1. The Economics of Financial Intermediation
Chapter 11
The Economics of Financial Intermediation

2. 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?

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

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

5. Financial and Economic Development

6. 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

7. Role of Financial Intermediaries: Importance of Indirect Finance

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

9. 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?

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

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

12. 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

13. 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.

14. 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

15. 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.

16. Role of Financial Intermediaries: Summary

17. 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.

18. 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.

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

20. 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

21. 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.

22. 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.

23. 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.

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

25. 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

26. 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

27. 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.

28. 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

29. 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.

30. 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.

31. Negative Consequences of Information Costs

32. 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

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

34. How Companies Finance Growth

35. 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.

36. Chapter 11
End of Chapter