Topic 4

Role of Financial Intermediation

http://www.pcgwm.com/images/top/financial.jpg

Outline for Topic 4

1. Financial Intermediaries Exist because:
a) asset transformation
b) transaction costs reduction
c) liquidity insurance
d) informational economies of scale and delegated monitoring
2. Solutions for Adverse Selection Problem:
a) Government regulation
b) Private production & sale of information
c) Financial intermediaries
3. Informational Economies Of Scale

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 Outline for Topic 4
4. Solution to reduce moral hazard problem in equity markets
a) Monitoring
b) Government regulation to increase information
c) Financial intermediaries active in the equity market
d) Debt contracts
5. Solution to reduce moral hazard problem in debt markets

making debt contracts incentive-compatible

monitoring & enforcing restrictive covenants

financial intermediaries
6. Delegated Monitoring Theory by Diamond (1984)

Outline for Topic 4

7. Future For Financial Intermediaries (Changing Trends in Banking Industry:
(a) Reduction in cost advantages in acquiring funds (consequences are:)
(i) a disintermediation process occurred
(ii) Money market mutual funds appeared & grew dramatically in USA 1980
(iii) Deregulation in 1980s
(b) Reduction in income advantages in using funds
(i) Improved information technology & diffusion of credit rating agencies
(ii) Securitization
8. Bank Reactions to the Decline in Their Intermediation Role
a) Banks expand into new, riskier lending
b) Bank use off-balance sheet activities
Proprietary trading increased dramatically
5

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 Learning Outcomes
• To explain the existence of financial intermediaries.
• To discuss the importance of financial intermediaries in the corporate
financing.
• To explain how financial intermediaries are able
(i) to reduce the transaction cost problem &
(ii) to reduce the adverse selection and moral hazard problems
• To discuss the expected developments affecting the role of the different
types of financial intermediaries (especially banks) in the future.

Introduction
• Why most financing is indirect through intermediaries?
• Why banks are important but stock markets are less important in the
business financing?
• Why financial intermediaries are more important than securities markets?
• This topic will
– analyze the reasons for the existence of financial intermediaries and
– illustrates the economic theories to understand the
existence, relevance & functioning of financial intermediaries
– investigate the future for traditional intermediation services.

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 Some Evidence On Financial Intermediation

8
Source: M. Buckle (2011) Principle of Banking and Finance, ch4

Introduction
1. Firm mainly raise fund from retained profits (internal funds).
2. Bank loans are the most important external funds in USA, Germany, Japan
& UK (USA: 56%, Japan & Germany: 86%).
But bank financing has been declining in recent years.
3. Stocks are the least important external source of funds (see figure 4).
(e.g. US: stocks 5 times < loan, Germany: 10 times, Japan: 20 times)
4. Bonds are more important than stocks (US:32%vs 11%, Japan 9% vs 5%)
Marketable securities (i.e. stock & bonds): US (43%) Germany (15%),
Japan (14%)
4. Households (direct finance) only buy small portion of marketable securities;
Non-bank financial intermediaries (pension funds, mutual funds & insurance
companies) are the key buyers (i.e. indirect finance)
• Indirect financing are more important than direct finance
• Surplus units can lend funds (earn a return) directly to deficit units (can
finance their investment). 9

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 Why Do Financial Intermediaries Exist?
• Financial intermediaries exist to solve/reduce market imperfections, e.g:
a) Difference in the preference (size, maturity, liquidity, risk) of lender &
borrower
b) presence of transaction costs, shocks in consumers’ consumption &
asymmetric information (cause adverse selection & moral hazard).
• The above can be explained by the following theories:
1) asset transformation
2) transaction costs reduction
3) liquidity insurance
4) informational economies of scale and delegated monitoring.

10

Why Do Financial Intermediaries Exist?

