Financial Intermediation

Topic 1a – The role of banks

Reading
• Text:
– Chapters 1 & 2

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Why do we need financing?
• Economics explanations:

1. Consumers:
• Smooth consumption creates more
utility/preference.

2. Entrepreneurs:
• Mismatch ideas idea and capital (money.)
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Smooth consumption

Day 1 Day 2 Day 3

WEEK 1 (BY GUANGQIAN PAN) 4

Different preferences
Day 1 Day 2

WEEK 1 (BY GUANGQIAN PAN) 5

Different preferences
Day 1 Day 2

WEEK 1 (BY GUANGQIAN PAN) 6

Entrepreneurs

WEEK 1 (BY GUANGQIAN PAN) 7

Why are banks important?
• The plan… let’s go back to the start…
– Investment (capital budgeting) versus
financing
– Financing options (i.e. capital structure)
• Equity (direct)
• Debt
– Private (bank) vs. public (bonds)
» Intermediated vs. direct

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Investment vs. Financing
• Investment
– i.e., capital budgeting
– I have many alternative investments but a fixed pool
of money, how should I allocate funds?
• Financing
– i.e., capital structure
– I have a fixed investment, but many (???) alternative
sources of funding, how should I fund the investment?

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A simple balance sheet…

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Assets must be funded (i.e. financed)
somehow…

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Investment vs. Financing
• Only some types of investors are willing/able to
invest in high risk projects
• Financing options are limited with high risk
projects
– E.g. start-up (small-med) businesses, households,
development projects
– Let’s determine what the feasible financing options for
high risk projects are

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Now I have a fixed investment…
• How do I fund this?

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How can I finance this? Debt vs. equity

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Where does equity come from?
• Personal savings
• Venture capital/Private equity
– Intermediated funding
– Specialize in risky projects, but are in it for a
return
– Clear exit strategy, short-term capital

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Where does equity come from?
• Angel investors
– Direct funding
– Private high net worth (rich) investors
– Investments range from $10,000 to $2m
– Each year in the US about 230,000 angels
investing $23bn in 50,000 firms
– Long-term capital
• Public stock sale (IPO)
– Direct funding
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Where does debt come from?
• Banks (and other bank like institutions)
– Loans
– Intermediated funding
• Bonds
– Public issues (direct funding)
– Various classes and types We will look at public
issues of intermediated
funding… i.e.
securitization

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…issue more debt

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Direct vs. intermediated funding
• For a given firm/project
– Equity is riskiest
– Bank debt is safest
• So comparing across firms/projects
– As risk increases so does the likelihood of
bank debt being the source of funds
• Why?
• What do we mean by risk here?
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Direct vs. intermediated funding
• What risk do investors care about?
– Credit/default risk
• Risk of non-payment
– Liquidity risk
• You invest so that you can liquidate (sell) when
you need to fund consumption

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Direct funding

Equity & Debt

Investors Firms/projects
(net savers) (net borrowers)
Cash

In a perfect market, no banks exist.

Intermediation is not needed!
Direct funding
• How does investor assess risk of default?
– Information asymmetries: this varies across firms/projects
– Moral hazard
– Agency costs: Costs relating to the risk that firm owners and
managers use investors’ funds in a way that is not in the best
interest of the savers
• How to get around these costs
– Debt covenants
– Monitoring
– Is this possible with direct funding?
– NO: high cost, free-rider problem

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Direct funding
• How liquid is (direct) debt and equity?
– Less liquidity: no market for resale (this varies
across firms/projects)
• E.g. suppse you can invest direclty in mortgages,
what happens if you have unexpected
consumption needs?
– Substantial price risk: even if a market exists
the depth may not be sufficient
• E.g. trading costs?

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Direct funding
• Little or no monitoring would occur
• Risk of investments would increase
• Also high liquidity risk
• Willingness to invest falls.
• Intermediated funding gets around these 2
problems

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 Intermediated funding

Investors Firms/Projects
Financial
Intermediary
Cash Cash
(Bank)

Secondary securities Primary securities

(deposits/liquid asset) (loans/illiquid asset)
Intermediated funding
• Agglomeration of funds resolves the following
problems:
– Reduced information costs/risk
• Economies of scale
– Greater incentive for information collection and
monitoring activities (no free-rider problem and
delegated monitor).
– Development of new secondary securities to more
effectively monitor.
• Short term debt contracts easier to monitor than bonds
(maintanence covenants)

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Intermediated funding
• Financial intermediaries (FIs) provide secondary claims
to investors:
– Provide investors with a safe asset.
– Highly liquid secondary claims have less price risk
– E.g. Bank provides demand deposits and invests in risky loans.
– These secondary securities are more marketable
• How can FIs do this?
– Diversification
• Credit risk
• Liquidity risk
• Less diversified institutions carry high default risk and more illiquid
claims.

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Intermediated funding
• Conclusion: intemediation lowers risk and
increases the willingness to invest (indirectly)
• By reducing information and liquidity costs
through
– Monitoring
– Diversification
• Lesson 1: Intermediated funding can increase
marketability of risky investments
• How exactly do banks reduce risk for
themselves?
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Suppose the value of vehicles (i.e.
assets) falls…
Balance sheet as of 10/30/2013

Assets Liabilities
Cash $ 9,500 Accounts Payable to Supplier $ 21,750
Equipment $ 5,000 Credit Card Balance $ 5,250
Vehicles $ 20,000 Long-Term Debt $ 45,000
Inventory $ 15,000 Total Liabilities $ 72,000
Accounts Receivable $ 20,000
Total Assets $ 69,500 Owner's Equity -$ 2,500

…so who get’s paid first?

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Remember the payment waterfall?
Banks

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Let’s look at how this is achieved…
• Here are examples of common stock,
preferred stock (hybrid), bonds and a loan
contract
– Financial contracts are just “pieces of paper”!
• Look at the wording…

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Let’s look at how this is achieved…
• Here is a loan
agreement…
• Let’s look at a more
realistic one…
• Banks protect
themselves and collect
information…this is
important…more on this
later.

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Bank loan contracts
• Loan amount

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Bank loan contracts
• Payment and pricing (an other fees)

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Bank loan contracts
• Pricing differs depending on (financial) risk

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Bank loan contracts
• Information collection and generation

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Bank loan contracts
• (Positive/maintenance) covenants

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Bank loan contracts
• (Negative/Incurrence) covenants and
restrictions

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Bank loan contracts

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