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Global Banking: Summary of all asynchronous lecturesAsynchronous Lecture 1
Ø The rationale for financial intermediaries
Within a world without financial intermediation, we have:
- Corporations or firms (net borrowers), of which we assume that they don’t have
enough financial means to finance their activities
- Households (net savers), of which have money they can lend to the net borrowers. In
return, they get equity and/or debt.
Theoretically, this solves the problem of the net savers.
Q: This raises the questions: when are FI useless?
Answer: in a perfect world, these FI are indeed redundant (useless).
• This is the Modigliani-Miller result.
• Assumptions for this:
o Complete markets
o Symmetric information
§ BUT: the real world faces frictions. We consider those/define those as
agency costs.
The problems we have in a world without the FI’s:
v Adverse selection.
Ø Before purchasing a firm’s debt or equity, investors don’t know quality of firm.
§ They cannot decide on which firm would be a good investment in terms of
equity/debt.
§ In this case, the poorest or adverse quality firms, have the greatest incentive to
issue the securities.
§ For good firms it is inconvenient to issue securities because these adverse firms
pull the investment amounts investors are willing to pay down.
v Moral Hazard.
Ø After purchasing securities, investors will need to monitor the firm’s manager
§ Managers might have the incentive to spend company money on risky projects or
perquisite consumption.
§ Manager could give less effort than promised
v Maturity and liquidity
Ø Firm’s debt or equity might have characteristics that are not attractive to investors.
Like maturity or liquidity;
§ It might be that the debt and equity is not sufficient at the specified maturity.
§ Than, securities must be liquidated at current prices that are not investor’s favor.
,Global Banking: Summary of all asynchronous lectures
Summing up problems without FI’s:
- Lower level of funds available as investors are not always eager in lending to a firm
- Higher information costs (to prevent moral hazard)
- Less liquidity in the economy
- Higher prices of risk for investors
And therefore, we need FI’s between firms and household.
They have two roles:
- Broker
o FI provides information about quality of securities and sells them.
§ the broker reduces screening costs through economies of scale.
§ Efficient in producing information and therefore partly solves the
adverse selection problem.
- Asset transformer
o FI provides primary securities (assets/bonds, loans) issued by firms into
secondary security like bank deposits. This solves two problems:
§ As a delegated monitor to efficiently produce information on the
firm’s activities reduces it moral hazard. Monitoring costs are lower on
average (economies of scale)
§ Maturity intermediation, the FI’s create liquidity, household hold
securities with very short maturity. Like demand deposits. Price risk
almost absent.
Other services by FI’s:
- Transmission of monetary policy
- Credit allocation (providing loans as mortgages)
- Payment service
- Intergenerational wealth transfer of time intermediation (pensions/life insurance)
- Denomination intermediation (mutual funds)
Importance of regulation:
- Banks play important roles in economies.
o Need special regulatory attention.
o Banks troubles can have negative externalities on the rest of the economy.
§ E.g. if a bank fails, that might destroy household savings and restricts
firm’s access to credit with contagious effects on the rest of the
economy. Furthermore, we consider a systemic risk in large
interconnected bank, because their failure might cause other banks to
fail as well. These banks are considered too big to fail.
Regulation imposes private costs, results in:
- No more than 10 percent of equity to single borrower
, Global Banking: Summary of all asynchronous lectures
- On site examinations can be long and costly
- Capital requirements
- Banks can be forced to invest in communities in which they take deposits
Benefits or regulation:
- Access to discount window and deposit insurance
- Access to TARP funds to boost capital
- Too-big-to-fail protection
Asynchronous Lecture 2
Ø Financial Intermediaries as Delegated Monitors (Part 1)
Core question: why do investors lend to banks who lend to borrowers, instead of lending
directly? Why can banks provide beneficial services?
- We need to consider:
o Type of financial contracts provided by banks
o Why these are optimal (why is everyone better of?)
Delegating monitoring: Asset services
- investor puts money into the bank, bank puts it into the firm and does the
monitoring for the investor.
- The next model shows that reduced monitoring costs are optimal in a sense.
Model overview:
K : individual cost of monitoring for an investor
m : lenders per borrower.
mK : Total monitoring cost, if everyone does his own monitoring.
- What is we bring money to the bank?
o Impose delegating costs for this
- BUT: can we make sure that the bank does the monitoring sufficient?
o Theory must explain why intermediation gives an overall improvement.
D : The delegation cost
S : The savings that arises from the monitoring
Now, we can conclude that the delegated monitoring is optimal if and only if:
K + D < min[mK, S]
Intuition:
- K + D : the cost of the bank. The bank needs to monitor (cost: K) and it requires an
additional fee for the delegation (cost: D)
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