a 20% down payment when you buy a house, you may be forced to get PMI With a smaller investment in the house, the lender views you as high risk PMI is insurance for the lender if you default

Deflation is when prices are declining When prices fall, firm revenue falls Borrowers continue to owe the same dollar amount even if prices fall Deflation lowers borrower net worth, making it more difficult to overcome the problems caused by information asymmetries

Information Asymmetries: Moral Hazard How can your boss be sure that you are working as hard as you can? Problem arises when we can’t observe people’s actions – can’t distinguish poor performance from bad luck.

Moral Hazard in Equity Finance How do you know if a companies managers will work hard? Solutions are hard to find Force managers to own a significant portion of the firm. Try to align stockholder and manager interests by giving managers stock options

Moral Hazard in Debt Finance Debt contracts encourage managers to take too much risk since they get the upside benefits but don’t face the downside costs. Solutions include covenants that are requirements for certain types of performance.

In developing countries it can be difficult to get legal title to land Without legal title, you can’t use something as collateral Strong property rights are essential to a well-functioning financial system.

Negative Consequences of Information Costs

Financial Intermediaries and Information Costs Screening and Certification to Reduce Adverse Selection Collect & evaluation borrower information Intermediaries have reputations to maintain Monitoring to reduce moral hazard Checkup on borrowers

How Companies Finance Growth Information asymmetries make it difficult to Issue stocks Issue bonds Obtain Loans Result is that they use internal funds.

How Companies Finance Growth

At prosper.com borrowers look for lenders directly Can they overcome the adverse selection and moral hazard problems that seem to plague all financial arrangements? Have a look and see if it’s working.

Chapter 11 End of Chapter