MONEY AND BANKING (Eco 340)
Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapter 11 ("The Economics of Financial Intermediation")
Last revised on 17 February 2009.

* In these notes:
I.    The role of financial intermediaries
II.   Information asymmetries and information costs
III. Financial intermediaries and information costs

I.    THE ROLE OF FINANCIAL INTERMEDIARIES

Earlier we noted that the terms financial intermediaries and financial institutions are often used interchangeably.  Since your textbook does, you can too, but more specifically a financial intermediary is in the business of channeling money from savers to borrowers, including businesses investing in new capital such as new buildings and equipment.  That channeling process, known as financial intermediation, is crucial to a well-functioning modern economy, since current economic activity depends heavily on credit (most of which goes through financial intermediaries, as with bank credit cards) and future economic growth depends heavily on business investment.  Student loans for college, which increase the level of education and human capital, are another example of how financial intermediation promotes future economic growth.

The classic example of financial intermediation is a bank loan.  The depositors put their money in the bank, and the bank loans it to various borrowers.  This is also called indirect finance, because the depositors are indirectly loaning their money to the borrowers.

In a sense, financial intermediaries like banks are even more important than the stock and bond markets.  This is so because loans account for the majority of funds raised by American businesses. 
--    A recent breakdown of the sources of firms' external funds was as follows: 55% loans (40% bank loans, 15% nonbank loans), 36% bonds, 9% stocks.
---- Thus, issuing marketable securities (stocks, bonds) is NOT the primary means of finance for businesses.  For all the attention that the stock market gets, only 9 cents out of every dollar of external funds raised by businesses comes from selling stock.
------ (Note:  Those figures are for external finance, meaning the money firms raise aside from their own profits or "retained earnings."  Firms actually raise the vast majority of their money -- 80% in the U.S. and Britain, nearly as much in Germany and Japan -- from internal funds.)

Direct finance (raising money directly from other people) is much less common.  Even when companies raise money by selling stocks or bonds, they typically sell them not to households but to intermediaries like mutual and pension funds and insurance companies.  (Of new bond issues, less than 5% are sold directly to households.  Of new stock issues, about half is sold directly to households, the rest to intermediaries.)

With all this in mind, we can see why the recent (~2008-) "credit crunch" has been devastating to many businesses and to the economy in general.  Businesses that want to raise money, whether for long-term capital investment or for short-term expenses in off-peak months, typically get it from banks.  If banks aren't lending (the definition of a "credit crunch"), then businesses can't raise money and there's a lot less business activity.

Before financial intermediaries came into being, some people borrowed money directly from other people (direct finance).  Direct borrowing is better than no borrowing, but it has some serious defects, namely --

* TRANSACTIONS COSTS: the time and money spent trying to purchase or sell (or trade) financial assets, goods, or services, or just to carry out financial transactions in general.  This includes trying to borrow or lend money.
---- Q: Why can't you buy just one share of stock?
---- A: There are economies of scale to financial market transactions (cost of buying 10,000 shares is only slightly higher than cost of buying 50)
------ Avoiding transactions costs can be costly in itself (e.g., driving across town to avoid ATM fees)
--------> Small investors use financial intermediaries, notably mutual funds
---------- Institutional investors, like banks and mutual-fund houses, can better bear the costs of gaining the expertise needed to avoid those transactions costs and to develop new innovations to do so (e.g., computerized trading, which gave rise to the NASDAQ stock market) 

* INFORMATION COSTS: the often-high cost of determining whether a borrower was a good credit risk and ensuring that he repays the loan.

Financial institutions are designed to overcome these defects.

The key function of financial intermediaries is financial intermediation, the channeling of funds from savers to borrowers.  Within that main function, financial intermediaries perform five key services:

(1) Pooling the savings of individuals -- Small savers may not have enough money individually to make large loans or buy bonds, but through the bank they can indirectly invest in loans, bonds, and other assets and earn better rates of interest than they could on their own.  Every small depositor indirectly owns a small piece of the bank's portfolio.

