Recall 4a-Existence of Financial Intermediaries

Financial intermediation occurs when a surplus unit lends to an intermediary, rather than lending directly to a deficit
unit. The financial intermediary then lends to deficit units.
In developed economies, most funds flow through intermediaries than directly from surplus to deficit units.

5 Theories for the Existence/ Importance of Financial Intermediaries

There are 5 theories which explain how financial intermediaries reduce/solve market imperfections are
[Market imperfect refers to (i) difference in the preference (size, maturity, liquidity, risk) of lender & borrower
(ii) presence of transaction costs, shocks in consumers’ consumption & asymmetric information (cause adverse selection & moral hazard)]

1) Asset transformation- to reconcile conficting requirements of lenders and borrowers

2) Transaction costs reduction
3) Liquidity insurance - intermediaries provide liquidity in response to shocks in consumers‘ consumption
4) Information Asymmetries leading to adverse selection
5) Information Asymmetries leading to moral hazard- leads to Diamond’s Delegated Monitoring (1984)
conclusion
the different theories help us explain why indirect finance is preferred over direct finance.

(1) Asset Transformation Theory

The process of indirect lending involves banks in a process of asset transformation. They satisfy borrowers’ needs for
long-term finance (by holding loans as assets) but fund this by borrowing short term (issuing deposit claims). They
effectively create liquidity for lenders. This satisfies the needs of many lenders for assets that they can liquidate
quickly. To enable institutions to reconcile the conflicting requirements of lenders and borrowers they undertake
4 asset transformations:
i) 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.
ii) Liquidity transformation – by lending long term and financing by issuing short term deposits. Hence there is a
mismatch of maturities of assets and liabilities of the bank.
iii) 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.
iv) Risk transformation – deposits are seen as relatively safe but bank loans have a higher degree of default risk.

Financial intermediaries such as banks, are able to undertake this process. Essentially they are able to undertake this
process because they have skills, structure and processes that enable them to manage the risks that asset
transformation exposes them to.

Banks are able to transform the risks by:

a. managing liquidity risk arising from liquidity transformation – using gap analysis, pooling & diversifying deposits
b. managing credit risk arising from risk transformation – screening, pooling, diversifying loans etc

Role of Conflicting requirements of lenders and borrowers

Conflicting requirements of lenders and borrowers requires intermediaries to hold the long term/high risk claims of
final borrowers but to fund these claims by issuing claims to lenders which are short term/low risk. This exposes
banks to credit and liquidity risk. Banks are better able to manage these risks compared to individual lenders.

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg1

 (2) Transaction Costs Reduction Theory
Transaction costs (significant in direct lending) exist for the time & money spent in the transactions and
causes difficulties for a lender in finding borrower.
Transaction costs include search costs, verification costs, monitoring costs and enforcement 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.
These costs are mainly borne by the lender and the last two occur after the loan has been made.

Financial intermediaries can reduce the transaction costs by

(i) internalizing transaction costs (ii) Economies of scale and (iii) Economies of scope.
(i) internalising transaction costs
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.
(ii) Economies of scale
Reduce transaction costs per $ of output (as transaction size increases). If Q1> Q2
C(Q1)<C(Q2)
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.
(iii) Economies of scope, C(Q1,Q2)<C(Q1) + C(Q2)
=cost advantage to producing more than one product jointly rather than producing them separately.
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.
Also, costs do not provide a full explanation of why banks exist as they do not explain why banks make better investment decisions.

Transaction costs help to explain why intermediaries act as agents.

Asymmetric information helps to explain why they act as principals and are better able to allocate resources.

(3) Liquidity Insurance Theory (=Consumption Smoothing Theory)

Liquidity Insurance provision (Diamond and Dybvig, 1983) says there is a demand for liquid assets as economic
agents are unsure when they will require funds to finance consumption due to unforeseen events. By the law of
large numbers, a large coalition of investors (e.g. bank) will be able to invest in illiquid but more profitable assets,
while preserving liquidity need to satisfy the individual investors (i.e. FIs 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.

The underlying operation in this model is the basis for fractional reserve banking.
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)

The role of banks as liquidity insurers creates systemic risk problems for the banking system. This leads banks to be
exposed to liquidity risk (i.e. banks have mainly illiquid assets financed by mainly liquid deposits).
A loss of confidence can cause a liquidity shock which can then be transmitted throughout the banking system
(contagion) because of asymmetric information.