11
Source: M. Buckle (2011) Principle of Banking and Finance, ch4

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 (1) Asset Transformation Theory
Financial intermediaries aims to:
• satisfy both borrowers’ needs for permanent or long-term capital & the
desires of many lenders for a high degree of liquidity in their asset holdings
(assets may be turned into cash at short notice).
• transform the primary securities (issued by firms) into the
indirect securities (required by lenders).
Firms issue liabilities (deposit claims) which are low risk, short-term, high
liquidity & firm use the funds to acquire the larger size, high-risk & illiquid
claims.
• 4 main transformations of financial intermediaries:
a) Maturity transformation
b) Size transformation
c) Liquidity transformation
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d) Risk transformation

(1) Asset Transformation Theory

a) Maturity transformation:
 Bank liabilities (i.e. deposits) mature quicker than assets (i.e. loan).
 banks make long-term loans & fund them by issuing short term deposits
(i.e. ‘borrowing short and lending long’).
 Financial intermediaries mismatch the
maturity of the assets held with the maturity of the liabilities issued.

b) Size transformation:
 The amount provided by lender are smaller than
the amounts required by borrowers.
 Financial intermediaries collect
the small amounts from lenders & parcel them into the larger amounts to borrowers.
13

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 (1) Asset Transformation Theory
c) Liquidity transformation:
 financial intermediaries provide secondary claims to depositors that have
superior liquidity than direct claims (e.g. bonds & stocks).
 Deposits are liquid & low risk.
 Loans are illiquid & with higher risk than deposits.
 Financial intermediaries can diversify their portfolio
by hold liabilities & assets with different liquidity
 Higher diversification, lower default risk.

d) Risk transformation:
 financial intermediaries transform risks to reconcile the preferences of
borrowers & lenders.
 The lenders (who hold the liability of the financial intermediaries) are safe.
14
 Banks bear default risk of its loans.

(1) Asset Transformation Theory

Banks transform the risks by:
i) Screening loan applications:
– Select good borrowers to minimize the risk of loss on loan

ii) Diversifying risk:

– lend to different types of borrowers, rather than concentrate in single
branch or single area of the country & to restrict the maximum size of any
single loan.
– E.g. The failure of 400 Texan banks over the period 1985–89 was due to
the heavy concentration of their loan portfolio in real estate dependent on
the oil business.

iii) Pooling risks:

– Have large number of loans to reduce the variability of losses.

15

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 (1) Asset Transformation Theory
 Asset transformation highlights the
existence of surplus units (lenders) & deficit units (borrowers) with
heterogeneous preferences.
 Lenders & borrowers are unable to diversify perfectly & optimize risk sharing.
 Financial intermediaries need to
reconcile the conflicting requirements of lenders & borrowers.

Asset transformation does not explain:

i) why borrowers do not undertake their own asset transformation
ii) why there are different types of financial intermediaries
iii) how different types of intermediaries perform their monetary, credit &
allocation functions.
16

(2) Transaction Costs Theory

• Transaction costs exist for the time & money spent in the transactions.
• Transaction costs causes difficulties for a lender in finding borrower.

4 main types of transaction costs:

i) Search costs:
- costs of searching out suitable counterpart (lenders & borrowers).
ii) Verification costs:
lenders incur costs to verify the accuracy of the information provided by
borrowers.
iii) Monitoring & auditing costs:
lenders incur costs to monitor the activities of borrowers & their adherence
to the conditions of the contract.
iv) Enforcement costs:
lenders incur cost to ensure the borrower is able to meet the conditions of
the contract. 19

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Financial Intermediaries Can Reduce Transaction Costs
Financial intermediaries can reduce the transaction costs by:
i) internalizing transaction costs
ii) Economies of scale
iii) Economies of scope

(i) internalising transaction cost

• develop branch networks & information systems (which enable lenders &
borrowers to avoid searching suitable counterpart).
• standardised products (cut the information costs of scrutinising financial
instruments).
• use tested procedures & routines.

21

Financial Intermediaries Can Reduce Transaction Costs

(ii) Economies of scale
• reduce transaction costs per $ of output (as transaction size increases).
• If Q1> Q2 C(Q1)<C(Q2) [C: total costs, Q1 & Q3: outputs]
• A bank is able to use a standard loan contract for a wide range of loans.
• The unit cost of the contract per loan is much smaller for the bank than for an
individual who has a loan contract drawn up when undertaking direct lending.
• important in lowering the costs of fixed investments.

22

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 Financial Intermediaries Can Reduce Transaction Costs

(iii) Economies of scope

= cost advantage to producing more than one product jointly
rather than producing them separately.
• C(Q1,Q2)<C(Q1) + C(Q2)
• E.g. deposit & payment services: deposits (banks both collect funds) to
satisfy the request of payment instruments.

