Why do Financial Institutions Exist?

September, 2021

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Transaction Costs

Transaction Costs: Transaction costs are costs borne in making an

exchange such as time, brokerage cost, account opening/maintenance
costs, legal cost, cost in verifying creditworthiness and cost of
monitoring the borrowers.
For small investment sizes, transaction costs are likely to be such a
high percentage of investment amount that investment is unlikely to be
profitable. Examples: Transaction costs involved in making a Rs 10000
investment in stock market; Transaction costs in making a small loan.
Transaction costs might also made diversification difficult for small
investors because large number of small transactions may result in very
high transaction costs.

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Financial Intermediaries Reduce Transaction Costs

Overtime, financial intermediaries have evolved to reduce transaction

costs allowing small savers and borrowers to benefit from financial
markets.
Economies of Scale: Bundling funds of many investors allows even
small investors to reduce transaction costs as a percentage of
investment size. Example: Mutual Fund, Banks.
By Developing Expertise to Lower Transaction Costs: Developing
expertise in legal aspects of loan contracts by banks.

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Asymmetric Information

Asymmetric Information: When one side of the market has more

information than the other side. This is due to one side’s inability to
observe (find out) other side’s type (quality) or actions that are
relevant to the transaction.
Examples
Only seller knows true quality of used car.
People not taking adequate care of insured products.
Employees not working hard enough when efforts are not observable.

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Asymmetric Information: Adverse Selection and Moral
Hazard

Adverse Selection (Hidden Types): This asymmetric information

problem occurs due to the existence of unobserved types. Adverse
selection occurs at the time of transaction.
Only sellers know true quality of used cars.
Managers of corporations have better information about their
corporations than potential investors.
Borrowers are better informed about their creditworthiness.
Moral Hazard (Hidden Action): This asymmetric information
problem occurs when individuals party to a transaction can take
unobserved action that affects outcome. Moral Hazard arises after the
transaction.
Insured people not taking adequate precautions raising costs of
insurance companies.
Borrowers taking high risks in the hope of earning high returns
increasing default probability.

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Adverse Selection: Lemons Problem

Lemons problem in the context of used cars market.

Potential buyers of used cars are unaware of the quality of car unlike
sellers.
Price that the buyer is willing to pay is somewhere between the low
value of a lemon and high value of a good car.
Seller knowing the quality of car is willing to sell it at this price if the
car is lemon but unlikely to sell if it is peach implying that only few
good cars will come to market.
Average quality of used cars in the market will be very low and so there
will be few sales leading to almost complete collapse of the market for
used cars

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Lemons in the Stock and Bonds Market

Lemons problem in the stock and bonds market will imply that
securities market will not function properly.
Explain for Stock.
Explain for Bonds.
Lemons problem explains why marketable securities are not the
primary source of financing for businesses in any country.

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Tools to Mitigate Adverse Selection Problem

Lemons problem will vanish in the absence of asymmetric information.

Why?
(1)Private production and sale of information
Can mitigate adverse selection problem by providing information to the
people supplying funds.
Free rider problem prevents this mechanism from completely solving
the adverse selection problem. How?
(2)Government regulation to increase information
Governments regulate securities markets in a way that encourages firms
to reveal true information about themselves.
Securities and Exchange Commission (SEC) in US (SEBI in India)
requires firms selling their securities to have independent audits where
accounting firms certify that the firm is disclosing accurate information
about sales, assets and earnings.
Government regulation even though reduces adverse selection problem
but can’t eliminate it completely as firms still continue to have more
information than investors.

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Tools to Mitigate Adverse Selection Problem...
(3)Financial Intermediation
Financial intermediaries (such as banks) can gain expertise in
producing information about firms that allows them to differentiate
good credit risks from bad firms.
Banks have an incentive to engage in information production activity
as it can profit by lending mostly to good credit risk firms.
This analysis explains greater importance of banks in financial systems
of developing countries since it is relatively harder to collect
information about private firms in developing countries.
(4)Collateral and Net Worth
Collateral makes lenders willing to make loans because it allows the
lender to recoup some of its losses in the event of a default thus
reducing the risk substantially.
Borrowers are willing to supply collateral because the reduced risk for
the lender makes it more likely that borrowers will get loans and at a
better interest rate.
Net worth performs a role similar to collateral. Lenders can takeover
the firm and recoup part of the losses in the event default by selling it
off.
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Moral Hazard: Choice Between Debt and Equity Contracts

Moral hazard has important consequences for whether a firm chooses

debt or equity contract to raise capital.
The choice will depend on whether the moral hazard problem is more
severe (hard to tackle) in case of debt or equity contract.

