Chapter 3

Asymmetric
Information and
The role of
Financial
intermediaries
FIGURE 1 Sources of External Funds for
Nonfinancial Businesses: A Comparison of the United
States with Germany, Japan, and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and
Empirical Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data
are from 1970–2000 and are gross flows as percentage of the total, not including trade and other credit
data, which are not available.
8-2
Eight Basic Facts

1. Stocks are not the most important sources of

external financing for businesses
2. Issuing marketable debt and equity securities is
not the primary way in which businesses finance
their operations
3. Indirect finance is many times more important
than direct finance
4. Financial intermediaries, particularly banks, are
the most important source of external funds used
to finance businesses.

8-3
Eight Basic Facts (cont’d)

5. The financial system is among the most heavily

regulated sectors of the economy
6. Only large, well-established corporations have
easy access to securities markets to finance their
activities
7. Collateral is a prevalent feature of debt contracts
for both households and businesses.
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers

8-4
Transaction Costs

• Financial intermediaries have evolved to

reduce transaction costs
– Economies of scale
– Expertise

8-5
Asymmetric Information

• Adverse selection occurs before the

transaction
• Moral hazard arises after the transaction
• Agency theory analyses how asymmetric
information problems affect economic
behavior

8-6
Market for Lemons

• Nice simple mathematical example of how

asymmetric information (AI) can force
markets to unravel
• Attributed to George Akeloff, Nobel Prize
(2001)
• Good starting point for this analysis,
although it does not deal with insuance

8-7
Problem Setup

• Market for used cars

• Sellers know exact quality of the cars they
sell
• Buyers can only identify the quality by
purchasing the good
• Buyer beware: cannot get your $ back if
you buy a bad car

8-8
• Two types of cars: high and low quality
• High quality cars are worth $20,000, low are
worth $2000
• Suppose that people know that in the
population of used cars that ½ are high
quality
– Already a strong (unrealistic) assumption
– One that is not likely satisfied

8-9
• Buyers do not know the quality of the
product until they purchase
• How much are they willing to pay?
• Expected value = (1/2)$20K + (1/2)$2K =
$11K
• People are willing to pay $11K for an
automobile
• Would $11K be the equilibrium price?

8-10
• Who is willing to sell an automobile at $11K
– High quality owner has $20K auto
– Low quality owner has $2K
• Only low quality owners enter the market
• Suppose you are a buyer, you pay $11K for
an auto and you get a lemon, what would
you do?

8-11
• Sell it for on the market for $11K
• Eventually what will happen?
– Low quality cars will drive out high quality
– Equilibrium price will fall to $2000
– Only low quality cars will be sold

8-12
Some solutions?

• Deals can offer money back guarantees

– Does not solve the asymmetric info problem, but
treats the downside risk of asy. Info
• Buyers can take to a garage for an
inspection
– Can solve some of the asymmetric information
problem

8-13
Adverse Selection: The
Lemons Problem
• If quality cannot be assessed, the buyer is willing
to pay at most a price that reflects the average
quality
• Sellers of good quality items will not want to sell at
the price for average quality
• The buyer will decide not to buy at all because all
that is left in the market is poor quality items
• This problem explains fact 2 and partially explains
fact 1

8-14
Adverse Selection: Solutions
• Private production and sale of information
– Free-rider problem
• Government regulation to increase information
– Not always works to solve the adverse selection problem,
explains Fact 5.
• Financial intermediation
– Explains facts 3, 4, & 6.
• Collateral and net worth
– Explains fact 7.

8-15
Moral Hazard in Equity
Contracts
• Called the Principal-Agent Problem
– Principal: less information (stockholder)
– Agent: more information (manager)
• Separation of ownership and control
of the firm
– Managers pursue personal benefits and power
rather than the profitability of the firm

8-16
Principal-Agent Problem:
Solutions
• Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
• Government regulation to increase information
– Fact 5
• Financial Intermediation
– Fact 3
• Debt Contracts
– Fact 1

8-17
Moral Hazard in Debt
Markets
• Borrowers have incentives to take on
projects that are riskier than the lenders
would like.
– This prevents the borrower from paying back the
loan.