• Expertise to lower transaction cost

– E.g. financial intermediaries have expertise in information technology
(e.g. automated teller machines (ATM), or Point of sales (POS)
to provide low-cost liquidity services.
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Financial Intermediaries Can Reduce Transaction Costs

Theory of transaction costs explains:
(i) The distribution of financial transactions between financial intermediaries &
financial markets.
• Financial intermediaries able to internalise many transaction costs because:
- they have developed expertise and
- take advantage of economies of scale and/or economies of scope.
• The different level of internalisation of transaction costs explains
why greater funds flow through financial intermediaries than financial markets.
• Transaction costs explains why indirect finance is much more important than
direct finance.
(ii) The distribution of financial transactions among different types of intermediaries.
• Different financial intermediaries (i.e. broker to banks)
charge different transaction costs.

(iii) Easier to conduct transaction with the presence of payment services (or 24
liquidity services) provided by financial intermediaries (especially by banks).

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 Financial Intermediaries Can Reduce Transaction Costs
Limitations of Transaction Costs Theory:
Transaction cost theory does not explain:
i) why financial intermediary makes a
better selection of investment opportunities.
ii) why recent technological innovations and new financial
instruments have reduced transaction costs.
• So, reduction in transaction costs cannot be the main reason for
explaining the existence of financial intermediaries and additional
theories are needed: these include the liquidity insurance theory
and the asymmetric information theory.

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(3) Liquidity Insurance Theory

= Consumption smoothing theory
• The theory says there is a demand for liquid assets as economic agents are
unsure when they will require funds to finance consumption.
• By the law of large numbers, a large coalition of investors (e.g. bank)
able to invest in illiquid but more profitable assets,
while preserving liquidity need to satisfy the individual investors.
i.e. financial intermediaries provide liquidity insurance
• Depository institutions are ‘pools of liquidity’ that provide households with
insurance against idiosyncratic shocks that affect their consumption needs.
• Depository institutions are ‘consumption smoothers’ that enable economic
agents to smooth consumption by offering insurance against
shocks to a consumer consumption path.

26

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 (3) Liquidity Insurance Theory
• If the shocks in householder consumption needs are imperfectly correlated,
the total cash reserve needed by a bank of size N (a coalition of N depositors)
increases less than proportionally with N (= Fractional reserve system)
• Fractional reserve system says some fraction of the deposits
can be used to finance profitable but illiquid loans.
but this is also the source of the potential fragility of banks
(it is depositors withdraw funds for not due to liquidity needs-
e.g. loss of confidence in the bank)
• Note:
The theory is valid for banks, depository institution & insurance companies.

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(4) Asymmetric Information Theory:

Asymmetric information
= one party to a transaction has less information than the other party, so
unable to make an accurate decision.

Examples:
Eg1. Potential investors have less information than the managers,
as they do not know (i) how good the projects to be financed are
(ii) unable to evaluate the risks & returns of the projects.
e.g.2 Life insurance companies do not know
the precise health of the purchaser of a life insurance policy.
e.g.3. Banks do not know how likely a borrower is to repay.

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 (4) Asymmetric Information Theory:
Adverse Selection & Moral Hazard
Consequences of asymmetric information:
(i) Adverse selection (ex-ante) or (ii) Moral hazard (ex-post)
(i) Adverse selection
• problem arise before transaction.
 The potential borrowers likely to produce an undesirable (adverse) outcome
are the ones who most actively seek out loans, so bad credit risks increase.
 So lenders may decide not to give loans, even to good credit risks.

(ii) Moral hazard

• problem arise after transaction.
= risk (hazard) that the borrower will engage in undesirable (immoral) activities,
reduce the repayment probability, so the lenders may not provide loan.
 Investors may behave differently when using borrowed funds
rather than when using their own funds. 29

(4) Asymmetric Information Theory

• George Akerlof (1970s) claimed that
‘the difficulty in distinguishing good quality from bad is inherent in the
business world; this may explain many economic institutions and may in fact
be one of the most important aspects of uncertainty’ (Akerlof, 1970, p.500).
• He analyzed the market for used cars (with good & poor-quality cars) &
realized that the seller has more information than the buyer about the quality
of the cars.
• The purchase price must reflect the average quality of the cars
(between the low value of a poor-quality car & the high value of a good car).
• Adverse selection problem arise as
only the owners of poor-quality cars will be happy to sell at this price, while
the owners of good-quality cars will be reluctant to sell at this same price.
30

