Chapter 3

Asymmetric Information &

The Role of Financial
Intermediaries
 Goals

Understand
• Transaction cost, Asymmetric Information
• Business Financial Structure

Analyse:
• Tools to solve information assymetry
• 8 basic characteristics of financial structure

Explain the role of financial intermediaries

 3.1 Definition
3.1.1 Transaction costs

 Economics: The cost

associated with exchange of
goods or services.
Transaction costs cover a
wide range: communication
charges, legal fees,
informational cost of finding
the price, quality, and
durability, etc., and may also
include transportation costs.
 3.1.1Transaction cost

 In finance, transaction costs are all fees and

commissions paid when buying or selling securities,
such as search costs, cost of distributing securities
to investors, cost of SEC registration, and the time
and hassle of the financial transaction.
 Include: search cost, negotiation – implementation cost,
monitoring cost (Dahlman, 1979)
 3.1.1 Transaction cost
 In general, the greater the transaction cost, the
more likely it is that a financial intermediary will
provide the financial service. Why and How?
 Minicase – Transaction cost

 Tony, the Thuy Cung coffee shop owner, learns that the bank
is willing to loan him the $25,000; however, he thinks that
the 9 percent loan rate is too high. Thus, Tony seeks an
individual investor who might offer a lower loan rate.
 Suppose that you have money to invest and are looking for
some investment opportunities. You do not know Tony
personally, but you have frequented the coffee shop when
you were in college. You are currently a business consultant
but not a financial expert. To keep the example simple, we
assume the loan is for 1 year and your profits are earned
from the gross interest rate spread, which is $1,000 ($25,000
x 0.04).
 Minicase – Transaction cost

 1. Discussion about transaction costs to make the

transaction between (Tony and you) happen. Similar
for the transaction between Tony and the bank
 2. So, how do the banks or financial intermediaries
reduce transaction cost?
Loan transaction scorecard
 3.1.1 Transaction cost

• Economies of scale
 3.1.1 Transaction cost

• Expertise
 3.1.1 Transaction cost

Technology
 3.1.2 Information Asymmetry
 In financial markets, one party often does not know
enough about the other party to make accurate
decisions. This inequality is called asymmetric
information.
 Asymmetric information occurs when buyers
and sellers do not have access to the same
information; sellers usually have more
information than buyers
3.1.2 Information Asymmetry
 3.1.2 Asymmetric Information

Securities Labor
Ngân market,
hàng
Banking investment market
Real
estate,
Insurance second
hand
market

Asymmetric Information occurs in any field

Examples of Information Asymmetry
 3.1.3. Asymmetric Information: Adverse Selection
& Moral Hazard
TThe problems which are created by
asymmetric information include:
Adverse Selection Moral hazard

 Occurs when one party in -occur after the transaction

a transaction has better
information than the other
party
Before transaction occurs
Potential borrowers most
likely to produce adverse
outcome are ones most
likely to seek loan and be
selected
(loan) takes place, when one
party has an incentive to behave
differently once an agreement is
made between parties
-occur if borrowers engage in
activities that increase the
probability that the borrower
will default
 Problems of Information Asymmetry - Example

 the owner of a woodworking shop goes to a

local bank for a business loan. The company
is in financial trouble and may fold unless
the owner is able to secure a loan for
working capital. What is the owner to say
when asked if he can repay the loan?
 Problems of Information Asymmetry

 Let’s say that the bank made the loan. Rather than
using the money for working capital, however, the
owner takes half the money and invest in real estate
market!.
 Why would a business owner take on additional risk
that would increase the firm’s probability of default?
 How adverse selection
influences financial
structure?
 The Principal-Agent Problem/ Agency problem

 Ownership & control: “the large corporation is

owned by so many shareholders that no single
shareholder owns a significant proportion of the
outside stock. Therefore no single shareholder has
the power to really control the actions of the officers
of the corporation”.
• Result of separation of ownership by stockholders
(principals) from control by managers (agents)
 The Principal-Agent Problem

 The bulk of the dividends go to outside shareholders.