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Moral Hazard in Equity Contracts (Principal-Agent
Problem)

Equity Contracts: These contracts are claims to share in the profits

and assets of a business.
Principal-Agent Problem (a type of moral hazard problem) occurs in
case of equity contracts due to the separation of ownership and
control in the modern corporations. Stockholders (principals) owning
most of the firm’s equity are separate from the managers in control
(agents) and these managers may act in their own interest rather
than the interest of stockholder-owners.
Example: Managers may choose to put in lesser effort than the level
that will maximize profits for the business. Managers may even
choose to divert some of the business cash flow for their private
benefits. Examples: Managers in Enron and Tyco International were
convicted for diverting funds for personal use.

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Tools to Mitigate Principal-Agent Problem

(1)Production of Information: Monitoring

Principal-Agent problem arises because managers are better informed
about their activities and actual profits than stockholders.
Stockholders can engage in monitoring of the firm’s activities by
auditing the firm frequently and checking on management activities to
reduce this moral hazard. However, monitoring is costly in terms of
time and money making the equity contract less desirable.
Free-rider problem decreases monitoring since individuals will try to
free-ride on the monitoring efforts of others making moral hazard
problem more severe.
(2)Government Regulation to Increase Information
Government forces firms to follow standard accounting principles
making profit verification easier.
Government also passes laws imposing stiff criminal penalties on people
hiding or stealing profits.

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Tools to Mitigate Principal-Agent Problem...
(3)Financial Intermediation
Financial intermediaries have the ability to avoid free-rider problem in
the monitoring of firms.
Example: Venture capital firms invest in startups and in exchange
receive equity share in these businesses. Venture capitals ensure that
several of their own people are on the board of the startup making it
easier to monitor firm activities.
Since firm equity is not freely marketable with venture capital on
board, other investors are unable to free-ride on the venture capital
firm’s verification effort.
(4)Debt Contracts
Equity is a claim on firm profits in all states: High profits, low profits,
losses etc. so moral hazard arises in all states.
In case of debt, moral hazard arises only when firm cannot meet its
debt payment and therefore, lender needs to verify firm’s profits only in
these states.
Less frequent need to monitor and thus lower cost of state verification
explains why debt contracts are more commonly used than equity
contracts to raise capital.
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Moral Hazard and Financial Structure in Debt Markets

Since a debt contract requires borrowers to only pay a fixed amount

and allows them to keep any profits above this amount, borrowers
have an incentive to take much riskier projects than lenders would like.
This is because if the risky investment is successful the borrower will
make huge profits but still needs to pay the same fixed amount to the
lender. If it fails then lender will end up loosing a substantial portion
of the capital loaned to borrower.
Numerical Example.

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Tools to Mitigate Moral Hazard in Debt Contracts
1 Net Worth and Collateral: High net worth and collateral reduces
borrowers incentives to take unreasonable risks reducing moral hazard.
2 Monitoring and Enforcement of Restrictive Covenants
Covenants to discourage undesirable behaviour. Example include
covenants requiring loan to be used only to finance specific activities.
Covenants to encourage desirable behaviour: Example of such a
covenant is that firm must maintain minimum holdings of certain
assets relative to firm’s size.
Covenants to keep collateral valuable: For example, automobile loans
require owners to maintain a minimum amount of insurance and
prevent sale unless loan is fully paid off.
Covenants to provide information: Example is covenants requiring
borrowing firm to provide periodic accounting and income reports.
3 Financial Intermediation: Since Monitoring and enforcement of
restrictive covenants are costly, the free-rider problem arises in debt
(bond) securities market just like stock market. A financial
intermediary such as bank can avoid free-rider problem by making
private loans.
4 Is China a counter-example? September, 2021 15 / 25
Financial Development and Economic Growth

1 Underdeveloped financial system leads to relatively low rates of

growth. Examples: Most developing countries and ex-communist
countries.
2 Financial systems in developing countries are underdeveloped and
function inefficiently because the system of property rights function
poorly making it hard to make use of collateral and restrictive
covenants in mitigating adverse selection and moral hazard problems.
Bankruptcy procedures are so slow and cumbersome that by the time
lender acquires the collateral it may have lost most of its value.
Governments may also intervene and prevent lenders from foreclosing
on borrowers in politically important sectors.
Inability to use collateral effectively means lenders will need more
information about borrower quality worsening the adverse selection
problem.
This makes it harder for financial system to channel funds to the most
productive investment slowing down the growth of the economy.

