Critically analyse how (i) transaction cost and (ii) delegated monitoring could lead to a

preference for intermediation over direct financing

Financial intermediation is a process which facilitates the movements of funds from surplus units to
deficit units. It involves surplus units depositing funds with financial institutions who then lend to
deficit units. However, shorter chain of transactions involved in direct financing would be less costly
than intermediated financing. In a situation of perfect knowledge, no transaction costs and no
indivisibilities, financial intermediaries would be unnecessary, but these conditions are not present
in the real world.

The presence of a bank lowers the transaction cost if the savings in the transaction cost is more than
the transaction cost incurred by the bank. Benston & Smith (1976) states that institutions emerge
because they help to diminish contracting costs such as:
4 different types of costs which banks lower costs:
(1) Search costs - transactors searching out agents willing to take an opposite position,
(2) Verification costs - evaluate the proposal for which the funds are required and
determine the likelihood of repayment.
(3) Monitoring costs - monitor the progress of the borrower and ensure that the funds
are used in accordance with the purpose agreed.
(4) Enforcement costs - costs will be incurred by the lender should the borrower violate
any of the contract conditions.

Banks can help to lower transaction cost as follows:

(1) Reduce search cost for customers with its network.
(2) Lowers monitoring cost (details in delegated monitoring section).
(3) Use standard forms of contract - negotiation is reduced.
(4) Economies of scale.
able to acquire information & services cheaper than household savers
(5) Economies of scope that arise from the various types of services provided by the
bank.

2.3 The presence of the bank lowers the overall cost of the transaction - if:
(Tb + Ts ) - (Tb1+ Ts1) > C [Show how equation is arrived]
Ts = Transaction cost for saver
Tb = Transaction cost for borrower
Ts1, Tb1 = cost after introduction of bank
C = Bank’s transaction cost.
3 Delegated monitoring is one of the key reasons for the dominance of intermediation over
direct financing
3.1 Definition of monitoring
(1) Information collection before and after a loan is granted, including
screening of loan applications, examining the borrower’s ongoing
creditworthiness
ensuring that the borrower adheres to the terms of the contract. (prevent
moral hazard)
3.2 Constraints on direct investments by household
(1) Due to effects of information asymmetry, it is costly to collect good information to
make informed decision to avoid adverse selection.
(2) Household savers do not have skills / time to monitor.
3.3 Consequence
(1) Free rider problem – leading to no one monitors
(2) Failure to monitor the borrower in a timely & complete manner may lead to losses
incurred by the household savers.
3.4 Financial Intermediary provides a solution through Delegated Monitoring
(1) Pools funds from the surplus units (household savers) and invest in claims of the
corporations.
(2) It is argued that household savers thus appoint banks as delegated monitors.
3.5 Delegated monitoring preferred due to the following:
(1) Efficiency in gathering information by banks
Bank has privileged information
o Information from operating accounts
o Banking secrecy borrower feels safer with bank when providing it
with information
Banks provides credibility to borrowers
o As a result, borrowers are prepared to provide banks with more
information. Lending by a bank can provide positive signal to the
market.
Economies of scale
o Bank has many borrowers
o It can acquire quality information more cheaply
Banks take higher level of risk than any individual depositor due to large
amount of loans granted
o More incentive to collect information
o This also alleviates the free rider problem associated with direct
financing
(2) Depositor relying on Expertise of Bank because:
Monitoring are performed by specialist in the bank
o As a result banks have developed reputational capital
Regulators are also monitoring the bank
(3) Bankks offer safe deposit contracts that needs little or no monitoring by depositor
Bank’s loans are sufficiently diversified across independent loans with
expected repayments in excess of the face value of deposits.
o Leading to low default risk of banks
o Diversifying the bank’s loan portfolio enables low-cost delegated
monitoring
3.6 Diamond (1984/96) - Cost & benefits of monitoring
(1) “The net demand for delegated monitoring depends on the cost of monitoring by the
bank”.
(2) There is a net demand for delegated monitoring when cost of delegated monitoring
is less than the minimum of:
costs without monitoring; and
total costs of direct monitoring
K+D <= min (S, mK) [Show how equation is arrived]
K = monitoring cost
D = delegation cost
S = costs without monitoring
m = number of lenders to borrower.
3.7 It is thus argued that suppliers of funds appoint banks as delegated monitors (to act on their
behalf).
Conclusion
Therefore it can be seen that there will be a preference for intermediation over direct financing if
the bank is able to lower the overall transaction cost and montoring cost for the surplus and
deficit units.
Discuss how the existence of Financial intermediaries is able to help resolve the problems of
imperfect information and asymmetric information. – 2017 ZA