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg2

(4) Asymmetric Information Theory [Adverse selection and moral hazard]
Information Asymmetries leading to adverse selection
Information Asymmetries leading to moral hazard- leads to Diamond's model of delegated monitoring

Asymmetric information
= one party to a transaction has less information than the other party, so unable to make an accurate decision.
Examples of asymmetric information
e.g.1. 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.

Asymmetric information causes: (i) Adverse selection problem (ex-ante) or (ii) Moral hazard (ex-post) problem

(i)Adverse selection problem (in a lending-borrowing market)

-is a problem created before a (loan) transaction is made
This is the risk of lending to a borrowers who is likely to produce an undesirable (adverse) or borrowers with a greater
default risk are the ones who are most likely to seek out lenders. So lenders may decide not to give loans, even to
good credit risks borrowers.

In debt markets lenders generally have less information than borrowers.

The existence of asymmetric information means that lenders will lend at a rate of interest reflecting average risk (as
they cannot distinguish between good and bad risks). This drives good quality borrowers (with lower risk) out of the
market leaving mainly poor quality borrower (with higher risk) remaining in the market. Hence the borrowers who
are more likely to want to borrow are poor risks.
In the case of debt security markets the good quality borrowers will find their securities are undervalued (higher
cost). And will be unwilling to sell them. As a consequence lenders may decide not to lend.
This is the reason why the existence of asymmetric information, and hence adverse selection can lead to less
lending/ borrowing and hence less investment / lower economic growth.

(ii) Moral hazard – is a problem created after (the loan) transaction is made
This is the risk (hazard) that created by the borrower who use the borrowed funds recklessly or engage in undesirable
(immoral) thus increase the default risk and reduce the repayment probability, Hence lenders need to monitor
borrowers after loan is made and this increases costs of lending. So the lenders may not provide loan.

George Akerlof’s (1970) paper ‘The market for lemons’

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.
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 so 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 thus reducing credit and
hence funds for investment by companies.

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg3

Conclusion
Transaction costs help to explain why intermediaries act as agents.
Asymmetric information helps to explain why they act as principals and are better able to allocate resources.
Banks are better at solving these asymmetric (adverse selection and moral hazard) problems compared to capital
markets because there is no free-rider problem.

Adverse selection explains (1) why bank loans are the most important source of external funds and
(2) why indirect finance is more important than direct finance.

Solutions for Adverse Selection Problem______________________

Lenders having more information about the circumstances of borrowers can help reduce adverse selection.
This information can be produced by: (a) government regulation (b)private production (c) financial intermediaries.

Adverse selection problem can be: Reduced by (1)government regulation & (2) private production of information &
solved by (3) financial intermediaries

(i) Government regulation - Governments (e.g. SEC) can regulate firms to disclose full information & adherence to
standard accounting principles to investors. But the recent collapse of the Enron Corporation shows that disclosure
requirements do not solve the adverse selection problem.
(ii) 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 & as a result the adverse selection problem remains.
(iii) 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.
The solution to the problems by financial intermediaries is more efficient as banks do not face a free rider problem
in acquiring information (to solve adverse selection) or monitoring (to solve moral hazard). This is because their
loans are not traded so no one can front-run the bank and extract some of the benefits from information acquisition
or monitoring by trading the same loans.

3 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).
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.
b) monitoring & enforcing restrictive covenants
Restrictive covenant = covenant which restrict the borrower’s activity.
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.

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg4

4 Solution to reduce moral hazard problem in equity markets____________
Moral hazard in equity contracts manifests itself as a principal-agent problem. Stockholders are principals and they
delegate management of the firm to managers (agents). This, combined with asymmetric information can lead
managers to run the firm in their own interest, rather than maximise stockholder wealth.

a) Monitoring-
Stockholders can engage in the monitoring (auditing) of firms’ activities to reduce moral hazard because
Monitor (auditing) firms’ activities can 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.).
However, monitoring is expensive in terms of money and time, or rather it is a costly state verification. 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). This is similar
to adverse selection & makes equity contracts less desirable.
In addition, if you know that other stockholders are paying to monitor the activities of the firm you hold stocks in,
you can free ride on the activities of the others. As every stockholder can free ride on others, the free-rider problem
reduces the amount of monitoring that would reduce the moral hazard (principal-agent) problem.
This is the same as with adverse selection and makes equity contracts less desirable.