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 (4) Asymmetric Information Theory:
Adverse Selection & Moral Hazard

• The market equilibrium can be inefficient:

the predominance of poor-quality cars implies a low number of transactions
carried out in the market, because the buyers are reluctant to purchase a car
unless they can obtain additional information.
• In the financial markets with asymmetric information,
lenders have less information than borrowers.
• Lenders charge an interest rate reflecting the quality (risk) of borrowers.
which is higher than good quality (with low risk) borrowers willing to pay
son only poor quality (with high risk) borrowers will seek a loan.
i.e. lender may resulted in lending to higher risk borrower.
so bank may decide not to lend.
31

(4) Asymmetric Information Theory:

Adverse Selection & Moral Hazard

Problems of asymmetric information

 affect lending & borrowing, it leads to:
(i) select the borrowers with the higher risk (adverse selection);
(ii) increase the risks of offering a loan due to opportunistic behaviours
of the borrowers (moral hazard).

34

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How Adverse Selection Influences Financial Structure?
• Issuers have more information than potential investors in the stocks & bonds
market due to adverse selection.
• Market is inefficient when the borrowers (i.e. issuing firms) have
private information on the projects they wish to finance.
• Investor is unable to distinguish good & bad firms,
investor tends to pay an average price (reflecting the average quality).
• Good firms are unwilling to sell (as the securities are undervalued).
Bad firms are willing to sell (as the securities are overvalued).
• As a result, investor has problems in selecting firms to invest in &
decide not to buy any security in the market.
• Asymmetric information:
– obstruct the transactions(& cause the market to collapse) or
– influence the level (& quality) of production activities.
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• So, marketable securities are not the primary source of external financing

Solutions for Adverse Selection Problem

1) Government regulation
2) Private production & sale of information
3) Financial intermediaries

Solution (1): Government regulation

• Governments (e.g. SEC) can regulate firms to disclose full information &
adherence to standard accounting principles to investors.
(Note: financial markets are heavily regulated)
• But the recent collapse of the Enron Corporation shows that
disclosure requirements do not solve the adverse selection problem.

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 Solutions for Adverse Selection Problem
Solution (2): Private production & sale of information
• Private companies (e.g. Standard & Poor’s, Moody’s, Value Line) can
produce & sell the information (e.g. financial statements, investment activities
to investors to distinguish firms & to select their securities.
• S&P classify 7 quality ratings (e.g. AAA, AA, A, BBB) based on the
perceived credit quality of the bond issuers.
• But free-rider problem exists when people who do not pay for information
take advantage of information acquired by other people.
• Investor can buy the information & use it to purchase undervalued securities.
But free-rider investors (who do not purchase the information)
may observe your behaviour & buy the same security, so the demand & price
for the undervalued securities will increase. This reduces the value of information.
• This causes the investors reluctant to buy information &
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as a result the adverse selection problem remains.

Solutions for Adverse Selection Problem

Solution (3): Financial intermediaries
• Financial intermediaries (e.g. banks) produce accurate valuations of firms &
are able to select good credit risks.
• Banks have information about borrowers from their bank accounts &
know their creditability (& loan repay ability).
• Banks can avoid the free-rider problem because
bank loans are private securities and not traded in the open financial market.
• Investors are unable to observe the bank & bid up the price of the loan,
• Banks ask the borrower to provide collateral (i.e. property promised to the
lender if the borrower defaults) to reduce the losses due to loan default.

Adverse selection problem can be:

Reduced by (1)government regulation & (2) private production of information &
39
Solved by (3) financial intermediaries

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 Solutions for Adverse Selection Problem

Adverse selection explains:

① why bank loans are the most important source of external funds.
② why indirect finance is more important than direct finance.

Others:
i. Banks are more important in developing than developed countries
because harder to get firms’ information in developed countries.
ii. Large & well-known corporations have easier access to securities markets
as the investors have more information about them.
iii. Information technology makes it easier to acquire firms’ information firms, &
reduces the lending role of financial institutions.