In financial markets, there are two types of individuals/firms – deficit units and surplus units. Deficit
units are those who wish to spend more than their current income while surplus units are those
whose current income exceed their current consumption. In the broadest sense, the existence of
Financial intermediaries is to provide financial intermediation which is the process of bridging the
two units to provide capital for the deficit units and provide a suitable risk adjusted return for the
surplus units.

Banks operates very differently from pension funds/insurance companies. Their main source of
liabilities which are deposits is for a fixed sum and does not affect how well its portfolio. The
liabilities have a lower maturity compared to their assets and it is withdrawable on demand. Their
main assets are loans, and it is largely non-transferable unless its securitized.

FI main functions to the financial markets includes: The Asset transformation function and the
brokerage function.

Zhenhao.titan@gmail.com

The brokerage functions include FIs providing information and transaction services, which will
reduce transaction costs and imperfect information between households and corporations resulting
in higher savings level, gather savers and borrowers and various other services such as trading
securities, financial advisory, screening/ratings, debt origination etc. An example would be Goldman
Sachs providing financial advisory for a M&A transaction or providing due diligence. Discount
brokers carry out buying/selling of securities at higher prices and efficiency than savers could
achieve through trading. This results in economies of scale without changing the nature of the
assets.

The asset transformation function occurs because FIs are able to transform large-denomination
financial assets into smaller units, optimizing risk-return for investors through diversification and
screen for bad credit risks. FIs also issue claims that are more attractive than direct claims by buying
primary securities & selling secondary securities. Claims issuance have lowered monitoring costs,
better liquidity and lower price risk. FIs evaluate credit risk for depositors so that they benefit from
lower transaction costs. Under asymmetric info, FIs also gain from an increase in size because of
lower incentive costs per agent. They filter and evaluate signals in a financial environment with
limited information as it is difficult for individuals to evaluate other agents credit risks.

Asymmetric information occurs when on party has less information than the other, thus unable to
make an accurate decision. Two major problems will arise due to AI. First being adverse selection.
Lenders have less information than borrowers and lenders will charge an interest rate reflecting
borrowers average risk. This is higher than what good borrowers will pay, so bad borrowers will
mainly seek loans. This reduces lending activity as market for good borrowers will pay, so bad
borrowers will mainly seek loans. This reduces lending activity as market for good borrowers falls.
The second major problem is moral hazard, which refers to when the borrower participates in
undesirable activities such as making risky decisions for their business. Despite the different
requirements of lenders and borrowers, one could still envisage that the shorter chain of
transactions involved in direct financing would be less costly than intermediated financing. In a
situation of perfect knowledge, no transactions cost and no indivisibilities, financial intermediaries
would be unnecessary, but these conditions are not present in the real world.

There are 3 reasons why FIs are necessary: to provide commitment to LT relationship with its
customers, economies of scale and the view of banks as info-sharing coalitions and delegated
monitoring.

Mayer (1990) suggest that if banks have close relationships with their borrowers, then this may
provide an alternative means of commitment. It is argued that, in particular, Japanese and German
banks do have a close relationship with their clients and in many cases are represented to on the
governing bodies. This enables the bank to have good information about the investment prospects
and the future outlook of the firm and may help prevent moral hazard and adverse selection.
Furthermore, Hoshi (1991) provides supportive evidence that firms with close banking ties appear to
invest more and perform more efficiently than firms without such ties. In contrast, there is the
danger of “crony” capitalism, and the close ties may inhibit banks from taking action.

Banks are also able to be economies of scale and info-sharing coalitions (Leland & Pyle 1977). As
borrowers have more info than a lender, it is necessary to collect info to resolve this. However, the
issues with collecting info are its cost and its nature as a public good. Anyone can resell or share the
info with other individuals, therefore reducing the value of info for the party who bought it initially.
Also, information quality is hard to judge, thus the price of the information will reflect average
quality, so only low quality borrowers will seek funds and those that seek high quality info will face
losses. Hence it is argued that FIs can eliminate these issues by collecting and using info to manage it
portfolio. Now, info is a private good and non-transferable. This provides an incentive for info
collection. A way a firm can provide info about its project is to offer collateral and this can be easily
demonstrated using a bank. Assume N borrowers investing in an identical project yielding same
return R. Variance of each agent return is x^2 without a bank. With a bank, the variance of each
agent’s return is now x^2/n which is much lower due to diversification.