 All the major decisions are taken by the corporate
officers.
 The outside shareholders are unable to control the
corporate officers.
 The interests of the shareholders and the corporate
officers diverge significantly.
 The Principal-Agent Problem

 Shareholders: PROFIT

 Corporate Officers: POWER, PRESTIGE,

PERSONAL WEALTH

 Senior managers may be in a position to enrich

themselves at the expense of the shareholders.
 Moral hazard problem
 Tools to Help Solve Adverse Selection (Lemons)
Problems

1. Private Production and Sale of Information

─ Free-rider problem interferes with this solution

─ The free-rider problem explains why investors are

reluctant to buy information. Thus the adverse
selection problem remains.
Free rider problem
Tools to Help Solve Adverse Selection (Lemons)
Problems

2. Government Regulation to Increase Information

(explains Fact # 5)
For example, annual audits of public corporations
 Tools to Help Solve Adverse Selection (Lemons)
Problems

3. Financial Intermediation
─ Used car dealers analogy for lemons problem

─ Avoid free-rider problem by making private loans (explains

Fact # 3 and # 4)
─ Also explains fact #6—large firms are more likely to use direct
financing.
4. Collateral and Net Worth
─ Explains Fact # 7
 Tools to solve the problems arising from
moral hazard in equity markets

 Several tools can be used:

 (i) Monitoring
 (ii) Government regulation to increase information
 (iii) Financial intermediaries active in the equity
market
 (iv) Debt contracts
 Tools to solve the problems arising from
moral hazard in equity markets

 (i) Monitoring: Stockholders can engage in the

monitoring (auditing) of firms’ activities to
reduce moral hazard:
• ensure that information asymmetry is not exploited by
one party at the expenses of the other
• the value of equity contracts cannot be certain or be
observed at the moment of purchase
 Monitoring is expensive in terms of money and time
 free rider  equity contracts less desirable
 Tools to solve the problems arising from
moral hazard in equity markets

 (ii) Government regulation to increase

information

 (iii) Financial intermediaries active in the equity

market  avoid free-rider problem, for example:
venture capital firms
 Tools to solve the problems arising from
moral hazard in equity markets

 (iv) Debt contracts:

 Equity contracts claims on profits in all situations ><
debt contracts is independently from the profits of the
firms
 Debt contract are preferred to equity contracts
 Explain why stocks are not the most important
external source of financing for firms.
 How Moral Hazard Influences Financial
Structure in Debt Markets

 Tools to Help Solve Moral Hazard in

Debt Contracts
1. Net Worth and Collateral
2. Monitoring and Enforcement of Restrictive Covenants.
3. Financial Intermediation—banks and other intermediaries
have special advantages
in monitoring
 Explains Facts # 1–4
 How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

 Tools to Help Solve the Principal-Agent Problem

1. Production of Information: costly monitoring
makes equity less desirable than debt
2. Government Regulation to Increase Information

3. Financial Intermediation (e.g, venture capital)

4. Debt Contracts

 Explains Fact # 1: Why debt is used more than

equity
 Tools to solve agency problem
-Stockholders, bondholders,
- Financial Press
- - SEC and other government
Monitoring regulators
- Outside auditors

- Provide a
-Trannsparent Agency compensation
responsibility system
Create a problem package to managers
- Business code of
strong that try to induce
ethics)
manage Incentives them to act in
ment stockholders’ interest
system - Usually this is
performance (or
value) based
incentives  Stock
options
Two decades of CEO pay
Summary
Financial Intermediaries
Flows of Funds Through the Financial
System
Sources of Foreign
External Finance
Financing sources of Vietnam SMEs
 Facts of Financial Structure

1. Stocks are not the most important source of finance for

businesses.
2. Issuing marketable securities is not the primary funding
source for businesses.
3. Indirect finance (financial intermediation) is far more
important than direct finance.
4. Banks are the most important source of external finance.
5. The financial sector is among the most heavily regulated.
6. Only large, well established firms have access to
securities markets.
7. Collateral is a prevalent feature of debt contracts.
8. Debt contracts are typically extremely complicated legal
documents with restrictive covenants.
 3.4 Financial intermediary definition
 Financial institution (such as a bank, credit union, finance
company, insurance company, stock exchange, brokerage
company) which acts as the 'middleman' between those who
want to lend and those who want to borrow.