41

Informational Economies Of Scale

• Scale economies in the lending-borrowing activity exists due to adverse
selection.
• Leland & Pyle (1977) said financial intermediaries are ‘information sharing
coalitions’
• Entrepreneurs can ‘signal’ the quality of their projects
by investing more or less of their wealth in the firm.
• Good firms can be separated from bad firms by the level of self-financing,
reduces the adverse selection problem.
• But ‘signalling’ is costly as entrepreneurs are risk-averse.
• Information (not publicly available) on the quality of the projects can be
obtained with an expenditure of resources.
This information can benefit potential lenders.
• If there are economies of scale in the production of this information,
specific organisations may exist to gather this information.
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 Informational Economies Of Scale
Problems in selling information to investors
a. Quality of the information:
buyers may not unable to ascertain the quality of the information.
As a consequence the price of the information will reflect average quality
so that firms that seek out high quality information will lose money.
b. Appropriability of returns (= free-rider problem):
Firm that originally collected the information may be
unable to recoup the value of the information.

• Financial intermediary (e.g. bank) can solve the above problems.

• Information embodied in portfolio & non-transferable.
• This provides an incentive for gathering information. 45

Informational Economies Of Scale

• For organization which can better in sorting risk (than other lenders),
borrowers of good risk wish to be identified &
to deal with an informationally efficient intermediary
rather than with a set of lenders offering the value of the average risk.
• With the best risk ‘peeled off’, the average risk is less valuable,
inducing borrowers of the next best risk to deal with the intermediary.
• Finally, borrowers of all types of risk will deal with intermediaries,
except the bottom class.

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 How Moral Hazard Influences Financial Markets
Moral hazard in equity contracts
= principal-agent problem (Jensen and Meckling, 1976).
• Stockholders (i.e. principals) own the firm’s equity,
are different from the managers (agents) of the firm.
• Managers have more information about their activities than stockholders
so asymmetric information problem exists.
• Both (i) separation of ownership & control and (ii) asymmetric information
induce managers to act in their own interest
rather than in the interest of stockholder-owners
A. Solution to reduce moral hazard problem in equity markets
a) Monitoring
b) Government regulation to increase information
c) Financial intermediaries active in the equity market 47
d) Debt contracts

How Moral Hazard Influences Financial Markets

a) Monitoring
Monitor (auditing) firms’ activities to:
• ensure that information asymmetry is not exploited by one party at the
expense of the other
• determines the value of contract which is determined by the post-contract
behaviour of a counterparty.
(information acquired before the contract is agreed may become irrelevant at
the maturity due to changes in conditions.)
• monitoring is expensive.
• Investor may free-ride on the activities that other stockholders are paying to
monitor the activities of the firm you hold stocks in.
• Free-ride problem reduces monitoring
(which will reduce the moral hazard principal-agent problem).
48
• This is similar to adverse selection & makes equity contracts less desirable.

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 How Moral Hazard Influences Financial Markets
b) Government regulation to increase information
Government can impose regulation to
• adhere to standard accounting principles (i.e. easier profit verification);
• impose stiff criminal penalties if fraud of hiding/stealing profits.
But these measures are not effective as difficult to discover frauds.

c) Financial intermediaries active in the equity market

• Venture capitalists provide funds to help entrepreneurs to
start new businesses in exchange for equity share in the new business.
• Venture capitalists participate in the management of the firm
(i.e. easier profit verification & lower moral hazard).
• Equity in the firm is not marketable to anyone but the venture capital firm
(i.e. eliminates free-riding problem). 49

How Moral Hazard Influences Financial Markets

d) Debt contracts
= agreement to pay the lender a fixed amount of money independently from the
profits of the firm.
[equity contracts are claims on profits in all situations (i.e. profits or loses situation)].
• are preferred as they require less monitoring.

• Moral hazard in debt contracts exists but is lower than in equity contracts.
• Debt contracts require borrowers to pay fixed amounts &
let them keep any profit above this amount.
• Borrowers have incentives to take investments riskier than lenders would like.

Note:
• Moral hazard problem in equity markets causes 50
stocks are not the most important external source of financing.

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 Solution To Reduce Moral Hazard In Debt Markets
• Moral hazard arise when borrowers tends to take risky investments to gain
higher returns (but this may cause lenders to lose most if the project failed).