8-18
Moral Hazard: Solutions

• Net worth and collateral

– Incentive compatible
• Monitoring and Enforcement of Restrictive
Covenants
– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information
• Financial Intermediation
– Facts 3 & 4

8-19
Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them

8-20
Asymmetric Information in Transition
and Developing Countries

• “Financial repression” created by an

institutional environment characterized by:
– Poor system of property rights (unable to use
collateral efficiently)
– Poor legal system (difficult for lenders to enforce
restrictive covenants)
– Weak accounting standards (less access to good
information)
– Government intervention through directed credit
programs and state owned banks (less incentive
to proper channel funds to its most productive
use).

8-21
Conflicts of Interest

• Type of moral hazard problem caused by economies

of scope (applying one information resource to
many different services).
• Arise when an institution has multiple objectives
and, as a result, has conflicts between those
objectives
• A reduction in the quality of information in financial
markets increases asymmetric information
problems
• Financial markets do not channel funds into
productive investment opportunities
8-22
Why Do Conflicts of Interest
Arise?
• Underwriting and Research in Investment
Banking
– Information produced by researching companies is used to
underwrite the securities issued by the same companies.
The bank is attempting to simultaneously serve two client
groups whose information needs differ.
– Spinning occurs when an investment bank allocates hot,
but underpriced, IPOs to executives of other companies in
return for their companies’ future business.

8-23
Why Do Conflicts of Interest
Arise? (cont’d)
• Auditing and Consulting in Accounting Firms
– Auditors may be willing to skew their judgments
and opinions to win consulting business.
– Auditors may be auditing information systems or
tax and financial plans put in place by their
nonaudit counterparts within the firm.
– Auditors may provide an overly favorable audit
to solicit or retain audit business.

8-24
Why Do Conflicts of Interest
Arise? (cont’d)
• Auditing and Consulting in Credit-Rating Firms
• Conflicts of interest can arise when:
– Multiple users with divergent interests depend on the
credit ratings (investors and regulators vs. security
issuers).
– Credit-rating agencies also provide ancillary consulting
services (e.g. advise on debt structure).
• The potential decline in the quality of information
negatively affects the performance of financial
markets.

8-25
Conflicts of Interest:
Remedies
• Sarbanes-Oxley Act of 2002 (Public
Accounting Return and Investor Protection
Act) increased supervisory oversight to
monitor and prevent conflicts of interest
– Established a Public Company Accounting
Oversight Board
– Increased the SEC’s budget
– Made it illegal for a registered public accounting
firm to provide any nonaudit service to a client
contemporaneously with an impermissible audit

8-26
Conflicts of Interest:
Remedies (cont’d)
• Sarbanes-Oxley Act of 2002 (cont’d)
– Beefed up criminal charges for white-collar crime
and obstruction of official investigations
– Required the CEO and CFO to certify that
financial statements and disclosures are accurate
– Required members of the audit committee to be
independent

8-27
Conflicts of Interest:
Remedies (cont’d)
• Global Legal Settlement of 2002
– Required investment banks to sever the link
between research and securities underwriting
– Banned spinning
– Imposed $1.4 billion in fines on accused
investment banks
– Required investment banks to make their
analysts’ recommendations public
– Over a 5-year period, investment banks were
required to contract with at least 3 independent
research firms that would provide research to
their brokerage customers.

