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Extensive summary financial intermediation
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Financial IntermediationIntroduction
The key questions in the course
1. Why do we need financial intermediation?
2. What types of financial intermediaries are there and what do they do?
3. What is interest rate risk? How do financial intermediaries handle it?
4. What is credit risk? How do financial intermediaries handle it?
5. What is liquidity risk? How do financial intermediaries handle it?
6. What is the regulation faced by financial intermediaries? What is the role of FinTech in the
modern financial system?
Module 1: Introduction to Financial Intermediation and Risks in Financial Intermediation
Plan:
1. What is financial intermediation?
2. Financial intermediaries and information frictions
3. Financial intermediaries and mismatch of needs
4. Functions and features of financial intermediaries
5. Financial intermediaries and growth
6. Regulation of financial intermediaries
7. Risk in financial intermediation
What is financial intermediation?
In the world, there are suppliers of funds and users of funds. Suppliers of funds are those that earn more
than they can spend. They want value for accumulated savings, they want to earn returns. Users of
funds on the other hand are entrepreneurs, people running companies, who need funds.
Between the two, there used to be direct financing, knowing someone and lending/borrowing money,
however, now there is financial intermediation. Direct financing still happens, to a small extent, nowm
especially between family members. This is because they trust each other.
There are several types of financial intermediaries:
1. Depository institutions: commercial banks, savings institutions, credit unions
2. Non-depository institutions: finance companies, securities brokerages & investment banks,
mutual funds, huge funds, pension funds and insurance companies
Intermediaries are necessary as they solve two big problems:
1. Information frictions:
In direct financing it is difficult to find the potential users of funds, assess the feasibility of the projects
that users of funds want to invest in and monitor the users to make sure they don’t waste money. All
these activities would translate into high transaction costs. Financial intermediaries can solve this
problem because they know both the suppliers and users of funds, moreover, they are specialized in
analysing projects and in monitoring.
2. Mismatch of needs
The timing of the user’s investment may not match the liquidity of suppliers (especially if the claims
cannot be sold easily - liquidity need = sudden, unexpected need for cash). Or, if the risk of the user’s
investment may not match the risk appetite of suppliers (savers are risk averse and firms are risk
,seekers, because of the exposure to idiosyncratic risk).
Financial intermediaries can design and issue their own financial claims and manage risk.
Let’s now discuss the two reasons for the need for financial intermediation in more detail:
Financial intermediaries and information frictions
One of the key problems in financing is information frictions. Financial intermediaries are good at solving
information frictions because of their economies of scale and advantage of concentration:
Economies of scale: The financial intermediary can assess creditworthiness of many users of funds and
monitor them, keeping internal records and thereby making it easy to access to access this information
in the future (less need for costly information collection in the future)
Advantage of concentration: A single financial intermediary has more incentives to monitor users of
funds than dispersed individuals. The financial intermediary therefore has the role of the designated
monitor.
Example: Economies of scale
We have five borrowers with business plans in hospitality and five people working in hospitality with a
lot of savings, who want to lend money. Each of the savers gets matched with one borrower.
To understand the risk, each lender has to analyse the business plan:
- One week needed to learn about the developments in the hospitality sector
- One day needed to apply the knowledge to the proposal
All lenders spend a total of five weeks and five days on the analysis, as each of them spends eight days
on the analysis. However, the financial intermediary would only need to spend one week and five days
on the analysis, because it would only need to learn about the developments in the hospitality sector
once. The economies of scale made the analysis cheaper for the financial intermediary.
Example: Advantage of concentration
One borrower needs $100,000 but no lender has this amount. Therefore, the borrower needs to borrow
from 100 individual lenders. Assume that he borrowed $1000 from each of the 100 lenders at a 0%
interest rate, for simplicity. If the borrower works hard, he can repay with 100% probability. However, if
he does not work hard, he repays with 50% probability. Assume that the borrower does not work hard if
he is not monitored, because working hard is costly. To monitor the borrower, the lender has to pay
$600.
Does it make sense to monitor for each individual lender?
- Expected payoff without monitoring: 50% x $1000 = $500
- Expected payoff with monitoring: 100% x $1000 - $600 = $400
→ Monitoring is not worth it for an individual lender.
Now suppose that the 100 lenders lend the money to a financial intermediary, which then in turn lends
to the borrower. Assume again for simplicity that the financial intermediary also lends at 0% interest
rate.
Does it make sense to monitor for the financial intermediary?
- Expected payoff without monitoring: 50% x $100,000 = $50,000
- Expected payoff with monitoring: 100% x $100,000 - $600 = $99,400
→ Due to the concentration advantage, the financial intermediary has incentives to borrow.
Individually, no one would spend the $600 to monitor, because it doesn’t make sense. But the financial
,intermediary has an incentive to do so. The advantage of concentration causes a change in the
incentives.