Solution to reduce moral hazard in debt markets?

a) making debt contracts incentive-compatible
(i.e. align the borrowers & lenders incentives)
b) monitoring & enforcing restrictive covenants
c) financial intermediaries

a) making debt contracts incentive-compatible

• borrowers tends to undertake risky investment when using borrowed funds.
• Can reduce moral hazard problem by increasing the stake of borrowers own
personal net worth in the investment project.
• Borrowers could lose their wealth if the project fails.
• So borrowers have an incentive to make the project less risky. 51

Solution To Reduce Moral Hazard In Debt Markets

b) monitoring & enforcing restrictive covenants
Restrictive covenant = covenant which restrict the borrower’s activity.

4 types of covenants:
① discourage undesirable behaviour by the borrower
① encourage desirable behaviour
② keep collateral valuable
③ provide information about the activities of the borrowing firm

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 Types of Restrictive Covenants
Type 1 covenant: discourage undesirable behaviour by the borrower
(i.e. not to undertake risky investment projects).
Examples:
i. to use the debt contract only to finance specific activities
(e.g. purchase of fixed assets)
ii. to prohibit the firm from issuing new debt, or disposing of its assets
iii. to restrict dividend payments if some ratios
(e.g. leverage ratio, debt to equity ratio) has not reached a critical level
iv. to limit purchases of major assets or merger activities.

Type 2 covenant: encourage desirable behaviour.

– E.g.a mortgage loan with a provision that requires the borrower to purchase
life insurance that pays off the loan in the event of the borrower’s death.
Type 3 covenants: keep collateral valuable.
Type 4 covenants: provide information about the activities of the borrowing firm,
53
e.g. quarterly accounting & income reports.

• Covenants reduce but not eliminate moral hazard problems.

• Covenants must be monitored & enforced.
• Monitoring involves increasing returns to scale.
• Monitoring is more efficiently performed by specialised financial institutions.
• Individual lenders tend to delegate the monitoring activities instead of
performing them directly.
• Thus the monitor has to be given an incentive to do its job properly.
• Monitoring & enforcement are costly, investors can free-ride on the
monitoring & enforcement undertaken by other investors.
• So insufficient resources will be devoted to these activities.

54

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c) financial intermediaries
• Banks do not face the same free-rider problem, as loans are not traded on
the market.
• Banks gain the full benefits of their monitoring & enforcement activities.
• Banks devote sufficient resources (e.g. screening & monitoring) to overcome
moral hazard.

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Delegated Monitoring Theory by Diamond (1984)

• As monitoring borrowers is costly so it is efficient for lenders to delegate the

monitoring task to specialised agents (e.g. banks).
• Banks have a comparative advantage relative to direct lending in monitoring
activities in the context of costly state verification.
• Banks can reduce monitoring costs by diversifying loans.

Conditions for delegated monitoring

a) scale economies in monitoring (i.e. bank finances many projects)
b) small capacity of investors as compared to the size of investments
(i.e. each project needs the funds of several investors)
c) low cost of delegation
(i.e. cost of monitoring the financial intermediary is less than the
benefit gained from exploiting scale economies in monitoring investment
projects) 59

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 Delegated Monitoring Theory by Diamond (1984)

Framework of Delegated Monitoring Theory

• the existence of n identical firms that seek to finance projects &
the requirement by each firm of an investment of one unit.
• The cash flow y that the firm obtains from its investment is unobservable to
lenders. This is where moral hazard arises.

Moral hazard can be solved by:

a) ‘monitoring’ the firm (at cost K) or
b) ‘designing’ a debt contract characterised by a non-pecuniary cost C
(i.e. unmonitored direct lending)

60

Delegated Monitoring Theory by Diamond (1984)

• If K<C, more efficient to choose the monitoring option for firm with unique
financier.
• If each investor has only 1/m to lend, then need m*n investors to finance the
projects.
• Direct lending implies that each of the m investors monitors the financed firm:
with total cost (TC) of n*m*K.
• If a bank (financial intermediary) monitor each firm, the total cost is n*K.
• Banks have specialised skill & can reduce the duplicated monitoring activities,
so banks have comparative advantages in monitoring the debts.
• Delegated monitor (i.e. bank) monitors borrowers on behalf of lenders
• Delegated monitor dominates direct lending as soon as n is large enough
(i.e. diversification exists, a large number of loans is held by the intermediary).
• Diversification reduces bank risk & increases the probability that the
intermediary has sufficient loan proceeds to repay a fixed debt claim to
depositors. 61

