why do banks exist?. 2-26 minimize transactions costsminimize transactions costs depository...

Why Do Banks Exist?

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Minimize Transactions Costs

Depository intermediaries like savings and loans, mutual funds, and banks link

ultimate borrowers (especially firms) and ultimate savers (households).

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While borrowers and savers might seek each other out and strike deals without going through intermediaries, traditional intermediation theory says process will be groping and inefficient.

Example:

Consider what typical saver must do to invest money without using intermediary.


• First, saver must locate a firm needing funds and determine creditworthiness.

• Then, saver and firm must bargain over how much will be invested, for how long, and at what rate of return. – Saver prefers buying securities with small denominations that pay off quickly.

– Firm prefers selling a few large securities with long maturities (because project may not pay off for a while).

• Suppose saver and firm overcome these problems and strike a deal. Then, saver must keep close watch on firm until repaid.

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TAKE-AWAYIntermediaries minimize transactions costs (search costs, negotiation costs, and enforcement costs) that serve as barriers between savers and borrowers.

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Transactions services provide by intermediaries to match borrowers and savers include:

1. Size transformation: Buying large securities and offering savers small accounts.

2. Liquidity transformation: Holding securities (like bank loans) that are illiquid (hard to sell, lemon’s problem) while offering securities that are highly liquid (deposits).

3. Diversification: Holding a large portfolio of securities with returns that are not perfectly correlated reduces risk for savers.

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Problem:• Nonbank financial intermediaries like mutual

funds can provide transactions services.

• Explaining why banks exist apart from other financial institutions requires another angle:

Asymmetric Information!

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Banks as Solutions to Information Asymmetries

Moral Hazard (Delegated Monitoring)

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Solving Information ProblemsMoral Hazard

Agency Problems

• Managers have inside information about payoffs from investment projects for their firms. This information problem makes it difficult for bondholders and stockholders to monitor.

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Holders of marketable securities have weak incentives to monitor.• Information is costly to collect.

• Free-Rider Problem: Monitoring is a public good.

- When one investor monitors a firm, other investors benefit whether they monitor or not.

- But each investor ignores benefits others receive when he decides whether to monitor. Thus, each investor may decide personal gains from monitoring are too small, even when total gains to all investors are quite large.

- Everyone would be better off if someone else monitored, yet no one may be willing to do so. Hence, “too little” monitoring occurs in securities markets.


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Managerial incentive schemes and bond covenants reduce, but do not eliminate, agency problems.

WHY? Bond contracts are inflexible.- Bond contracts with possibility of costly default discipline

management.

- But firm (especially new firm in new market) with healthy prospects might miss a payment or break a covenant due to temporary factors beyond management control (a recession).

- Both managers and investors would benefit if managers had breathing space to recover and respond.


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Bond contracts are inflexible (cont.): - But, when no investor is willing to monitor, firm’s managers cannot easily

convince investors a reprieve will not be used merely to delay day of reckoning.

- Thus, opportunities for timely renegotiation of contract will be lost. Instead, with threat of default in mind, managers will attempt to fulfill terms of contract, even when this means dumping profitable projects.


WORST CASE SCENARIO:

Bankruptcy due to severe but temporary shock. Everybody loses from failure to negotiate. Bank lending has the flexibility to avoid this outcome!

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SOLUTION: Banks act as delegated monitors!

– Borrowing from bank enables firm to replace many small lenders with single lender, thus providing more flexibility. Since bank, for example, makes large investments in firms, it will be more willing to monitor and renegotiate contracts than would a group of individual investors.

– Replacing many small lenders with one lender also reduces duplication and, hence, total monitoring costs, particularly if economies of scale exist in monitoring.

– Bank monitoring will also preserve borrower confidentiality that might be compromised if borrower had to share details of project with capital market. Confidentiality is especially important if project is easily copied, like a new marketing campaign.


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BUT…Delegating monitoring to bank does not eliminate agency problem!

– When households lend to firms indirectly through a bank, they have not found a magic wand to make agency problems disappear.

– Bank itself is an agent of its depositors, delegated to monitor on

their behalf.

– Bank insiders know more than depositors about bank’s current revenues, about problem areas in the loan portfolio, about efficiency of bank management, etc.


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Bank Agency Problems:• While agency costs of indirect lending help explain why

bank loans don’t always replace direct securities, they also pose a paradox.