(2) Providing safekeeping, accounting, and access to the payments system -- Banks are safe places to deposit one's money, especially since bank deposits are insured up to $250,000.  The periodic account statements that banks send you in the mail, and the online balance information that is available at all times, keep you informed about your income, expenditures, and cash flow.  Finally, since the payments system involves more than just cash, a bank account is basically necessary to access the payment system, e.g., to pay your bills with checks or online payments, to receive your paycheck via direct deposit, to pay at the gas pump or an Internet site with your debit card.

(3) Providing liquidity -- (Recall:  liquidity = convertibility into cash.  Also recall that money is a good store of value in that it is highly liquid.)  Checking deposits are practically as liquid as cash, savings deposits can be converted into cash with a quick visit to the ATM, and even certificates of deposit can be converted into cash with a trip to the bank.)  Although a bank's main assets, loans, are not terribly liquid, the depositor's main assets (their deposits) are very liquid.  Another case in which financial intermediaries enhance liquidity is when mutual funds or stock brokers allow you to set up online transfers with your bank account, which make your mutual fund shares or stock shares more liquid, as you can sell a stock and immediately have the money in your checking account.

(4) Reducing risk by diversifying -- When banks pool the savings of individuals, they invest them in a wide variety of loans, bonds, and other assets.  Diversifying (otherwise known as not keeping all your eggs in one basket) is a proven way to reduce risk.  Likewise, a typical stock mutual fund invests in about 130 stocks, whereas an individual small saver might only be able to invest in one stock on her own.  Buying shares in a stock mutual fund and indirectly owning a small piece of 130 stocks is a lot less risky than owning just one stock.  That one company could easily lose almost all of its value; it is highly unlikely that 130 companies would.

(5) Collecting and processing information -- Banks have a much easier time than individuals do when it comes to screening out bad credit risks and monitoring loans for compliance.  This is because banks have a wealth of information about current and past applicants, as well as standardized procedures for evaluating creditworthiness and keeping tabs on loan recipients.

II.   INFORMATION ASYMMETRIES AND INFORMATION COSTS

Recall "TRIMS" principle number three:  Information is the basis for decisions.  Participants in the financial sector thrive on information.  A person buying a house will shop around for the best deal on a mortgage, perhaps checking out online mortgage-financing information sites for better comparison shopping. When that person goes to a bank to try to get a mortgage loan, the bank will look up that person's credit history, have the person fill out numerous forms, and have the person document that her income and wealth are enough for her to have an easy time repaying.  As long as both the borrower and the bank can obtain that information quickly, the loan will either be approved or rejected quickly.

But getting the necessary information to make an informed decision is not always easy.  This is a big reason why direct finance is so uncommon.  It is very hard the average person to judge the creditworthiness of another person, or of a company, so most people sensibly avoid loaning money directly. ("Neither borrower nor lender be," said Shakespeare.)  Buying stock or bonds from an unknown company is even more of a non-starter.  You would want to know more about the company's growth prospects and chances of defaulting on the bond.  You can get that information about better-known companies, so you'd probably choose to invest in some of them instead.  
-- A potential borrower knows more about his own trustworthiness and ability to repay than a potential lender does.  The same goes for a company issuing new stock or bonds.

ASYMMETRIC INFORMATION: the unequal knowledge that each party to a transaction has about the other party. Because of this lack of information about the trustworthiness and other characteristics of the other party, many mutually beneficial transactions never take place. For example, people routinely pay several thousand dollars extra for new cars instead of buying used cars in excellent condition, because it is hard for them to get information about the car's true condition or about the reliability of the person selling it. Adverse selection and moral hazard are two key instances of the asymmetric information problem.

ADVERSE SELECTION: the problem created by asymmetric information before a transaction occurs (pre-contractual asymmetries of information). In particular, the people most undesirable from the other party's point of view tend to be the ones who are most likely to want to engage in the financial transaction. In the above used-car example, owners of "lemons" are the most likely to want to resell a recently purchased car, and they may try to conceal the car's defects. Prospective used-car buyers know that lemons are out there, and know they may be unable to spot them, so they might end up not buying a used car at all.
---- In insurance markets, reckless drivers will tend to be the first in line to purchase auto insurance. And, as a result, car insurance companies will charge high premiums to all people who fit a particular high-risk demographic profile (e.g., 20-ish males), thereby discouraging many perfectly safe drivers from buying insurance or even buying a car at all.
---- In the banking industry, bad credit risks will be the first in line to obtain new loans.
---- In the primary market for stocks and bonds, obscure companies know that they will be seen as risky and therefore won't be able to get much for their new securities.  If people lack the necessary information about which companies are good prospects and which are bad prospects, then all these companies' stocks (or bonds) would sell at the same price, and the good companies will decide not to issue stock rather than sell it for too low a price.  All the remaining obscure-company stock on the market is from the bad companies.  Potential investors will figure out this dynamic and avoid those stocks altogether.  And just like that, there is no market for obscure-company stocks!