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 Asymmetric Information Problems & Ways to Reduce them

62
Source: M. Buckle (2011) Principle of Banking and Finance, ch2

Future For Financial Intermediaries

• Traditional banking has declined in recent years (e.g. USA, UK).
• The share of financial assets held by US financial intermediaries changed
over the period 1970–2005.
• Since 1970 the bank share of financial assets has steadily declined
• Thrift institutions (savings & loan associations) have lost even more ground
than banks.
• But mutual companies have increased their market share dramatically.

65
Source: M. Buckle (2011) Principle of Banking and Finance, ch4

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 Future For Financial Intermediaries
US commercial bank
• (i) Assets to nominal GDP ratio and (ii) loans to nominal GDP
increased over the last four decades (Boyd and Gettler, 1994).
• Banks performed badly in the late 1980s and early 1990s
Profitability to GDP increased sharply from 1992 & stable 1993– 2006 period,
(Mishkin & Eakins, 2009).
• Return on equity (ROE):16.03% (1993),13.86% (in 1992) & 13.06% (in 2006)
• Return on assets (ROA):0.94% (1992), 1.4% (2003), 1.33% (in 2006)

EU Bank
• ROE: 16.5% (in 2004), 20% (in 2005), with a degree of dispersion of
performances around the average ROE considerably narrower in 2005
compared with 2004.
66

Future For Financial Intermediaries

67
Source: M. Buckle (2011) Principle of Banking and Finance, ch4

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 Future For Financial Intermediaries
Changing Trends in Banking Industry:
a) Reduction in cost advantages in acquiring funds
• Increased inflation in the 1960s & regulatory restriction on interest payable
on checkable deposits caused investors were more sensitive to interest
rate differentials.
• Low-cost deposits were not ready as a source of funds for banks.
• Resulted 3 consequences:
(i) a disintermediation process occurred:
low interest rate on deposits - investors take their deposits out of banks &
to look for higher-yielding investment opportunities.

68

Future For Financial Intermediaries

(ii) Money market mutual funds appeared & grew dramatically in USA (1980s):
MMMF are issued by financial intermediaries to raise funds to be invested in
short-term money market securities, investors get interest payments.
MMMF enable investor to write cheques against the held shares (like banks),
although they are not legally deposits & are not subject to reserve
requirements & prohibitions on interest payments.
so investors can have checking account-like services & earn high interest.
(iii) Deregulation in 1980s (eliminate the ceilings interest rate on time deposit)
increase banks competitiveness in acquiring funds, but higher costs.
Banks experienced reduced cost-competitive advantage over other institutions.

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 Future For Financial Intermediaries
(b) Reduction in income advantages in using funds
(i) Improved information technology & diffusion of credit rating agencies make it
easier for firms to issue securities (e.g. short-term commercial papers or long-
term bonds) directly to the public.
• As investors can screen out bad and good credit risks, firms go to the
cheaper commercial paper market (rather than to banks) to raise short-term
funds.
• Firms go to the bond market (& use banks less often) even if they are less
well-known corporations with lower credit ratings (junk bond market)

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Future For Financial Intermediaries

(ii) Securitization
= process of transforming illiquid financial assets (e.g. loans & mortgages)
into marketable securities.
• Financial intermediaries can cheaply bundle together a portfolio of loans
(e.g. mortgages, credit card receivables, commercial & computer leases)
with varying small denominations (less than $100,000),
collect the interest & principal payments on the loans in the bundle, &
then pay them out to 3rd parties.
• By dividing the portfolio of loans into standardised amounts,
the claims to the principal & interests can be sold to third parties as securities
which are liquid & well diversified.
• Financial institutions make profits by servicing the loans & charge a fee to the
third party for this service.
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 • Securitisation allows other financial institutions to originate loans,
accurately evaluate credit risks, bundle these loans & sell them as securities.
• Banks have lost their advantage in the loan business.
• Securitisation reached a peak in 2007 but declined dramatically due to
securitised subprime mortgage debt & other securitised debt products
during the financial crisis 2007–09.

