Topic 2: Theoretical Concepts in Banking

Some Theoretical Concepts in Banking Principal-agent problem Adverse selection Moral hazard problem The implications of the above to:  Relationship banking  Arm’s length banking

Principal-agent problem in banking As already discussed in Topic 1, Banks act as intermediaries b/w depositors and borrowers. The intermediary role of banks leads to organisational structures containing principals and agents to different extents.

Principal-agent problem in banking Bank activities are usually collection of contracts b/w principal and agents. Whenever these contracts are not honoured properly, principal-agent problem will arise.

Principal-agent problem in banking This principal-agent problem may exists b/w: shareholders (principal) and management (agent) the bank (principal) and its officers (agents) the bank (principal) and its debtors (agents) depositors (principal) and bank (agent) Reason is: different priorities and incentives. Principal agent problem with debtors usually arise due to the fact that agent has more information about his/her characteristics than the principal.

Asymmetric information: Adverse selection and moral hazard Asymmetric information – a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction. The presence of asymmetric information leads to adverse selection and moral hazard problems. Example: Managers of a company have better information about how well their business is doing than their shareholders.

Adverse selection problem in banking An asymmetric information problem that occurs before the transaction. AS can lead to problems in banking because the principal has inferior information compared to the agent => problems when it comes to signing agreements based on this information. The highest risk groups are the most likely to enter into the contract. Examples:  Banks making bad loans to customers who, on the surface, seem to have an acceptable risk profile.  Big risk takers are most eager to take out a loan because they know they are unlikely to repay it.

Adverse selection problem in banking Tools to help solve the AS problem: Private production and sale of information – rating agencies, however Free-rider problem Government regulation to increase information  Produce information to distinguish good from bad firms – political problems may arise  Regulate the market in order to encourage the companies to disclose honest information, for example independent audits. Financial intermediation – banks are experts in producing information about other firms, so that it can sort out good credit risks from bad ones. Collateral – reduces the consequences of AS, because it reduces the lender’s losses in the event of a default.

Moral hazard problem in banking MH arises after the transaction occurs. MH occurs when incentive changes for any party, which are core of the contract. The lender runs the risk that the borrower will engage in activities that are undesirable and decrease the possibility for repayment of the loan. Example:  Investors may take loans and intentionally default or engage in risky activities.  Managers may consider their own objectives are more important than that of the firm, as they have less incentive to maximize profits.

Moral hazard problem in banking Tools to help solve the MH problem: Monitoring – frequent audits – higher cost Government regulation – standard accounting principles that make the profit verification easier Financial intermediation – venture capital companies – pool the resources of their partners; in exchange for the capital the financing company receives a share in the new business and has own members in the management body. Debt contracts – fixed amount at periodic intervals Self participation in the project Restrictive covenants

Relationship banking Relationship banking can help to minimise the principal-agent, adverse selection and moral hazard problem arising b/w a bank and borrowers and bank and depositors. Under relational banking, lenders and borrowers have a relational contract.  Bank and borrower and bank and depositors will try to give full information to each others (better flows of information). Relationship banking is very common in Japan and Germany.

Arms’ length banking An extreme opposite is an arms’ length transactional or classical contract where many banks compete for the customers business and customers shop around several banks.  Both parties will try to disclose bear minimum information and stick to the contract clauses. The UK and USA banking is more akin to this system.

True or False? 1. Asymmetric Information arises when one party does not know all that he or she needs to know about the other party to make a correct decision. Borrower has better (more) information than the lender about the potential returns and risks.

True or False? 2. Moral hazard arises after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view, because they make it less likely that the loan will be paid back.

True or False? 3. Adverse selection occurs when agents with the greatest potential risk are more likely to enter into arrangements that reduce their risk. 4. Adverse selection occurs before the transaction occurs. 5. Potential bad credit risks are the ones who most actively seek out loans.

True or False? 6. Relationship banking can help to minimise the principal-agent, adverse selection and moral hazard problem arising b/w a bank and borrowers and bank and depositors. 7. Relationship banking is very common in UK and USA. 8. Relationship banking is the ultimate solution for all problems in banking.

Multiple choices questions 1. The principal-agent problem: a)Occurs when managers have more incentive to maximize profits than the stockholders-owners do. b)Would not arise if the owners of the firm had complete information about the activities of the managers. c)In financial markets helps to explain why equity is a relatively important source of finance for American business. d)All of the above.

Multiple choices questions 2. Remedies for the principal-agent problem include: a)Giving managers a larger equity stake b)Limiting the firm's free cash flow c)Monitoring the firm closely d)Threatening a takeover. e)All of the above

Multiple choices questions 3. Ways in which bank regulations reduce the adverse selection and moral hazard problems in banking include: a)restrictions that prevent banks from acquiring certain risky assets, such as common stocks. b)high bank capital requirements to increase the cost of bank failure to the owners. c)all of the above.