8-28
Banking and
the Management
of Financial
Institutions
The Bank Balance Sheet

• Liabilities
– Checkable deposits
– Nontransaction deposits
– Borrowings
– Bank capital

8-30
The Bank Balance Sheet

• Assets
– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets

8-31
Table 1 Balance Sheet of All Commercial
Banks (items as a percentage of the total,
December 2008)

8-32
Basic Banking: Cash Deposit

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100

Cash deposits deposits

• Opening of a checking account leads to an increase

in the bank’s reserves equal to the increase in
checkable deposits

8-33
Basic Banking: Check Deposit

First National Bank When a bank receives

additional deposits, it
Assets Liabilities
gains an equal amount of reserves;
Cash items in +$100 Checkable +$100
process of deposits when it loses deposits,
collection it loses an equal amount of reserves

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits

8-34
Basic Banking: Making a
Profit
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Required +$100 Checkable +$100 Required +$100 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves

• Asset transformation: selling liabilities with one set of

characteristics and using the proceeds to buy assets with a
different set of characteristics
• The bank borrows short and lends long

8-35
Bank Management

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk

8-36
Liquidity Management:
Ample Excess Reserves

Assets Liabilities Assets Liabilities

Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M

• Suppose bank’s required reserves are 10%

• If a bank has ample excess reserves, a deposit
outflow does not necessitate changes in other parts
of its balance sheet

8-37
Liquidity Management:
Shortfall in Reserves

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M

• Reserves are a legal requirement and the shortfall

must be eliminated
• Excess reserves are insurance against the costs
associated with deposit outflows

8-38
Liquidity Management:
Borrowing

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

• Cost incurred is the interest rate paid on the

borrowed funds

8-39
Liquidity Management:
Securities Sale

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M

• The cost of selling securities is the brokerage and

other transaction costs

8-40
Liquidity Management:
Federal Reserve

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M

• Borrowing from the Fed also incurs interest

payments based on the discount rate

8-41
Liquidity Management:
Reduce Loans

Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M

• Reduction of loans is the most costly way of

acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a
substantial discount
8-42
Asset Management: Three
Goals
• Seek the highest possible returns on loans
and securities
• Reduce risk
• Have adequate liquidity

8-43
Asset Management: Four
Tools
• Find borrowers who will pay high
interest rates and have low possibility
of defaulting
• Purchase securities with high returns and
low risk
• Lower risk by diversifying
• Balance need for liquidity against increased
returns from less liquid assets

8-44
Liability Management

• Recent phenomenon due to rise of money

center banks
• Expansion of overnight loan markets and
new financial instruments (such as
negotiable CDs)
• Checkable deposits have decreased in
importance as source of bank funds

8-45
Capital Adequacy
Management
• Bank capital helps prevent bank failure
• The amount of capital affects return for the
owners (equity holders) of the bank
• Regulatory requirement

8-46
Capital Adequacy Management:
Preventing Bank Failure

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M

Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

8-47
Capital Adequacy Management:
Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
 
equity capital assets equity capital
ROE = ROA  EM

8-48
Capital Adequacy
Management: Safety
• Benefits the owners of a bank by making
their investment safe
• Costly to owners of a bank because the
higher the bank capital, the lower the return
on equity
• Choice depends on the state of the economy
and levels of confidence

8-49
Application: How a Capital Crunch
Caused a Credit Crunch in 2008

• Shortfalls of bank capital led to slower credit

growth
– Huge losses for banks from their holdings of
securities backed by residential mortgages.
– Losses reduced bank capital
• Banks could not raise much capital on a
weak economy, and had to tighten their
lending standards and reduce lending.

8-50
Credit Risk: Overcoming Adverse
Selection and Moral Hazard

• Screening and Monitoring

– Screening
– Specialization in lending
– Monitoring and enforcement of
restrictive covenants

8-51
Credit Risk: Overcoming Adverse
Selection and Moral Hazard

• Long-term customer relationships

• Loan commitments
• Collateral and compensating balances
• Credit rationing

8-52
Interest-Rate Risk
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital

• If a bank has more rate-sensitive liabilities than assets, a rise

in interest rates will reduce bank profits and a decline in
interest rates will raise bank profits

8-53
Interest Rate Risk: Gap
Analysis
• Basic gap analysis:
(rate sensitive assets - rate sensitive liabilities) x  in bank
 interest rates = 
profit
• Maturity bucked approach
– Measures the gap for several maturity
subintervals.
• Standardized gap analysis
– Accounts for different degrees of rate sensitivity.