Banks also are able to provide “monitoring” services which refers to information before and after
the transaction, screening of loan applications, examination of borrower’s credit collection history
and ensuring their adherence to the terms of contract. In Diamond’s model (1984, 1996) banks are
delegated the task of monitoring as lenders cannot monitor them effectively due to free riding thus
reducing the quality of information. FIs pool funds from deposits and have more incentive and
expertise to monitor. The conditions of the theory of delegated monitoring are: scale economies in
monitoring, small capacity of individual investors and low cost of delegation. There are three types
of contractual agreements considered here between lenders and borrowers. (a) no monitoring, (b)
direct monitoring and (c) delegated monitoring via an intermediary.

(a) no monitoring the only option to the lender if the borrower fails to repay is through bankruptcy
proceedings and the costs is S. This is both expensive and inefficient if borrower fails.

(b) Direct monitoring is costly and here is why: consider a borrower who needs to raise a large
quantity of capital say $1million, while investor has 1m/m units to invest. Let the number investors,
m be 10,000 and so each lender has capital of $100. Let the cost of monitoring by each lender be
K=$200, and so duplicated monitoring by each of the 10,000 investors costs 10,000 x 200 = $2
million. This is very expensive and duplicated monitoring leads to the free rider problem and lower
quality of information.

(c) Now consider the third scenario, let delegation costs per borrower be D. The cost after delegation
would be (K+D) as against (mK) in direct monitoring. Thus, delegated monitoring is effective when
the cost of delegated monitoring is less than the minimum costs without monitoring and direct
monitoring.

The monitoring cost per transaction will fall due to economies of scale and scope. Also there is the
problem of lenders/borrowers monitoring the behaviour of the bank since lenders cannot observe
the information obtained by the bank about the borrowers. It is assumed that the bank is well-
diversified so that lenders earn almost riskless return and are not exposed to adverse selection
problems. Depositors can withdraw their deposits anytime to enforce discipline on the bank to
monitor its borrowers. Furthermore, depositors are further protected by the regulatory authority
conducting bank supervision. Hence, the conditions offered to depositors are different from those
offered to borrowers. Delegated monitoring is effective as the FI collects deposits to make loans for
lending. Any bankruptcy costs will be spread over N depositors, reducing the average loss incurred
by a depositor. Diversification of bank’s portfolios reduces the cost of delegated monitoring and
default probability on its deposits to near zero. There is an issue. If savers delegate the task to the
monitor, how reliable is the information collected by the monitor? The factors affect the banks’
ability to monitor include its reputation and the regulatory framework surrounding the bank.

FIs improves the issues of adverse selection and moral hazard due to imperfect information and
asymmetric information. There is incentive for FIs to gather info via economies of scale, its role as
info-sharing coalitions and delegated monitoring. Even in this day and age, where the internet
provides plenty of information, savers will still suffer from imperfect information. Hence a bank is
still needed even in the fintech world of crowd sourcing and P2P lending.
Explain how the theories of information sharing coalitions and delegated monitoring resolve the
problems of information asymmetry that arise in direct financing and lead to the dominance of
financial intermediation over direct financing. 2017 ZB

Financial intermediation is a process which facilitates the movements of funds from surplus units to
deficit units. It involves surplus units depositing funds with financial institutions who then lend to
deficit units Despite the different requirements of lenders and borrowers, one could still envisage
that the shorter chain of transactions involved in direct financing would be less costly than
intermediated financing. In a situation of perfect knowledge, no transactions cost and no
indivisibilities, financial intermediaries would be unnecessary, but these conditions are not present
in the real world.

Asymmetric information occurs when on party has less information than the other, thus unable to
make an accurate decision. Two major problems will arise due to AI. First being adverse selection.
Lenders have less information than borrowers and lenders will charge an interest rate reflecting
borrowers average risk. This is higher than what good borrowers will pay, so bad borrowers will
mainly seek loans. This reduces lending activity as the market is filled with bad borrowers since good
borrowers would not pay the interest for their risk. The second major problem is moral hazard,
which refers to when the borrower participates in undesirable activities such as making risky
decisions for their business.

