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Bachelor Studies in Finance
Year 2, Spring 2012
Overview
1. Information economies
2. Theories of financial intermediation
3. The benefits of financial intermediation
BANKING
Lecture 2
Banks as financial intermediaries
Ewa Kania, Department of Banking
2
1. Information economies
•
In this context, financial intermediation can be explained in
terms of
reduction of transaction costs
:
•
Secondary securities are less risky, more convenient and
more liquid than primary securities, because banks benefit
from
economies of scale
in transaction technologies and are
able to carry out a rational diversification of risks.
•
Banks differ from other financial intermediaries for two
main reasons:
(1) bank liabilities (i.e., deposits) are accepted as a
means of exchange; and
(2) banks are the only intermediaries that can vary the
level of deposits and can create and destroy credit.
•
This allows them to offer lower loan rates relative to direct
financing. However, most bank assets are illiquid (non-
negotiable) and this can be explained by issues relating to
asymmetric information.
•
Modern views on financial intermediation indicate as a
crucial function of financial intermediaries the
transformation of primary securities issued by firms
(deficit units) into secondary securities that are more
attractive to surplus units.
•
As discussed earlier, banks provide an important source of
external funds used to finance business and other activities.
One of the main features of banks is that they reduce
transaction costs by exploiting scale and scope economies
and often they owe their extra profits to superior information.
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There is an extensive literature and debate on the degree to which
scale economies are present in banking. The term is a long-run
concept, applicable when all the factor inputs that contribute to
a firm’s production process can be varied. Assuming all factor
inputs are variable, a firm is said to exhibit:
Increasing Returns to Scale or Scale Economies
: if
proportionate increases in factor inputs yield a greater than
proportionate increase in output. However, at some point scale
diseconomies may set in, i.e., if a bank increases its output,
average costs will rise.
Decreasing Returns to Scale or Scale Diseconomies
: if
proportionate increases in factor inputs yield less than
proportionate increases in output.
Constant Returns to Scale
: if proportionate increases in factor
inputs yield an proportionate increase in output.
Economies of scale and economies of scope
•
Financial intermediaries reduce transaction,
information and search costs mainly by exploiting
economies of scale. By increasing the volume of
transactions, the cost per unit of transaction decreases.
•
Moreover, by focusing on growing in size, financial
intermediaries are able to draw standardised contracts
and monitor customers so that they enforce these
contracts.
•
They also train high-quality staff to assist in the process
of finding and monitoring suitable deficit units
(borrowers).
•
It would be very difficult, time-consuming and costly
for an individual to do so.
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•
Economies of scope
refer to a situation where the joint costs
of producing two complementary outputs are less than the
combined costs of producing the two outputs separately.
•
Information
is at the heart of all financial transactions and
contracts. Three problems are relevant:
1.
not everyone has the same information;
•
Let us consider two outputs, Q1 and Q2 and their separate
costs, C(Q1) and C(Q2). If the joint cost of producing the
two outputs is expressed by C(Q1,Q2), then economies of
scope are said to exist if:
2.
everyone has less than perfect information, and
3.
some parties to a transaction have ‘inside’ information which
is not made available to both sides of the transaction.
•
Such ‘asymmetric’ information can make it difficult for two
parties to do business together, and this is why regulations
are introduced to help reduce mismatches in information.
C(Q1,Q2) < C(Q1) + C(Q2)
•
Decisions are made beforehand (
ex ante
) on the basis of less
than complete information and sometimes with
counterparties who have superior information with the
potential for exploitation.
•
This may arise when the production processes of both
outputs share some common inputs, including both capital
(e.g., the actual building the bank occupies) and labour (such
as bank management).
•
However, the literature indicates that economies of scope are
difficult to identify and measure.
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•
Information asymmetries, or the imperfect distribution of
information among parties, can generate
adverse selection
and
moral hazard
problems. Another type of information
asymmetry relates to the
agency costs
between the
principal
(e.g. bank) and
agent
(e.g. borrower).
•
In any financial system, information is not symmetrically
distributed across all agents, which implies that different
agents have
different information sets
.
•
The problem arises because information is not a free good
and the acquisition of information is not a costless activity.
•
Adverse selection in financial markets results in firms
attracting the wrong type of clients; this in turn pushes up
insurance premiums and loan rates to a disadvantage of
lower-risk customers.