8-54
Interest Rate Risk: Duration
Analysis
 in market value of security  - percentage point in interest rate
%
x duration in years.
• Uses the weighted average duration of a financial
institution’s assets and of its liabilities to see how
net worth responds to a change in interest rates.

8-55
Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)

• Generation of fee income. Examples:
– Servicing mortgage-backed securities.
– Creating SIVs (structured investment vehicles)
which can potentially expose banks to risk, as it
happened in the subprime financial crisis of
2007-2008.

8-56
Off-Balance-Sheet Activities

• Trading activities and risk management

techniques
– Financial futures, options for debt instruments,
interest rate swaps, transactions in the foreign
exchange market and speculation.
– Principal-agent problem arises

8-57
Off-Balance-Sheet Activities

• Internal controls to reduce the principal-

agent problem
– Separation of trading activities and bookkeeping
– Limits on exposure
– Value-at-risk
– Stress testing

8-58
Role of Financial Institutions
Financial institutions are needed to resolve the
limitations caused by market imperfections
such as limited information regarding the
creditworthiness of borrowers.
1.Role of depository institutions - Depository
institutions accept deposits from surplus units
and provide credit to deficit units through loans
and purchases of securities.
a.Offer liquid deposit accounts to surplus units
b.Provide loans of the size and maturity desired by
deficit units
c. Accept the risk on loans provided
d.Have more expertise in evaluating creditworthiness
e.Diversify their loans among numerous deficit units
8-59
Role of Financial Institutions
Depository Institutions include:
1. Commercial Banks
a. The most dominant type of depository
institution
b. Transfer deposit funds to deficit units through
loans or purchase of debt securities
2. Savings Institutions
a. Also called thrift institutions and include
Savings and Loans (S&Ls) and Savings Banks
b. Concentrate on residential mortgage loans
3. Credit Unions
a. Nonprofit organizations
b. Restrict business to CU members with a common
bond
8-60
 2. Role
Role of nondepository
of Financial Institutionsinstitutions
a.Finance companies - obtain funds by issuing
securities and lend the funds to individuals and
small businesses.
b.Mutual funds - sell shares to surplus units and
use the funds received to purchase a portfolio of
securities.
c.Securities firms - provide a wide variety of
functions in financial markets. (Broker,
Underwriter, Dealer, Advisory)
d.Insurance companies - provide insurance
policies that reduce the financial burden associated
with death, illness, and damage to property.
Charge premiums and invest in financial markets.
e.Pension funds – manage funds until they are
withdrawn for retirement
8-61
Exhibit 1.3 Comparison of Roles among Financial
Institutions

8-62
Comparison of Roles among Financial Institutions

1. Financial institutions facilitate the flow of

funds from individual surplus units (investors) to
deficit units.
2. Financial institutions also serve as monitors of
publicly traded firms.
1. By serving as activist shareholders, they can help
ensure that managers of publicly held corporations are
making decisions that are in the best interests of the
shareholders.

8-63
How the Internet Facilitates Roles of Financial
Institutions

The Internet has enabled financial institutions to

perform their roles more efficiently.
1. Allows for lower costs and fees.
2. Makes firm more competitive forcing other firms
to price their services competitively

8-64
Relative Importance of Financial Institutions

1. Households with savings are served by

depository institutions.
2. Households with deficient funds are served by
depository institutions and finance companies.
3. Several agencies regulate the various types of
financial institutions, and the various regulations
may give some financial institutions a
comparative advantage over others.

8-65
Exhibit 1.4 Summary of Institutional Sources and
Uses of Funds

8-66