-- Solving the adverse selection problem:  The adverse selection problem stems from a lack of information, so producing more information can help solve it.
---- Disclosure of information is the law for "public companies" (firms whose securities are bought and sold in key financial markets).  The Securities and Exchange Commission (SEC) requires firms to disclose info about sales, assets, earnings, etc. in a prospectus.  Companies are also required to adhere to standard accounting principles.  This helps a lot, but when companies issue dishonest or misleading reports (as with Enron and WorldCom in 2001-2002), the adverse selection problem is still present.
------ Some private companies, like Moody's and Value Line, produce even more information about companies' prospects.  Moody's and Standard & Poor's have long been in the business of rating bonds according to their likelihood of default.  Most of this information costs money, often a lot.  This can give rise to the FREE-RIDER PROBLEM (in which people who don't pay anything can help themselves to a good or service that others have paid for).  For example, suppose you paid top dollar for, say, a Value Line report on small-company stocks and used its recommendations to buy stocks.  Others might notice your strategy and copy it, without paying for the Value Line service.  This could raise the price you pay (if they get in their orders at the same time you get in yours), hence lowering your return.  Also, they'd have reaped the same return as you, without bearing any of the cost.  This could make you more inclined to copy someone else's paid picks, or just to stop buying small-company stocks altogether, because you don't want to be the only person paying for Value Line and you don't want to buy small-company stocks without their guidance.  This free-rider problem may make individuals reluctant to do the necessary homework involved in buying obscure securities, in which case the demand for those securities will be low, and they may fetch such low prices that the company could raise money more cheaply through a bank loan than by issuing its own securities.  Moreover, if enough people free-ride on Value Line's work, then it will become less profitable and will no longer be done as well (or perhaps not at all).  This too will reduce the demand for obscure securities, since few people would buy an obscure security without a professional recommendation.
------ Collateral and net worth requirements:  
-------- COLLATERAL is property pledged to the lender in the event that the borrower defaults.
---------- A loan is called secured if it is backed by collateral; an unsecured loan is not backed by collateral.
-------- NET WORTH = Assets - Liabilities.  (Negative net worth means you are insolvent.  The concept applies to both households and businesses.)
-------- These are ways to compensate the lender in case the borrower defaults.  This reduces the risk for the lender,and it also reduces the adverse-selection problem.  A poor credit risk is less likely to have much collateral or net worth, and so would not be approved.  Knowing that, the poor credit risk probably will no longer be in line for a loan.  And a dishonest potential borrower who knew that not repaying meant he would lose his house, car, or other collateral might be induced to either (1) repay or (2) not apply for the loan in the first place.