•
If either were the case, there would never be a problem of
asymmetric information.
•
Asymmetric information, and the problems this gives rise
to, are central to financial arrangements and the way
financial institutions behave to limit and manage risk.
•
Financial firms such as banks and insurers, therefore, seek to
screen out (monitor) such customers by assessing their risk
profile and adjusting insurance premiums and loan rates to
reflect the risks of individual clients.
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•
In banking, adverse selection
can occur as a result of loan
pricing. The relationship between the return the bank can
expect from a certain loan and the loan price is increasing and
positive up to a certain point (e.g., an interest rate of 12 per
cent as shown in Figure 1.5).
•
Another issue relating to information asymmetries is
moral
hazard
(or
hidden action
). Superior information may enable
one party to work against the interests of another.
•
In general, moral hazard arises when a contract or financial
arrangement creates incentives for parties to behave against
the interest of others.
•
Any prices above that level will decrease the expected return
for the bank because of adverse selection: only the most risky
borrowers (i.e., those with a low probability of repayment)
will be ready to accept a loan at a very high price.
•
E.g., moral hazard is the risk that the borrower might engage
in activities that are undesirable from the lender’s point of
view because they make it less likely that the loan will be
repaid and thus harm the interest of the lender.
•
Thus for a bank, moral hazard occurs after the loan has been
granted (
ex post
) and is associated with the monitoring and
enforcement stages.
•
Examples of moral hazard in banking relate to deposit
insurance and the lender-of-last-resort function of the central
bank.
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Relationship and transaction banking
•
In recent years, the intense disintermediation process that
has characterised the financial and banking markets,
coupled with the increasingly common
transaction
banking
, has started to challenge the importance of banks
as relationship lenders.
•
In credit markets one way to overcome agency and adverse
selection problems, is for the parties to enter a
relational
contract.
•
Relational contracts are informal agreements between the
bank and the borrowers sustained by the value of future
relationships.
•
Transaction banking involves a pure funding transaction
where the bank essentially acts as a ‘broker’; an example
is that of a mortgage loan made by a bank and then sold
on to an investor in the form of a security. (This process
is known as securitisation.)
•
Modern financial intermediation theory has emphasised the
role of banks as relationship lenders: this is when banks
invest in developing close and long-term relationships with
their customers.
•
It is obvious that in transaction banking there is no
relationship between the parties and no flexibility in the
contract terms.
•
Such relations improve the information flow between the
bank and the borrower and thus are beneficial to both
parties.
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2. Theories of financial intermediation
•
A bank is delegated the task of costly monitoring of loan
contracts written with firms who borrow from it. It has a gross
cost advantage in collecting this information because the
alternative is either duplication of effort if each lender
monitors directly or a free-rider problem in which case no
lender monitors.
There are four main theories of financial intermediation:
I. Delegated monitoring
•
One of the main theories put forward as an explanation
for the existence of banking relates to the role of banks
as ‘monitors’ of borrowers.
•
Financial intermediation theories are generally based on some
cost advantage for the intermediary. Schumpeter assigned such
a delegated monitoring role to banks.
(Diamond, 1984)
•
Since monitoring credit risk (likelihood that borrowers
default) is costly, it is efficient for surplus
units(depositors) to delegate the task of monitoring to
specialised agents such as banks.
•
Diamond’s study investigates the determinants of delegation
costs and develops a model in which a financial intermediary
has net cost savings relative to direct lending and borrowing.
•
Banks have expertise and economies of scale in
processing information on the risks of borrowers and, as
depositors would find it costly to undertake this activity,
they delegate responsibility to the banks.
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III. Liquidity transformation
•
Banks provide financial or secondary claims to surplus units
(depositors) that often have superior liquidity features
compared to direct claims (like equity or bonds).
II. Information production
•
If information about possible investment opportunities is
not free, then economic agents may find it worthwhile to
produce such information.
•
Banks’ deposits can be viewed as contracts that offer high
liquidity and low risk that are held on the liabilities side of a
bank’s balance sheets.
•
E.g., instance surplus units could incur substantial search
costs if they were to seek out borrowers directly.
•
These are financed by relatively illiquid and higher risk assets
(e.g., loans) on the assets side of the bank’s balance sheet.