b) Government regulation to increase information

Government have incentives to reduce the moral hazard problem (& adverse selection). Government can
(i) impose regulation to adhere to standard accounting principles (i.e. easier profit verification);
(ii) Impose laws to impose stiff criminal penalties on people who commit the 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 capital firms are an example of an intermediary that is able to avoid the free-rider problem in the face of
moral hazard. 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). Moreover, the equity in the firm is not marketable to anyone but the venture
capital firm (i.e. eliminates free-riding problem)

d) Debt contracts
Debt contracts require borrowers to pay the lender a fixed amounts of money independently from the profits of the
firm. & let them keep any profit above this amount.
This can lead the borrowers to have more incentives to take investments riskier than lenders would like.
Moral hazard is less in debt contracts than in equity contracts because
A equity contracts they are claims on profits in all situations, whether the firm makes or loses money
A debt contract is one that pays a contractual amount of money without reference to whether the firm makes a
profit or not. This reduces the need to monitor managers.
Consequently debt contracts have lower moral hazard than equity contracts.

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

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg5

 Delegated Monitoring Theory
Main idea of the delegated monitoring theory:
Since monitoring borrowers is costly, it is efficient for surplus units (lenders) to delegate the task of monitoring to
specialised agents such as banks. Banks have a comparative advantage relative to direct lending in monitoring
activities in the context of costly state verification.
In fact, banks have a better ability to reduce monitoring costs because of their diversification

Conditions/ Hypotheses required for delegated monitoring to work:

① existence of scale economies in monitoring, that means that a typical bank finances many projects
② small capacity of investors as compared to the size of investments, that means that each project needs the
funds of several investors
③ low cost of delegation, that means that the cost of monitoring the financial intermediary itself has to be less
than the surplus gained from exploiting scale economies in monitoring investment projects.

Framework of the delegated monitoring theory:

(i.e. many lenders to one borrower and the delegated bank has a pooled and diversified portfolio of loans,
therefore reduces risk for the ultimate lender)
a) It is based on the existence of n identical firms that seek to finance projects and the requirement by each firm of
an investment of one unit.
b) The cash flow y that the firm obtains from its investment is a priori unobservable to lenders. This is where moral
hazard arises.

Moral hazard can be solved by:

① either ‘monitoring’ the firm (at cost K)
② or ‘designing’ a debt contract characterised by a non-pecuniary cost C.

Main findings of Delegated Monitoring Theory by Diamond (1984)

1) Assume that K<C. If the firm has a unique financier, it would be efficient to choose the monitoring option.
However, assume that each investor owns only 1/m, so that m of them are needed for financing the project.
Assume also that the total number of investors is m*n, so that all the projects can be financed.
Direct lending implies that each of the m investors monitors the financed firm: the total cost is n*m*K.
If a bank (financial intermediary) emerges, it can choose to monitor each firm (total cost n*K) or
2) to sign a debt contract with each of them (total cost n*C). Since K<C, the first solution is preferable: the
bank is a delegated monitor, which monitors borrowers on behalf of lenders (note that the banks is not monitored
by its lenders – the depositors). Financial intermediation (delegated monitor) dominates direct lending as soon as n
is large enough: this means that diversification exists (i.e. a large number of loans is held by the intermediary).
Diversification is important because it increases the probability that the intermediary has sufficient loan proceeds to
repay a fixed debt claim to depositors.

Contribution of delegated monitoring theory (thus the existence/ importance of bank)

under certain conditions/ framework, since monitoring borrowers is costly,
it is efficient/preferable for lenders to delegate the task of monitoring to specialised agents such as banks.
The delegation cost is virtually zero due to the low risk of default of the bank due to diversification.
Banks are more efficient at monitoring because they are able to obtain the benefits of diversification in lending so
reducing risk. This explanation provides another justification for the existence/ importance of banks.

Recall 4a-Existence of FI+ Diamond Delegated Monitoring-pg6