• Namely, if depositors place funds with banks to avoid agency costs of direct lending, but simply end up with another difficult-to-monitor agent, how can bank loans ever improve over direct lending?


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SOLUTION? Diversification!• If a borrower has multiple projects spread across

multiple markets, it is unlikely all will go bad at once.

• Similarly, if bank faithfully monitors large portfolio of loans including different firms in many different markets, probability of many firms facing troubles at same time is quite small.

• And this probability falls as bank’s portfolio grows larger and more diversified.


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Diversification as Answer to Bank Agency Problems:• Even with diversification, threat of bankruptcy forces

bank to monitor.

• If bank is lackadaisical about soundness of its loan portfolio, then many loans could go bad, and bank will be unable to pay depositors.


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Diversification (continued):• But as long as bank does monitor, the revenues from a

large loan portfolio will tend to be stable.

• By monitoring, bank reduces likelihood of bankruptcy for its borrowing firms, and by holding a diversified portfolio, it lowers its own probability of bankruptcy.

• Thus, indirect lending through a delegated monitor that is well-diversified actually reduces the wasted time and effort of premature bankruptcy proceedings.


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Banks have a comparative advantage in monitoring (uncollateralized loans) because:

• Single Lender: As discussed, monitoring and renegotiation are more efficient with a single lender than with multiple lenders (reduction in total monitoring costs and greater ease of renegotiation).

− If story is correct, banks will lose edge as lenders in financial markets over time. Finance companies, stockbrokers, insurance companies could perform single-lender function.

• History as Lender: Bank is better able to screen loans because it has loaned to same borrower before.

− If story is correct, banks have an edge as lenders in financial markets because of industry’s long history as commercial lenders, but they may lose out to other financial institutions.


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Banks have comparative advantage in monitoring (uncollateralized loans) because:

• Bank is better able to monitor because of an informational economy of scope between lending and checking (checking account hypothesis).

• Specifically, access to transactions of borrowers through their checking accounts gives bank additional information that makes it cheaper to monitor loans.

• If true, institutions legally permitted to issue checking accounts have unique edge.


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IMPLICATION:

Informational economies of scope in supply of checking and lending services should be greatest for small-firm borrowers/depositors doing business mostly in local markets.

– Checking accounts of such firms contain detailed history of cash flows.

– Checking account of large firm with subsidiaries across country (and, hence, many other checking accounts) contains less information.


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Banks as Solutions to Information Problems

Adverse Selection

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Solving Information ProblemsAdverse Selection

Banks provide “Seals of Approval”

• Hence, when firms obtain bank loans (or other services from a bank), they receive a “seal of approval.”

• This seal makes other securities marketed by the firm more attractive (i.e., lowering their costs).

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EXAMPLE: Stock price of firm X rises when news bank has loaned money to firm X hits market.

• Bank loan “signals” market the firm is sound. Market values signal because bank presumably has inside information.

• Hence, bank loan helps overcome information asymmetry between market (outsiders) and firm management (insiders).


In short…Households and firms value delegated monitoring by banks. Households enjoy higher returns because of lower agency costs in lending, and firms enjoy lower costs of selling other securities because of “seal of approval.” (Not to mention, value of the funds obtained from banks!)

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Liquidity Insurance…Another Adverse Solution Angle:

• Economy offers illiquid projects with high returns and liquid projects with low returns. Obtaining high returns means running risk of suffering a “liquidity shock.”

• If probability of suffering liquidity shocks were publicly observable, it would be insurable. Agents could invest in illiquid projects and take out “liquidity insurance policies.”

• Because liquidity risk is privately observable, however, such policies are not available.


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So….• Banks plug hole in asset markets by pooling funds obtained from

depositors and investing principally in illiquid, high return projects.

• Banks also invest some funds in liquid project, so they have sufficient funds to cover the needs of “liquidity shocked” agents.


Argument is new and improved version of “liquidity transformation” transactions service provided by intermediaries. It also provides a

“market failure” justification for deposit insurance!

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Questions?

why do banks exist?. 2-26 minimize transactions costsminimize transactions costs depository...

Documents

large securities

negotiation costs

enforcement costs

securities markets

large portfolio of securities

asymmetric information

typical saver

savers small accounts