FIN 726:

Financial Institutions

Professor Isil Erel

 Today
  Course Overview
  Organization
  Requirements

  Introduction to Financial Institutions

Financial Institutions, Prof. Isil Erel 2

 Basic Function of
Financial Institutions (FI)?

  Channeling Funds from Savers (entities

with a surplus of funds) to Borrowers
(entities with a deficit of funds).

  This course is about the role that the financial

institutions play in this process and how they
make profit filling this role.

Financial Institutions, Prof. Isil Erel 3

 A Financial System without FIs

Equity &
Debt
Individuals Firms
(Savers) (Borrowers)
buy financial assets Cash buy real assets

Financial Institutions, Prof. Isil Erel 4

 Why should firms use FIs instead of
directly raising funds from individuals?

  In an ideal world, where information were

complete and costless, we would probably not
need financial intermediaries.

  But, information about borrowers is very costly

to gather and is often incomplete!

  Without FIs: Low level of fund flows!

Financial Institutions, Prof. Isil Erel 5

 Low Level of Fund Flows due to…
  Information Costs
  Adverse Selection  Prior to purchasing a firm’s
debt or equity, each individual must incur costs to
investigate firm’s quality.
  If not, they are likely to lend to the poorest
(adverse) quality firms.

  Moral Hazard  After purchasing a firm’s securities,

each individual needs to monitor the firm’s managers.
  If not, managers may invest in excessively risky
projects (agency cost!)
  Monitoring is extremely costly for individuals.
  Free rider problem!
Financial Institutions, Prof. Isil Erel 6
 Low Level of Fund Flows due to…
  Less liquidity
  If there isn’t any secondary market to liquidate the
financial assets, individuals face a high liquidity risk.

  Substantial price risk

  Risk that the sale price of the financial asset will be
lower.

  Transaction Costs
  It would be very expensive for large firms to raise
enough funds to finance their investments if they had
to contract individually with thousands of people.
Financial Institutions, Prof. Isil Erel 7
 A Financial System with FIs

FI
(Brokers)
Individuals Firms

FI
Cash Equity & Debt
(Asset
Transformers)
Deposits/Insurance Cash
Policies

Financial Institutions, Prof. Isil Erel 8

 Functions of FIs
  Brokerage (e.g. Merrill Lynch (Bank of America),
Charles Schwab)
  Purchase or sell securities for commission or fees;
  Provide recommendations for investment alternatives
of individuals.
  Example: Research and inform investors on the
quality of firms that issue an initial public offering
(IPO) of securities.

  Reduce costs through economies of scale

(produce information more efficiently solving Adverse
Selection problem) Financial Institutions, Prof. Isil Erel 9
 Functions of FIs (Continued)
  Asset Transformation
  Purchase “Primary Securities” (e.g. equity, debt)
from firms and sell “Secondary Securities” (e.g.
deposits, insurance policies) to individuals.

Bank Firm
A L A

Firm Loan Bank Equity Real Assets Firm Equity

Deposits Loan

Financial Institutions, Prof. Isil Erel 10

 Why is Asset Transformation of FIs
Attractive for Individuals?
1. FIs are specialists in both doing “due diligence” (in
order to solve the adverse selection problem) and also in
“delegated monitoring” (in order to efficiently produce
information on a borrowing firm’s activities and reduce
moral hazard).
  Individuals give their funds to a bank in exchange for
a deposit account and the bank makes a loan to the
firm using the collection of funds plus its own equity.
  As a larger stake holder, the bank has greater
incentives to monitor the firm. It also incurs lower due
diligence and monitoring costs
  due to economies of scale of information collection and
expertise
  secondary securities that the bank creates, such as loans,
are shorter term and are easier to monitor.
Financial Institutions, Prof. Isil Erel 11
 Why is Asset Transformation of FIs
Attractive for Individuals? (Continued)

2. FI can increase liquidity (e.g. deposit contacts

that can be withdrawn immediately) and can
bear the risk of mismatching maturities of
their assets and liabilities (e.g. long maturity
assets vs. demandable deposits).

Puzzle: How can an FI offer highly liquid contracts on

the liability side while investing in relatively illiquid
and risky assets?

Financial Institutions, Prof. Isil Erel 12

 Why is Asset Transformation of FIs
Attractive for Individuals? (Continued)
3. FI can allow economic agents to share and diversify
away some of their portfolio risk. A domestically and
internationally diversified FI may be able to generate an
almost risk-free return on its assets.
Example: An insurance company pools different types of risks
faced by many individuals and individuals obtain claims in
return for contributing an insurance premium (cash).
Example: A mutual fund purchases a portfolio of many firms’
equities (stocks) and issues shares to individuals that are more
diversified (lower risk) than each of the equities.