 Classify financial institutions into: Bank and non-bank financial

institutions/ depository and non-depository institution/ Depository
institutions, contractual savings institutions and investment
intermediaries
 The Economics of Financial Intermediation

 In a world of perfect financial markets there would

be no need for financial intermediaries (middlemen)
in the process of lending and/or borrowing
 Costless transactions
 Securities can be purchased in any denomination
 Perfect information about the quality of financial instruments
 Reasons for Financial Intermediation

 Transaction costs
 Cost of bringing lender/borrower together

 Reduced when financial intermediation is used

 Relevant to smaller lenders/borrowers

 Portfolio Diversification
 Spread investments over larger number of securities and reduce risk
exposure
 Option not available to small investors with limited funds

 Mutual Funds—pooling of funds from many investors and

purchase a portfolio of many different securities
 Reasons for Financial Intermediation

 Gathering of Information
 Intermediaries are efficient at obtaining information,
evaluating credit risks, and are specialists in production of
information
 Asymmetric Information
 Adverse Selection
 Moral Hazard
 Depository institutions

 Accept deposits from individuals and institutions and

make loans.
 Include commercial banks and the so-called thrift
institutions (thrifts): savings and loan associations, mutual
saving banks, and credit unions
Balance Sheets of Depository Institutions

 All have deposits on the right-hand side of

balance sheet
 Investments in assets tend to be short term in
maturity
 Do face credit risk because they invest heavily in
nontraded private loans
 Depository institution: Commercial banks

 Raise funds by issuing checkable deposits, savings

deposits, time deposits
 Use funds to make commercial, consumer and mortgage
loans and to buy government securities/ municipal bonds
 Gather small amounts of money from households and
make (bigger) loans
 Depository institution: Savings and Loan
Associations / Mutual Savings Banks

 Obtain funds through savings deposits, time and

checkable deposits.
 Use funds to make mortgage loans and commercial loans
(often for small businesses)
 Depository institution: Credit Unions

 Small cooperative lending institutions organized around a

particular group: union members, employees of a
particular firm,...
 Acquire funds from deposits (called shares) and make
consumer loans
 Balance Sheets of Non-
depository Financial
Intermediaries

 Some experience credit risk associated with

nontraded financial claims
 Asset maturities reflect the maturity of liabilities
 Insurance and pension funds have long-term policies
and annuities—invest in long-term instruments
 Consumer and commercial finance companies have
assets in short-term nontraded loans—raise funds by
issuing short-term debt
 Contractual savings institutions

 Are financial intermediaries that acquire funds at periodic

intervals on a contractual basis
 Include insurance companies and pension funds
 Predic accurately how much they will have to pay out in
benefits  not worry as much as depository institutions
about losing funds quickly  liquidity of assets is not as
important consideration  invest in long-term securities
 Contractual savings institutions: Life
insurance companies

 Insure people against financial hazards following a death

and sell annuities (annual income payments upon
retirement)
 Acquire funds from the premiums that people pay for the
insurance contract and use funds to buy corporate bonds,
mortgages, and stock (restricted in the amount they can
hold).
 Contractual savings institutions: Fire and
Casualty insurance companies

 Insure people against loss from theft, fire and accidents.

 Acquire funds from the premiums that people pay for the
insurance contract and use funds to buy municipal bonds
(largest), corporate bonds and stocks, government
securities
 Have a greater possibility of loss of funds if major
disasters occur  buy more liquid assets than life
insurance compnaies
 Contractual savings institutions:
Pension funds and government
retirement funds

 Provide retirement income in the form of annuities to

employees who are covered by a pension plan.
 Acquire funds from contributions from employers and
employees (automatically deducted from paychecks or
contribute voluntarily).
 Use funds to buy corporate bonds and stocks
 Investment Intermediaries: Finance
Companies

 Raise funds by selling commercial paper and by issuing

stock and bonds
 Lend funds to consumers and to small business.
 Gather big amounts of money and then lend small
amounts to consumers & SMEs
 Investment Intermediaris: Mutual Funds

 Acquire funds by selling shares to many individuals

 Use funds to purchase diversified portfolios of stocks and
bonds.
 Investments in mutual funds can be risky
 Investment Intermediaries: Money market
mutual funds

 Similar to mutual fund but also function as a depoitory

institution
 Sell shares to acquire funds and use to buy money market
instruments
 Shareholders can write checks against the value of their
shareholding
Investment Intermediaries: Investment banks

 Not take in deposit and lend them out.

 Help a corporation issue securities:
 Which type of securities to issue
 Help sell (underwrite) the securities by purchasing them
from corporation at a predetermined price and resell in the
market.
 Act as deal makers and earn fees by helping corporations
in M&A deals