Risks of Financial IntermediationRisks of Financial Intermediation

Introduction

Financial intermediation is a persistent feature of all of the world’s economies.

The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth.

Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment.

Why intermediation?

“complete markets” world, financing of firms and governments by households occurs via financial markets – no transactions costs, full set of dependent markets, no credit rationing and no role for intermediaries

Markets are not strong form due to the likely failures which undermine the complete markets paradigm.

Banks as Financial Intermediaries

The overwhelming proportion of every dollar financed externally comes from banks.

Banks are key channels for intermediating between savers and borrowers.

As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy.

Banks as Financial Intermediaries

Bank loan covenants can act as trip wires signaling to the bank that it can and should intervene into the affairs of the firm.

Bankers are often on company boards of directors.

Banks are also important in producing liquidity.

Why do intermediaries exist?

(1) Transactions costs restricting scope for direct financing

(2) Banks and other financial intermediaries offer services to which transactions are the visible counterpart

Aspects of intermediary activity

(1) Match transactors (information based financial services) - Brokerage

- Fee based compensation- No position taking involved, although reputation risk- Basis of cost of gathering informationreusability of information at zero cost- Larger the grid, the more the saving,and the more difficult observation is- Can be reused cross sectionally or through time

Examples: transactions services, financial advice, screening, origination, issuance, funding

Aspects of intermediary activity

(2) Manage risks and transform nature of claims – qualitative asset transformation or QAT

- Provide better alternative to finding a counterpart for every transaction

- Transformations include duration, credit risk, liquidity, currency

- Risk of loss to the intermediary- Diversify (mutual funds) shift risk to others or accept

exposure (banks)

Examples: monitoring, management, expertise, guaranteeing, liquidity creation

Functions of Intermediaries

Theories of intermediationApproaches to the theory of intermediation emphasize on:

- Why don’t transactions occur via markets?- Largely focus on qualitative asset transformation or QAT- Focus on transactions costs and asymmetric information

Some approaches are:

(1) Economies of scale

-Transactions costs at core

-Declining average trading costs

- Size and diversification – so individuals can no longer diversify perfectly (banks pool risk and diversify portfolios cheaper than do individuals, also provide payments services more cheaply)

Theories of intermediation(2) Asymmetric information

(a) Intermediaries and screening- To overcome adverse selection, intermediaries can

screen quality of entrepreneurs and firms (credit analysis),

- Communicate proprietary information at lower cost than borrowers, then sell claims to a diversified portfolio to investors.

Theories of intermediation

)b (Intermediaries and monitoring

- Financial intermediaries act as delegated monitors (from depositors) to overcome asymmetric information, and risk of moral hazard.

- Technology of monitoring offers economies of scale (e.g. obtained from ongoing credit relations, deposit history, transactions services)

- Diversification lowers borrowing costs (projects are too large for investors to finance alone).

- Investors need to monitor the intermediary, e.g. via non pecuniary penalties or the threat of a “run” (costs of this less than benefits from scale economies in monitoring investment projects).

Theories of intermediation

(3) Control

Justification for intermediation is basedon:- Incompleteness of loan contracts- Ability of intermediary to influenceborrowers’ behavior when loan outstanding- And ability to restructure when loan isin default.

Theories of intermediation

(4) Commitment

Formation of long term relationships byintermediaries with borrowers, reducinginformation asymmetry and moralhazard, while intermediary’s reputationprotects borrower.

Why are some transactions by banks and other by markets?

Application of theories of intermediation:(1) Economies of scale – small loans made by banks and

smaller firms borrow from banks

)2 (Asymmetric information that reputation is needed to access market financing. So smaller and less reputable firms borrow from banks (firm life cycle)

)3 (Control implies that banks will finance high risk firms as can exert control better than markets

)4 (Commitment suggests relationships important in banking not in bond markets

New approaches to the theory of intermediation Deregulation has improved information provision, via technology and functions of financial system, lowering transactions costs and improving investor information

Traditional approaches seem to make less sense, although intermediation per se is increasing

Possible explanations:

New approaches to the theory of intermediation

1. Risk transfer and risk controlThere are a number of reasons why companies wish to control risk, not least the costs of financial distressIntermediaries are better placed to perform value added services in financial markets for risk control instruments more efficiently and knowledgably.Risk avoidance – via underwriting standards, portfolio diversification etcRisk transfer – via purchase and sale of financial claims such as swaps and adjustable rate lendingRisk absorption – via holding non marketable assets such as bank loans

New approaches to the theory of intermediation

2. Facilitating participation in markets of individuals

Assume fixed costs of learning about a

stock or financial instrument, and/or

marginal costs to monitoring markets

daily

Offer information, invest on individual’s behalf or offer a fixed income claim against the intermediaries’ balance sheet

New approaches to the theory of intermediation

3. Intermediaries and functions of the financial system

Clearing and settling payments: Banks provide payments services but so do markets

Pooling: bank loan books are in this diversified form, so are the asset portfolios of institutional investors

Transfer economic resources: Banks are able to accomplish this via transformation in terms of maturity, foreign, industrial lending - so are bond markets

Manage uncertainty and control risk: Banks in themselves limit risk to depositors by backing liquid deposits which are insulated by bank capital from volatility of loans (liquidity insurance)

Price information: Banks tend to rely on private information, although their lending itself may thus offer information to others.

Incentive problems: See the asymmetric information, control and commitment theories. Banks have comparative advantage for the small

and information intensive assets

New approaches to the theory of intermediation

4 .The evolution of financial systems and the role of banks

- Declining role through the three stages

- Blurring of distinctions between intermediaries (cheque writing,

tradability of assets, equity finance by banks as venture capital)

RisksRisks- We examine financial intermediation when banks can offer We examine financial intermediation when banks can offer

deposit or loan contracts contingent on macroeconomic shocks.deposit or loan contracts contingent on macroeconomic shocks. - We show that the risk allocation is efficient provided there is no We show that the risk allocation is efficient provided there is no

workout of banking crises.workout of banking crises.

- In this case, banks will shift part of the risk to depositors. In this case, banks will shift part of the risk to depositors.

- In contrast, under a workout of banking crises, depositors In contrast, under a workout of banking crises, depositors receive non-contingent contracts with high interest rates while receive non-contingent contracts with high interest rates while entrepreneurs obtain loan contracts that demand a high entrepreneurs obtain loan contracts that demand a high repayment in good times and little in bad times. repayment in good times and little in bad times.

- As a result, the present generation over-invests and banks As a result, the present generation over-invests and banks create large macroeconomic risks for future generations, even if create large macroeconomic risks for future generations, even if the underlying risk is small or zero.the underlying risk is small or zero.

RisksRisksThere is a relationship between risk and productive activity and the degree There is a relationship between risk and productive activity and the degree of financial intermediation in a model with moral hazardof financial intermediation in a model with moral hazard. .

Entrepreneurs can simultaneously get credit from two types of competing Entrepreneurs can simultaneously get credit from two types of competing institutionsinstitutions: : ‘financial intermediaries’ and ‘local lenders’‘financial intermediaries’ and ‘local lenders’. . The former are The former are competitive firms with a comparative advantage in diversifying credit risks, competitive firms with a comparative advantage in diversifying credit risks, and the latter have superior information about the investment returns of a and the latter have superior information about the investment returns of a ‘nearby’ entrepreneur‘nearby’ entrepreneur. .

This information advantage allows local lenders to save on intermediation This information advantage allows local lenders to save on intermediation costs that are otherwise related to lending activitycosts that are otherwise related to lending activity. .

By diversifying risks, financial intermediaries are able to offer a safe asset to By diversifying risks, financial intermediaries are able to offer a safe asset to local lenders and, because of intermediation costs, the latter are willing to local lenders and, because of intermediation costs, the latter are willing to diversify their portfolio by offering some direct lending to the nearby diversify their portfolio by offering some direct lending to the nearby entrepreneur entrepreneur ((incomplete insuranceincomplete insurance). ).

In some cases, a fall in intermediation costs, by inducing local lenders to In some cases, a fall in intermediation costs, by inducing local lenders to choose a safer portfolio, reduces entrepreneurs’ effort and increases the choose a safer portfolio, reduces entrepreneurs’ effort and increases the probability of defaultprobability of default..