However, so far, we talked about the payoffs of lenders, not their profits.
Profits are defined as the difference between payoff and initial investment ($1000 for the individual
lender and $100,000 for the financial intermediary). However, since we assumed that the interest rate is
0%, all profits are negative. But we can calculate the interest rate needed so that the lender makes no
losses. When we find the interest rate at which profits are equal to zero, we have found the minimum
interest rate required by the lender.
Profit=Payoff −Initial investment
Minimum interest rate→ Profit=0
For individual lenders the profit is equal to 0 when payoff is equal to the initial investment, so:
50 %∗X (Promised repayment [ principal+interest ])=$ 1,000
X =$ 2,000
Now to find what the interest rate is we simply have to calculate the percentage increase from $1000 to
$2000:
2000−1000
interest rate= =100 %
1000
As for the financial intermediary, the profit is equal to 0 when payoff is equal to the initial investment,
so:
100 %∗X (Promised rep a yment [ principal+interest ])−$ 600=$ 100,000
X =$ 100,600
Now to find what the interest rate is we simply have to calculate the percentage increase from $100,000
to $100,600:
100,600−100,000
interest rate= =6 %
100,000
So, without financial intermediaries, without monitoring, the minimum interest rate is 100%. However,
with financial intermediaries that monitor, the minimum interest rate is 6%.
The lesson to learn from here is that financial intermediaries enable monitoring, which allows the
borrower to borrow at a much lower cost.
Financial intermediaries and ex-ante information frictions
Ex ante information frictions are also called adverse selection. An example is that of the sellers having
better information about the quality of for example the car they are selling in the market for lemons. In
the financial markets, the users of funds have better information than the suppliers of funds. This
information can affect the likelihood that users of funds will repay back in full. Since this information is
not available to lenders, lenders have to assign an average probability of repayment of all borrowers and
charge a relatively high interest rate. This high interest rate is necessary to allow them to be covered in
the case in which some users of funds default.
However, this causes users of funds with high probability of repayment to see borrowing as less
attractive. Since their cost of borrowing increases, the expected return of their projects is not high
enough, as when you have a high probability of repayment and a high interest rate, most of the
proceeds will go into repayment.
, Financial intermediaries solve this problem by analysing risk and sorting borrowers into categories. This
way they can make loans conditioned on the risk and alleviate information asymmetries.
For example, banks rate your credit risk by asking customers for proof of income, wealth education,
history of repayments and so on. In the US, there is FICO which is a consumer credit scoring agency,
then there are credit rating agencies for corporations and so on, which perform this service.
Financial intermediaries and ex-post information frictions
Users of funds can use the funds in ways that harm the suppliers. For instance, they can put the money
into projects that give them personal gains, take too much risk with their investments or not work hard
enough. This phenomenon is called moral hazard.
Financial intermediaries specialize in monitoring users of funds and can design contracts thanks to their
role as information producers, which allow them to intervene.
For example, a financial intermediary can issue short-term loans which require frequent refinancing, so
that without ‘passing’ the bank’s monitoring test, the firm cannot continue to operate.
Financial intermediaries and the mismatch of needs
The mismatch of needs is one of the key problems in financing. Financial intermediaries are good at
solving the mismatch of needs problem because of diversification. Diversification allows the financial
intermediaries to satisfy the liquidity needs and risk appetites differences at a lower cost. It happens this
way:
- Financial intermediaries receive funds from many suppliers: only some of these supplies will
have liquidity needs, so the financial intermediary can keep fewer reserves
Satisfying liquidity needs: diversified funding supply → Users of funds can typically only repay after
many years and suppliers of funds may have unexpected liquidity needs in the meantime. However,
financial intermediaries intermediate funds of a large number and variety of suppliers and they can
estimate how many are likely to have liquidity needs and keep the necessary cash to provide them with
the liquidity they need.
Sourcing from many suppliers (diversified funding supply) allows the financial intermediaries to
transform long maturity claims into very short term maturity products.
Example: demand deposits issued by banks.
Numerical example:
Suppose there are 100 savers, each saving $1000. There are also 100 borrowers, who want to borrow as
much as possible. The borrower’s project will have a large payoff in two years, but no payoff in the first
year. In one year, 1 among the 100 savers will need to use $500 of his savings.
Question: if each borrower is matched with one saver, how much can he borrow?
Since each saver may need $500 in the first year, each of them will be willing to lend $1000-$500=$500.
Suppose that now each saver gives his money to a financial intermediary, which decides how much to
lend. The financial intermediary knows that only one saver will need $500 in the first year, therefore it
will keep in total only $500 cash. The financial intermediary can therefore lend $1000x100savers -$500
cash = $99,500.
Without the financial intermediary, each borrower could only get $500. Now with the financial
intermediary, each borrower can get $995.
The gain from the financial intermediary is the increase in the credit available.
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