There are 3 elements whereby banks help to overcome the problems of moral hazard and adverse
selection: to provide commitment to LT relationship with its customers, economies of scale and the
delegated monitoring of borrowers.

Info-sharing coalitions (Leland & Pyle 1977) states that borrowers have more info on the risk of the
project than the lender, it is necessary to collect info to resolve this. However, the issues with
collecting info are its cost and its nature as a public good. Anyone can resell or share the info with
other individuals, therefore reducing the value of info for the party who bought it initially. Also,
information quality is hard to judge, thus the price of the information will reflect average quality, so
only low quality borrowers will seek funds and those that seek high quality info will face losses.
Hence it is argued that FIs can eliminate these issues by collecting and using info to manage it
portfolio. Now, info is a private good and non-transferable. This provides an incentive for info
collection. A way a firm can provide info about its project is to offer collateral and this can be easily
demonstrated using a bank. Assume N borrowers investing in an identical project yielding same
return R. Variance of each agent return is sigma^2 without a bank. With a bank, the variance of each
agent’s return is now sigma^2/n which is much lower due to diversification and does not alter the
expected return per project.

Banks also are able to provide “monitoring” services where surplus units delegate the role of
monitoring deficit units to banks because banks are better at monitoring the borrowers.

The bank collects Information on its client before and after the transaction, screening of loan
applications, examining the firm’s credit worthiness and ensuring their adherence to the terms of
contract.

The banks have private information on the client’s cash flows as they operate the clients current
account. The bank screens loan application by going through the firm’s business model and assess
whether it will be a viable project. The bank examines the firm’s credit worthiness using their credit
scoring method and assign a loan amount fit for the client. The bank will then set covenants to the
firm or use accounting ratios eg gearing ratio to ensure the firm adheres to the loan contract,
otherwise the loan will be cancelled and the collateral forfeited.

In Diamond’s & Dybvig model (1984, 1996) banks are delegated the task of monitoring as banks
are more efficient, have more expertise and have a diversified loan portfolio. Banks are more
efficient as banks have private information on the firm, and they have the economies of scale. The
will act more efficient as they face higher risks than an individual lender as they have a reputation
and thus have more incentive to collect information. This alleviates potential “free-rider” problem.
The bank also has expertise in monitoring loans such as loan specialists and risk managers.
Regulators will also monitor the bank’s portfolio. Banks are able to diversify risks as they hold a
huge portfolio of different loans, and will enable for low cost delegated monitoring.

There are three types of contractual agreements considered here between lenders and borrowers.
(a) no monitoring, (b) direct monitoring and (c) delegated monitoring via an intermediary. The
benefits of delegated monitoring lie heavily on the cost of it.

(a) no monitoring the only option to the lender if the borrower fails to repay is through bankruptcy
proceedings and the costs is S. This is both expensive and inefficient if borrower fails.

(b) Direct monitoring is costly and here is why: consider a borrower who needs to raise a large
quantity of capital say $1million, while investor has 1m/m units to invest. Let the number investors,
m be 10,000 and so each lender has capital of $100. Let the cost of monitoring by each lender be
K=$200, and so duplicated monitoring by each of the 10,000 investors costs 10,000 x 200 = $2
million. This is very expensive and duplicated monitoring leads to the free rider problem and no
lender will have to monitor.

(c) Now consider the third scenario, let delegation costs per borrower be D. The cost after
delegation would be (K+D) as against (mK) in direct monitoring. Thus, delegated monitoring is
effective when the cost of delegated monitoring is less than the minimum costs without monitoring
and direct monitoring.

In conclusion, FI will overcome the problems of information asymmetry due to information sharing
coalitions and delegated monitoring. Lenders can leverage on banks economies of scale,
diversification benefits and the ability to obtain private information, this will reduce the risks of
lenders. However, this is subjected to the cost of delegated monitoring, if the cost of delegated
monitoring is less than the minimum cost without monitoring or the cost of directly monitoring the
loan, then delegated monitoring would not be viable. In today’s age of the internet, information is
widely available everywhere and disintermediation such as P2P is getting more common, but FIs
would not fade away as lenders will still face some form of information asymmetry.
Explain how transaction costs and liquidity insurance theories propose the dominance of financial
intermediation over direct financing. – 2017 ZB

Financial intermediation is a process which facilitates the movements of funds from surplus units to
deficit units. It involves surplus units depositing funds with financial institutions who then lend to
deficit units. However, shorter chain of transactions involved in direct financing would be less costly
than intermediated financing. In a situation of perfect knowledge, no transaction costs and no
indivisibilities, financial intermediaries would be unnecessary, but these conditions are not present
in the real world.