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Source: M. Buckle (2011) Principle of Banking and Finance, ch4

Bank Reactions to the Decline in Their Intermediation Role

1. Banks expand into new, riskier lending

(e.g. to real estate companies, to corporate takeovers & to leverage buyouts).
• In 80’s, Japanese banks expanded real estate construction lending rapidly.
• In 90’s, interest rate increased sharply & the asset price bubble burst, &
land prices declined sharply over many years. Resulted many ‘bad loans’.
• Economic downturn in Japan & the Asia crisis deteriorated bank loan
portfolios further.
• In 1997, Hokkaido Takushoku Bank (10th largest commercial bank) merger
with a smaller regional bank stalled, caused the larger bank collapsed.
• Similar problems happened in the US & Europe financial crisis 2007–09 as
banks provide many housing loan when rapidly rising house prices.
When the housing bubble burst, banks ended with many bad debt.
Many banks in solvent 76

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 Bank Reactions to the Decline in Their Intermediation Role

2. Banks use off-balance sheet activities (e.g. loan commitments & LC)
which produce fee income instead of interest income.
• Bank income =
net interest income (earnings from balance sheet assets net of interest costs)
+ non-interest income (non-interest earnings from off-balance activities).
• Income from off-balance sheet activities increased strongly as a share of total
bank income in the period since the 1960s.
• Banks’ profitability are stable & traditional banking businesses has declined.
But, non-traditional activities might be riskier for banks.

3. Poprietary trading increased dramatically in the 15 years prior to 2007 crisis

whereby banks hold assets & derivatives for speculative purposes.
Market risk increases due to bank’s trading activities
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Summary for Topic 4

• This topic has investigated how several theories explain why there are
financial intermediaries. They exist to:
– transform assets in order to satisfy simultaneously the different
requirements of lenders and borrowers in terms of maturity, size and risk
– reduce transaction costs by taking advantage of economies of scale,
economies of scope and expertise
– satisfy the liquidity needs of individual investors
– reduce problems arising out of asymmetric information. On the one
hand, financial intermediaries reduce adverse selection thanks to their
expertise in information production and their ability to avoid the freerider
problem by issuing private securities (loans) against collateral. On the
other hand, they reduce moral hazard because they gain the full benefits
of their monitoring and enforcement, and have an incentive to devote
sufficient resources to these activities. 80

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 Summary for Topic 4
• The future of financial intermediaries. The traditional intermediation
services provided by banks have declined in recent years, and banks have
sought to maintain profits by expansion into other areas of business.
However, this expansion exposed banks to new and greater risks and
contributed to the financial crisis of 2007–09.

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Sample examination questions

1. Discuss how the key economic theories of financial intermediation enable us
to understand the existence (and relevance) of financial intermediaries.
2. a. Describe how the presence of market imperfections explains the
importance of financial intermediaries (and the relative unimportance of
financial markets) in the financing of corporations.
b. What are the forms of asset transformation undertaken by banks?
3. a. Explain how financial intermediaries are able to reduce transaction costs
in the economy.
b. Explain how financial intermediaries are able to reduce/solve the
problems arising from adverse selection and moral hazard.

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4. a. Explain the hypotheses, the framework and the main findings of the
delegated monitoring theory.
b. How is the free-rider problem related to information asymmetries in
financial markets?
5. ‘There is evidence that traditional banking has declined in recent years in
countries such as the USA and the UK.’ Discuss.
6. a. What factors have caused the decline in the share of financial assets held
by the US banks in recent years?
b. What have been the main consequences of disintermediation for banks?

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References
• M. Buckle (2011) Principle of Banking and Finance Subject Guide, Chapter 4.
Essential Reading
• Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) pp.47–52.
• Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 15 and 18.

Further Reading
• Bain, A.D. The Economics of the Financial Systems. (Oxford: Blackwell
Publishers Ltd, 1992) Chapter 4.
• Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 2.
• Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The
MIT Press, 2008) Chapter 2.
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 9-89
Appendix-Key Players in the Securitization Process:
Cash Flows & Supporting Services That Make the Process Work & Generate Fee Income

89
Source: Rose (2013) Bank Management and Financial Services, ch9

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