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Chapter 4: Role of financial intermediaries (Asset transformation (Has its…
Chapter 4: Role of financial intermediaries
Asset transformation
Maturity transformation
Size transformation
Liquidity transformation
Risk transformation
Has its limitations
Why do borrowers not undertake their own asset transformation
Why do different types of financial intermediaries exist
How do the different types of financial intermediaries perform their monetary, credit and allocation functions
Why are financial intermediaries needed
Theory of transaction costs
Types of transaction costs
Pre-loan: Search and verification costs
Post-loan: Monitoring and enforcement costs
Solution: Financial intermediaries internalise the costs
Economies of scale
Economies of scope
Expertise
Conclusions made
Distribution of financial transactions between financial intermediaries and financial markets
Distribution of financial transactions between the different types of financial intermediaries such as depository institutions and investment institutions
Presence of payment services offered by the financial intermediary to customers for transactions
Limitations
Why do financial intermediaries make better investment decisions
Recent technological and financial instrument innovation reduces or eliminates transaction costs
Theory of liquidity insurance
Consumption smoothing theory by Diamond and Dybvig (1983)
Economic agents have uncertain preferences about their expenditures in the future, therefore creating a need for liquid assets
Depository institutions (banks) provide the liquidity to meet the demands of the economic agents
The high liquidity provides insurance for households against idiosyncratic shocks that may affect their consumption needs
If the shocks in consumption needs are not perfectly correlated, then by law of large numbers, a depository institution can invest in illquid but more profitable assets while preserving a fraction to provide the liquidity to satisfy the needs of individual depositors
A fractional reserve system is a source of fragility of banks, if the shocks in consumption needs become correlated (natural disasters or negative news on the bank), it might lead to a bank run, making the bank insolvent
Theory of asymmetric information
Adverse selection (Pre-loan)
Potential borrowers who are the riskier are the ones more likely to seek a loan and be selected
Lenders know this and therefore choose not to lend, even to borrowers with good credit risk
A person behaves differently with borrowed funds compared to when using one's own funds
Example: 10 people who wants to get a loan, ranging from the best credit risk and the worst credit risk
The worst credit risk borrowers are willing to accept an interest charge of 10% and the best credit risk borrowers are only willing to accept an interest charge of 1%
As lenders have asymmetric information, they cannot differentiate between the good and bad credit risk, so they are only willing to loan their funds at the average of 5%
Borrowers with good credit risk only willing to accept an interest rate of 1% to 4% would then exit the market, leaving borrowers with worse credit risk that are willing to accept the 5% interest rate
Lenders then change their expectations, now only willing to supply funds at the average of 7.5%
This goes on and on until the market now comprises of mostly bad credit risk borrowers and a few good credit risk borrowers, but then the good credit risk borrowers might still be denied financing
Solutions
Private production and sale of information which identifies between borrowers of good and bad credit risk
Leads to free-rider problem as people who did not pay for the information will take advantage of those who paid
Government regulation
Ensures that firms fully disclose information to potential investors
Financial markets are heavily regulated
Financial intermediaries
Able to use information available in customers' account to derive more information
Information economies of scale can lead to specific organisation specialised in gathering information (Moodys', S&P)
Does not have free rider problem as information produced is for its own benefits
Due to the bank secrecy act, information on loans made to borrowers are private and cannot be traded on to drive up or down their prices
Banks also ask for collateral from borrowers to reduce losses in event of default
Conclusions
Bank loans are the most important source of external funds raised by borrowers
Indirect financing is more important than direct financing
Banks are more important in less developed countries, as information is more difficult to acquire
More developed countries have lesser need for banks as they are more connected to capital markets
Moral hazard (Post-loan)
AKA principal-agent problem, where the separation of ownership and control can lead to the manager acting in his own interests, rather than the shareholders' interest
Solution
Monitoring
Necessary as value of financial contract is dependent on post-contract behaviour of a counterparty
Ensure that information asymmetry is not exploited by the managers at the expense of the shareholders
Can lead to free-rider problem as shareholders free-rides on each other, taking advantage of those who pay for monitoring
Government regulation
Have laws to enforce firms to adhere to standard accounting principles
Imposes stiff penalties on people who commit fraud
Not very effective as these frauds are difficult to uncover
Financial intermediaries active in the equity market
Venture capital
Use their own funds to finance entrepreneurs, in exchange they obtain an equity share in the firm
Have their own people in the business as part of management for monitoring purposes, which reduces moral hazard
Equity in the firm is not marketable, eliminating free-rider problem
Banks
As they receive full benefits from monitoring and enforcing their private loans, they will devote sufficient resource to mitigate the moral hazard problem
Requiring transactions go through the bank
All drawndown of loans are to be supported against invoices
Loans can only be used for purchase of productive assets
No further debts allowed without prior consent from the bank
Loans can be recalled if firms make changes
Delegated monitoring theory
Debt contracts
Contractual agreements to pay the lender a fixed some of money that is independent of the profits made, unlike equity contracts which are claims on all profits, whether the firm is making or losing money
Reduces the need for monitoring in certain situations
May lead to borrowers taking investments riskier than anticipated
Can be solved by making debt contract incentive compatible, by aligning incentives of lenders and borrowers
Restrictive covenants (Provision aimed at restricting a borrower's activities
To discourage undesirable behaviour
To encourage desirable behaviour
To keep collateral valuable
Disclosure of information
Have to maintain monitoring and enforcement
Leading to free-rider problem
Conclusion
Cannot eliminate moral hazard entirely