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Financial Development and Economic Growth...
1 Governments in developing and transition economies use government
authority to direct credit to themselves or to other favored sectors
(that too at low interest rates). Unlike private institutions
governments may not channel funds towards the most productive
sector.
2 Most big banks in many developing countries are owned by
government and direct substantial portion of credit to government
itself instead of the most productive uses.
3 Underdeveloped regulatory system in developing countries (e.g. weak
accounting standards) also constrains the flow of useful information
to the financial institutions hampering its ability to channelise funds
to most productive uses.
4 Poor legal system, inadequate government regulation and government
intervention in allocation of credit and state ownership of banks
account for substantial difference in growth rates of countries.
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Financial Crises and Economic Crises

Financial crises is a situation when a major disruption in the financial

system causes such a sharp increase in adverse selection and moral
hazard problems that financial markets are unable to channel funds
efficiently from savers to people with productive investment
opportunities.
Causes of financial Crises
Increase in interest rates
At high interest rates adverse selection problem worsens as only good
credit risks are interested in borrowing.
High interest rates lead to decline in cash flow making it more difficult
to finance projects internally. Raising more funds externally means
increased adverse selection and moral hazard problems.
Increases in uncertainty
Increased uncertainty makes it harder for lenders to screen borrowers
making it difficult for them to solve the adverse selection problem.

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Causes of Financial Crises Cases...
Asset Market Effects on Balance Sheets
Declines in stock markets have negative effects on net worth which
increases the adverse selection and asset market problems.
Deflation and depreciation of foreign currency may lead to increase in
value of firm liabilities deteriorating their balance sheets increasing
agency problems in financial markets.
Problems in the banking sector
Decrease in bank lending due to problems in banking sector (most
likely due to multiple bank failures) leads to increase in interest rates
worsening agency problems.
Collapse of existing banks also means loss of useful soft information
about firms collected by banks over time again worsening agency
problems.
Government Fiscal Imbalances
People may not be willing to buy government bonds fearing default if
government runs large fiscal deficits. Government may force banks to
buy these bonds negatively impacting health of the abnking sector.
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Financial Crises in the United States

Stage One: Initiation of Financial Crisis

Mismanagement of financial liberalization/innovation.
Asset price boom and bust.
Spikes in interest rates
Increase in uncertainty
⇒ Rise in adverse selection and moral hazard leading to decreased
lending and consequent decline in investment and output.
Stage two: Banking Crisis
⇒ Raises interest rates leading to further worsening of crisis.
Stage three: Debt Deflation ⇒ Deterioration in net worth leading to
further worsening of agency problems.

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Financial Crises in Advanced Economies

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Financial Crises in Emerging Market Economies

Stage one: Initiation of Financial Crisis

Path one: Mismanagement of financial liberalization/globalization.
Weak supervision and lack of expertise leads to a lending boom.
Domestic banks borrow from foreign banks (Fixed exchange rates give
a sense of lower risk).
Banks play a more important role in emerging market economies, since
securities markets are not well developed.
Path two: Severe fiscal imbalances
Governments in need of funds sometimes force banks to buy
government debt.
When government debt loses value, banks lose and their net worth
decreases.
Additional factors
Increase in interest rates (from abroad)
Asset price decrease
Uncertainty linked to unstable political systems

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Financial Crises in Emerging Market Economies...

Stage two: Currency crisis

Government cannot raise interest rates as it will increase agency
problems
Speculators expecting currency devaluation may lead full-blown
speculative attacks forcing devaluation
Stage three: Full-Fledged Financial Crisis
The debt burden in terms of domestic currency increases (net worth
decreases)
Increase in expected and actual inflation reduces firms’ cash flow.
Banks are more likely to fail
Individuals are less able (sometimes less willing also) to pay off their
debts (value of assets fall)
Debt denominated in foreign currency increases (value of liabilities
increase)

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Financial Crises in Advanced Economies

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References

1 F.S.Mishkin and S.G. Eakins. Financial Markets and Institutions,

Pearson Education, 6th Edition, 2011.

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