•
If there were no banks, then there would be duplication
of information production costs as surplus units would
individually incur considerable expense in seeking out
the relevant information before they committed funds to
a borrower.
•
It should be clear that banks can hold liabilities and assets of
different liquidity features on both sides of their balance sheet
through diversification of their portfolios.
•
In contrast, surplus units (depositors) hold relatively
undiversified portfolios (e.g., deposits typically have the same
liquidity and risk features).
•
An alternative is to have a smaller number of specialist
agents (banks) that choose to produce the same
information.
•
The better banks are at diversifying their balance sheets, the
less likely it is that they will default on meeting deposit
obligations.
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IV. Consumption smoothing
Commitment mechanisms
•
The three aforementioned theories are usually cited as the
main reasons why financial intermediaries (typically banks)
exist. However, recent studies have suggested that banks
perform a major function as consumption smoothers.
•
Another theory that has recently developed aims to provide a
reason as to why illiquid bank assets (loans) are financed by
demand deposits that allow consumers to arrive and demand
liquidation of those illiquid assets.
•
Namely, banks are institutions that enable economic agents to
smooth consumption by offering insurance against shocks to
a consumer’s consumption path.
•
It is argued that bank deposits (demand deposits) have
evolved as a necessary device to discipline bankers.
•
To control the risk-taking propensity of banks, demand
deposits have evolved because changes in the supply and
demand of these instruments will be reflected in financing
costs and this disciplines or commits banks to behave
prudently (ensuring banks hold sufficient liquidity and capital
resources).
•
The argument goes that economic agents have uncertain
preferences about their expenditure and this creates a demand
for liquid assets. Financial intermediaries in general, and
banks in particular, provide these assets via lending and this
helps smooth consumption patterns for individuals.
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3. The benefits of financial intermediation
The benefits to ultimate borrowers (deficit units)
Benefits to ultimate lenders (surplus units)
1.
Loans will generally be available for
a longer time period
from financial intermediaries than from the ultimate
lenders.
1.
Greater liquidity is achieved by lending to a financial
intermediary rather than directly to an ultimate borrower.
2.
Financial intermediaries will generally be prepared to grant
loans of
larger amounts
than will ultimate lenders.
2.
Less risk is involved, due to the pooling of risk, the
improved risk assessment and the portfolio diversification.
This reduction in risk may be reflected in guaranteed interest
rates on deposits with a financial intermediary.
3.
Using financial intermediaries will generally involve
lower
transaction costs
than would be incurred if borrowers had
to approach ultimate lenders directly.
3.
Marketable securities may be issued as the counterpart to
deposits with a financial intermediary.
4.
The
interest rate
will generally be
lower
when borrowing
from financial intermediaries, compared with borrowing
directly from ultimate lenders.
4.
Transaction costs associated with the lending process are
likely to be reduced significantly.
5.
When borrowing from financial intermediaries, there is a
greater likelihood that loans will be
available when
required
.
5.
The lending decision is simplified, since there are fewer
lending opportunities to financial intermediaries than there
are ultimate borrowers.
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The benefits to society as a whole
• There is evidence that traditional banking, i.e.,
financial
intermediation has declined in recent years
in countries
such as the US, Germany and the UK. The main reasons are:
1. Low cost deposits from the public are not as readily available
as a source of funds.
2. Credit rating agencies now collect and sell financial
information on a large number of companies. This makes it
easier for firms with a good credit rating to borrow directly
from markets by issuing securities such as commercial paper
or bonds. The wider availability of information on borrowers
has eroded, to some extent, the informational advantages that
banks possess that enable them to carry out the intermediary
function.
Financial intermediation is not only beneficial to borrowers and
lenders, but it is considered likely to:
1.
Cause
a more efficient utilisation of funds within an economy
,
since the evaluation of lending opportunities will be
improved.
2.
Cause a
higher level of borrowing and lending to be
undertaken
, due to the lower risks and costs associated with
lending to financial intermediaries.
3.
Cause an
improvement in the availability of funds to higher-
risk ventures
, due to the capability of financial intermediaries
to absorb such risk. High-risk ventures are widely considered
to be important for creating the basis of future prosperity for
an economy.
•
This process whereby firms bypass banks and borrow directly
from markets has been termed
disintermediation
.
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