03 Financial Intermediation

TOC

1. The costs of direct financing 1.1 Mismatch of preferences 1.2 Transaction costs 2. Gains from financial intermediation 2.1 Reconciles the mismatch in borrowers and lenders’ preferences 2.2 Reduces direct transaction cost 2.3 Reduces the indirect costs of information asymmetry 2.4 Reduces the indirect costs of moral hazard 2.5 Who monitor banks

1. The costs of direct financing

1.1 Mismatch of preferences

There exists mismatch of preferences beween borrowers and lenders

The lenders: prefer small amount (diversification), low risk, and short-term lending

The borrowers: prefer large amount, higher risk, and long-term lending

The mismatch reduces the probability of a sucess transaction, increases transaction costs, prolongs the period of negotiation, reduces efficiency.

1.2 Transaction costs

Broadly, there are four stages of a transaction: The searching stage, The valuation and verificaiton stage, The monitoring stage, The enforcement stage. In each stage, there are direct transaction costs.

Direct lending also involves indirect transaction costs, these costs arises from information asymmetry including Adverse selection, Moral hazard.

Information Asymmetry

It arises when one party knows more about certain aspect(s) of a transaction than others do, scenarios like: The old car market, Bank lending, Employees at work, insurance market, etc.

Adverse selection

It is a situtaion where, due to information asymmetry, a system fails because the information poor parties suspect that the information rich parties use information to their disadvantage, and decide not to participate.

Without any offsetting mechanism, the system would fail / collapse, and only the worst type of information-rich party chooses to stay in the market.

Certain mechanisms that prevent market failure

Some mechanisms reduce the level of information asymmetry

Disclosure requirements; auditing; media coverage, etc.
Financial intermediation: Relationship banking, credit rating, Paydex score

Some mechanisms minimizes the information-poor parties’s loss in the event of default

collaterals; guarantee; credit default swap (CDS) etc.

Some mechanisms remove choices

Car insurance in the UK (every driver has to be insured); National Health Service (NHS)

Moral Hazard

Definition:

Moral hazard is a situation where the borrower take actions riskier than what was promised upon the transaction to the lender. The borrower’s riskier action increases the probability of default and the lender bears the cost of the borrower’s unscrupulous action

“Moral” element: the borrower does not keep its promise and the lender have to bear the consequence of the borrower’s irresponibility

Example:

Certain mechanisms are needed to restrict moral hazard, like screening, covenants, monitoring

Under moral hazard, a lender is worse off because the borrower is betting using the lender’s money

Note that Adverse selection occurs before the signing of a contract (including searching stage). The consequence of moral hazard occurs after the signing of a contract.

2. Gains from financial intermediation

Generally, financial intermediation can

reconciles the mismatch in borrowers and lenders’ preferences

reduces direct transaction cost

reduces the indirect costs arising from information asymmetry

2.1 Reconciles the mismatch in borrowers and lenders’ preferences

Financial intermediation performs three sets of transformation:

Size transformation

Banks take deposits in small amounts, aggregate the small deposits, and lend to borrowers (firms or individuals) in large sum

Risk transformation

Minimize the risk of individual loans

Screening: perform credit check; relationship banking; loan credit score; Paydex; closeness to default
Monitoring: require regular financial reports; Loan covenants

Diversification

lending to borrowers from different industries, which diversifies the industry risks
lending to firms in different geographical areas or different nations
lending to multiple borrowers in the same industry or geographic area, which diversifies firm-specific risk

Maturity transformation

Liquidity risk:

The maturity is quite unbalanced between assets and liabilities on a bank’s balance sheet: liabilities are mostly of short term (sight deposits, interbank loans) while assets are mostly of long term (mortgages, term loans)

How do banks address the liquidity risk:

It is necessary to have a large number of depositors
Banks perform liquidity management

2.2 Reduces direct transaction cost

Financial intermediation can reduce the direct transaction costs in each stage of a transaction:

It reduces searching costs like customer database, business network

It reduces valuation and verification costs, like risk analysis, analyst report, relationship banking, loan credit ratings, Paydex score

It reduces monitoring costs, like relationship banking, regular financial reporting, loan covenants

It reduces enforcement costs, like recovery procedures, legal process, collaterals

2.3 Reduces the indirect costs of information asymmetry

Financial intermediation achieve that by overcoming the free-rider problem in the information generating process. The information possessed by financial intermediaries are largely proprietary. A intermediary’s decision is not readily observed by other banks

2.4 Reduces the indirect costs of moral hazard

A bank mitigate the adverse impact of moral hazard by requesting collaterals which are pieces of asset pledged to guarantee the repayment of a loan, forfeited in the event of a default

2.5 Who monitor banks

The delegated monitors theory maintains that banks do not need monitoring because a bank is unlikely to default:

The law of large numbers: the average outcome of a large number of repeated experiments converges to the theoretical value

The actual loan default rate converges to a theoretical default rate when the number of loans is large. The theoretical rate can be estimated from the historical data

A bank can factor in this rate when pricing the loan and setting other loan terms