MORAL HAZARD: the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view, after the transaction has taken place. (It stems from post-contractual asymmetries of information.) If the old barn out back is fully insured and no longer of much use to you, why not burn it down and collect the insurance money? If your bike is fully insured, why bother locking it? If your employer gives you a multi-year guaranteed contract (or tenure!), what's to stop you from slacking off, given that you get paid anyway? Certain contractual arrangements give rise to perverse incentives like these ones.
---- Moral hazard is especially prominent in the banking industry, where guarantees and insurance are common. If bank deposits are insured by the federal government, as they have been since the 1930s, the bank's managers can afford to take more risks with the bank's assets.  If large banks believe that the federal government will bail them out if they become insolvent because they are considered "too big to fail," then their managers and executives may lack proper incentives to avoid reckless or corrupt behavior.  (This particular moral hazard issue has been invoked a lot during the bank bailouts of 2008-2009.) At the international level, if developing countries like South Korea and Indonesia know that the International Monetary Fund will bail them out in the event of a financial crisis caused by their own recklessness and corruption, there's little incentive for them to behave more responsibly so as to avoid such crises.
------The PRINCIPAL-AGENT PROBLEM (a particular type of moral hazard problem) occurs when the managers in control (the agents) have incentives to act in their own self-interest rather than in the interest of the owners (the principals). At a bank, the stockholders want to see a high and safe return on their equity, while the bank's managers, who typically are not among its major stockholders, may have other objectives, such as earning a high salary and making a name for themselves so that they can move on to bigger and better jobs. In an extreme case, if oversight is lax, the bank's managers may find it more lucrative to embezzle from the bank than to operate it efficiently and honestly. Companies are always on the lookout for ways to bring the managers' interests into harmony with the owners' interests, thereby thwarting the principal-agent problem; their efforts to do so help explain the profusion of stock options in employee compensation in recent years. Because these problems are so inherent in the financial sector, the government's major banking and financial regulations typically address one or more of these problems.
---- Moral hazard and principal-agent problems can occur in equity markets, too, since stockholders in a firm have little way of controlling what the firms' managers do or even knowing what they do.  Executives that spend millions on two-week retreats to Las Vegas or on redecorating their offices are not acting in the stockholders' interest.
------ Solving the moral hazard problem in equity financing is not easy.  The standard attempted solution is to make the managers part-owners of the company or give them stock options, so that they'll have the incentive to maximize the company's profits and stock price.  This seems to work up to a point.  It stops working when managers focus excessively on boosting stock prices in the short term and goose up the stock prices by falsifying earnings reports and hiding risks (see Enron, World Com, 2008 financial meltdown).
---- The moral hazard problem also arises in debt financing (bonds and loans), despite collateral and net worth requirements.  People and companies with risky but potentially lucrative ventures may be so attracted by a possibly huge payout that they don't worry much about the danger of losing their collateral.  Suppose Bob wants to buy 1,000 lottery tickets for $1 each.  That's a foolish venture, but if the jackpot is $1 million he might figure, "So what?  Either I win $1 million or I lose $1000 worth of collateral."  No sane person would lend Bob $1000 for that project, so he might find himself lying about it, describing some safe project (say, buying a snowplow blade) instead.  
------ A common solution to the moral hazard problem in debt financing is RESTRICTIVE COVENANTS: provisions in debt contracts that restrict and specify certain activities the borrower can engage in (ex.: car or house buyers must purchase insurance).  In the example above, the lender might require Bob to actually purchase the snowplow blade and produce the receipt.  Other restrictive covenants may require the borrower to keep a minimum bank balance, to abstain from purchasing certain goods and services, or to abstain from certain risky activities (like attempting hostile takeovers of other businesses).

III. FINANCIAL INTERMEDIARIES AND INFORMATION COSTS

Information costs and transactions costs are the main reasons why direct finance is so rare and indirect finance, or financial intermediation, is so common.  

Key things that banks and other financial intermediaries do to reduce asymmetric information problems:

* Screening and certifying to reduce adverse selection
-- Credit scores are a big part of this.  A loan applicant's credit score is based on her credit history and bill-payment history.
-- Banks also are in unique possession of information about their own depositors.  A person with a good credit history but a volatile bank balance and numerous overdrafts probably would not get a loan from his own bank.
-- The big corporations that issue securities use leading investment banks and underwriters like Goldman Sachs not just to sell the securities but also to vouch for them in a sense.  Even big companies' securities do poorly sometimes, so the fact that a well-known investment bank is putting its reputation and profits on the line for a particular company reassures many potential investors that the securities are not so risky after all.

* Monitoring to reduce moral hazard
-- Restrictive covenants and collateral clauses in contracts are not necessarily enough.  A creditor (someone who has lent out money) or a stockholder may find it necessary to verify that the borrower or company is using their money as they said they would.  Monitoring, just like screening and certifying, is easier for an financial institution that has experience and sufficient resources to allocate to monitoring.
---- A bank that loans money to a car dealer to finance a new fleet of cars might be nervous that the dealer or some of his friends are illicitly driving some of those cars.  To check on the dealer, the bank might send someone out to secretly count the number of cars at the dealership.
---- An insurance company employs claims adjusters to verify that payment claims submitted by their contract holders are legitimate.