Supplement Chapters 11-13

Objectives: Chapter 11&12 Differentiate Adverse Selection and Moral Hazard Identify 5 different types of financial institutions.

Unit Overview Securities Market Institutions Transactions Costs Investment Institutions Adverse Selection Contractual Savings Institutions Asymmetric Information Costs Depository Institutions Moral Hazard Government Financial Institutions

Moral Hazard Example Lender lends $100 to borrower at 5% interest. Borrower can choose between two investment projects each of which require an upfront pay-off of $100. Project A is a risky project but potentially lucrative. With an 80% probability, project A will generate 0 payoff. With a 20% probability project A will generate a $205 payoff. Project B is a non-risky project which will generate a pay-off of $110 with an 80% probability and a pay-off of $95 with an 20% probability. Three Questions Which project will A choose if he is risk-neutral. Which project would B choose if he is risk-neutral Which project is most advantageous to a risk-neutral society.

PayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2 Expected Value We can use the statistical concept of expected value to answer these questions. Expected payoff to a project with two possible outcomes PayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2

Which project is socially beneficial? Expected payoff to project A is .8∙$0 +.2·$205 = $41 Since cost is $100, the expected payoff to project A is less than the cost. To a risk neutral or risk averse society this project will be bad. Expected payoff to project B is .8∙$110 +.2·$95 = $107 Since cost is $100, the expected payoff to pro ject B is more than cost. To a risk neutral society this project is good (though the risk might be to large for a suffiiciently risk-averse society).

Pay-off to Borrower and Lender Project A. With 80% probability, the payoff to the project will be $0 so both the borrower and lender get $0. With 20% probability, the pay-off to the project will be $205, so the lender will be repaid $105 and the borrower will keep $205-$105 = $100. The expected payoff to the project for the lender will be .2∙$105+.8∙0=$21. The expected payoff to project A for the borrower is .2∙$100+.8∙0=$20. Project B. With 20% probability, the payoff to the project will be $95, so the lender will only be repaid $95 and the borrower keeps $0. With 80% probability, the payoff to the project will be $110, so the lender is repaid $105 and the borrower keeps $5. The expected payoff to the project for the lender will be .2∙$95+.8∙$105 =$103. The expected payoff to project A for the borrower is .2∙$0+.8∙$5=$4

Which project will be undertaken? If the borrower has control of the funds, then he will choose project A. The expected value of the payment to him is higher for the riskier project. This is because the lender bears all of the upside of a risky investment and none of the downside. The lender of course prefers the reverse. He would choose the socially beneficial project B. This example demonstrates the problem of moral hazard in debt markets. Because he shares none of the downside, the borrower will choose inefficiently risky projects once he has control of the funds.

Depository Institutions Investment & Contractual Savings Mutual Funds Hedge Funds Pension Funds Insurance Financial Markets 1. Primary: Investment Banks 2. Secondary: Exchanges 3. Secondary: Brokers & Dealers Investment Finance Companies Savers Government Mortgage Companies Borrowers Depository Institutions Banks RLB’s & DTC’s

Maturity Requirements Size Names Restricted License Banks None $500,000 GE Capital Hang Seng Finance Deposit Taking Companies 3 Months $100,000 Dao Heng Finance Wing Lung Finance

Asymmetric Info Banks Depositors Borrowers Liqudity Monitoring

Core Deposits vs. Managed Liabilities Bank Liabilities can be divided into two parts. Core Deposits – Demand Deposits, Savings Accounts, Small Time Deposits (Retail Funds) Managed Liabilities – Borrowings from Other Banks, Securities, Large CD’s and Time Deposits (Wholesale Funds) Retail funds have lower interest costs and are thought to be more stable.

Primary Reserves Banks primary reserves is equal to their cash. Cash includes both vault cash (the actual paper currency that banks hold) plus bank reserves at the central bank. In Hong Kong, banks reserves at the central bank (the HKMA) are called Clearing Balances. These are held for the sole purpose of clearing interbank transactions. For example, if a depositor at Hang Seng bank writes a $100 check to a depositor at Bank of China, the transaction will be cleared when the HKMA deducts $100 from Hang Seng’s Clearing Balance account and credits the BOC’s Clearing Balance account. In Hong Kong, primary reserves are very small. The primary reserve ratio is Average Hong Kong primary reserve ratio is .21% in June 2001.

Secondary Reserves Secondary reserves are liquid assets held by banks. Secondary reserves = Primary Reserves + Short Maturity, Liquid Securities + Short-term Deposits at Other Banks. Bank of East Asia has total assets of $181,764,933 Secondary reserve ratios B of EA (2001) Mill $HK Cash & Short Term Funds $43,760,587 Other Securities $4,150,218 Secondary Reserves $47,910,805 Secondary Reserve Ratio .264

Sources of Bank Profits Net Interest Margin is traditionally the main source of profits for banks. Non-Interest Income which includes fees for services are also important. For B of East Asia, net interest income is almost 4 times the size of non-interest income.

Equity Multiplier For any firm, we can calculate the Equity Multiplier, as Average Equity Ratio in Hong Kong Banks in July, 2001 is 10.2 Equity Ratio for Bank of East Asia is 9.961

ROA/ROE A measure of the returns earned on assets is Return on Assets Owners of banks are concerned with the pay-off they earn per each dollar originally invested in the bank. They care about the Return on Equity Its easy to see that equity returns are a positive function of ROA and leverage

Liquidity Measures Liquidity Ratio – Measure of assets due within 1 month relative to liabilities due within 1 month. Loan to Deposit Ratio – Ratio of illiquid loans to liquid deposits. High measure of loan-to-deposit ratio indicates high liquidity risk.