The presence of a bank lowers the transaction cost if the savings in the transaction cost is more than
the transaction cost incurred by the bank. Benston & Smith (1976) states that institutions emerge
because they help to diminish contracting costs such as: search costs, verification costs, monitoring
costs and enforcement costs. Search costs is associated with searching out agents who are willing to
take an opposite position. Verification costs is to evaluate the proposal for which the funds are
required and to determine the likelihood of repayment. Monitoring costs is for monitoring the
progress of the borrower and ensure the funds are used in accordance with the purpose agreed.
Enforcement costs is for when a borrower violate the contract condition and have to enforce action
on the borrower.

Banks are able to reduce search cost by tapping onto their existing customers for its network and
with the use of the internet. They are able to lower monitoring cost using delegated monitoring.
They use standard forms of contracts which reduces costs, and banks have economies of scale which
will reduce costs. Scope of economies arise from diversification of the business. Therefore the
introduction of FIs lowers the cost of transferring funds from deficit to surplus units. However, there
are some caveats to this. Firstly, economies of scale will be exhausted very early and a number of
large firm with high class reputations find it cheaper to obtain direct finance through markets for
equity, bonds and commercial papers.

A formal model presented by Benston & Smith differentiates the transaction costs of using indirect
financing to direct financing.

The role of costs can be examined more formally. In the absence of a bank the cost/ return structure
of the two parties is depicted below denoting the rate of interest as R, the various costs incurred by
the borrower is TB and those by the saver is TS:

Return to saver = RS = R – TS

Cost to borrower = RB = R + TB
Spread = RB – RS = TB + TS

The spread provides a profit opportunity, which can be exploited by the introduction of a bank. The
bank has a transactions cost denoted by C
 Return to saver = RS = R – T’S
Cost to borrower = RB = R + T’B +C
Spread = RB – RS = T’B + T’S + C

Without perfect information, consumers are unsure of their future liquidity needs during
unanticipated events, and hence will maintain a pool of liquidity. Provided the shocks are not
perfectly correalated, the cash reserves held by a bank of N depositors increases less than
proportionally with N. this is the fractional reserve system in which some frction of the deposits can
be used to finance illiquid but profitable loans.

Diamond and Dybvig presents a three-period model (T=0,1,2) to account for banks existence. Each
agent is endowed with 1 unit of good at T=0 and makes investment decisions. Without an
intermediary, their investments are locked up due to its illiquidity.
There are three possible equilibriums:

The first is the autarky equilibrium, a model without a bank and trading between consumers. If
consumers consume early in period 1, they receive lower payoffs because early consumption
requires premature liquidation of long-term investments. If consumers consume late in period 2 ,
they receive higher payoffs.

The second case is the insurance equilibrium without a bank. If consumers can insure themselves
against the odds of having to liquidate the long-term illiquid investment in period 1, they will achieve
higher utilities. However, the type of information is a private good and hence not directly
observable. Hence, the market allocation is not efficient.

The third scenario is the insurance equilibrium with a bank. Due to imperfect information,
consumers are uncertain of their future liquidity requirements so they rather maintain a pool of
liquidity than invest directly. Banks can overcome this by pooling resources and offering fixed
deposits, making larger payments to early consumers and smaller payments to later consumer.
Hence they offer liquidity insurance, enable consumers to smooth consumption patterns and
improves the allocation of resources in the economy.

Both transaction cost and liquidity insurance theories propose the dominance of financial
intermediation. High transaction costs lead to the high spreads between the returns of a saver and
borrower which reduces profit opportunities. An Fi can internalize them through branch networks,
mobile and internet banking and standardized contracts which reduces negotiation costs. Liquidity
insurance protects consumers against consumption shocks during unanticipated events via an FI
pooling funds and making larger payments to type 1 consumers who needs liquidity urgently and
smaller payments to type 2 consumers who has a longer investment horizon. Hence FIs can result in
higher savings levels and higher liquidity.