FI can also enjoy lower transaction costs (ex: pay less

commissions in equity trades) due to economies of scale.
% Share of Total Assets of FIs
(1948 vs. 2009)

Financial Institutions, Prof. Isil Erel 14

 Recent Trends in FI Industry

  Growth in mutual funds (investment companies), which

provide investments that closely mimic diversified
investments in the direct securities markets at a lower
cost.
  Why?
…

  Large and medium-sized firms have shifted toward capital

markets, but banks are still primary source of funding for
small businesses.
15
Financial Institutions, Prof. Isil Erel
 Recent Trends (Continued)

  Housing market bubble

  Encouraged subprime market and more exotic mortgages

  Some examples of regulation changes:

  Removal of branching restrictions (1994)  Merger wave
of commercial banks
  Financial Services Modernization Act (1999) 
  Mergers between commercial and investment banks (J.P Morgan
and Chase Manhattan (2000, 33.6 billion))
  Shift from “originate and hold” to “originate and distribute” model
  Post-crisis restrictions on bank activities due to negative
externalities of FI failures. 16
 Global Trends
  US FIs facing increased competition from foreign FIs

  Only two of the top ten banks are US banks

  Foreign bank assets in the US are typically more than

10% (as high as 21.9%)!

Financial Institutions, Prof. Isil Erel 17

World’s Top 10 Banks in 2004, 1995,
and 1985 (Source: Economist (2006))

Financial Institutions, Prof. Isil Erel 18

 World’s Largest Banks as of 2009
Bank Name Consolidated
Assets (Billion $)
The Royal Bank of Scotland Group (UK) 3,500.95
Deutsche Bank AG (Germany) 3,065.31
Barclays PLC (UK) 2,992.68
BNP Paribas SA (France) 2,888.73
HSBC Holdings (UK) 2,418.03
Credit Agricole Group (France) 2,239.37
JP Morgan Chase & Co (US) 2,175.05
Mitsubishi UFJ Financial Group (Japan) 2,025.83
Citigroup (US) 1,938.47
UBS (Switzerland) 1,894.42
Source: The Banker
19
 20
Source: Deutsche Bank Research
 Recent Trends (Continued)
  Does banking consolidation lead to cost savings due
economies of scale/scope or risk diversification? Are the
gains in operating efficiencies reflected on borrowers as
reductions in loan rates or increased market power widens
loan rates?
  Erel (2009): The effect of bank mergers on loan prices:
Evidence from the U.S.
  Reform of bank capital regulation (Basel II, Basel III)
  Loan selling (asset securitization).
  Declining trust in FIs…
  …

Financial Institutions, Prof. Isil Erel 21

Delegated Monitoring
[Diamond (1996)]
 A Financial System without FIs

Equity &
Debt
Individuals Firms
(Savers) (Borrowers)
buy financial assets Cash buy real assets

Financial Institutions, Prof. Isil Erel 23

 What kind of contract would arise between
lenders and borrowers without monitoring?

  Assume:
  The firm needs to raise $1 million, henceforth referred
to simply as $1;
  Lenders’ required rate of return is 5%;
  Everyone agrees that the firm has a profitable project to
finance;
  Only the firm (the borrower) will be able to observe how
profitable the project turns out to be.

  In this case, a conflict of interest exists between the firm’s

insiders, who can appropriate resources to themselves,
and lenders (outsiders to the firm).
Financial Institutions, Prof. Isil Erel 24
 The Project
  Costs $1 to finance and has two possible outcomes:

  High (H) — which can be thought of as occurring

during good business conditions, with probability of
0.8, in which it returns $1.4; and

  Low (L) — which can be thought of as occurring

during a recession, with probability of 0.2, in which it
returns $1.

Financial Institutions, Prof. Isil Erel 25

 How would an equity contract work in
these circumstances?

  It would have to be some sort of profit sharing arrangement.

  Let’s assume it takes the form of a promise on the part of
the firm to pay a fraction α of the profits from the project
to the investor.
  Problem: The payoff to the firm and the investor are not
portions of the project’s true value, V, but of the value
reported by the firm.
  With no monitoring, the firm has an incentive to report that
the project has turned out to have a low value - as low as
zero.
  So: Equity contracts do not work well - if at all - without
monitoring. Financial Institutions, Prof. Isil Erel 26
 Lender’s Response
  Obviously, the lender would like to be able to put some kind
of sanction on the firm when it appears that the firm is
under-reporting the project’s value. Here we will assume:
  The lender can force the firm into bankruptcy and seize
and liquidate the assets of the firm;
  But: Bankruptcy is expensive. So expensive, in fact, that
the lender recovers only γ percent of the value of the
firm’s assets, where 0 <= γ <= 1.
  Therefore, the amount recovered by lenders is: γV

  Bankruptcy costs are: (1-γ)V.

27
 Lender’s Problem
  The investor would like to set a face value on the loan, f,
(principal + interest) that will
(a) allow him to meet the required rate of return of 5%, and
(b) will somehow induce the borrower to repay the loan if
he can.

  Note that only tools available to the lender in the absence of

monitoring are the power to force the firm into bankruptcy
and the ability to set the face value of the loan.

Financial Institutions, Prof. Isil Erel 28

 Payoffs
  With bankruptcy and liquidation now possible, the
payoffs are:

Outcome: L (with 1-P = 0.2) H (with P = 0.8)

V: $1 $1.4
Return to firm: 0 V–f
Return to lender: γV f

Financial Institutions, Prof. Isil Erel 29

 How should the lender set f ?
  Expected return to lender =

0.8f + 0.2γV = $ 1.05 (the required rate of return);

  Therefore: f = ($1.05 – 0.2γV)/0.8

  Recovery rate, γ Face value of loan, f

1.00 $1.0625
0.50 $1.1875
0.25 $1.25
0.00 $1.3125 (Diamond example)
Financial Institutions, Prof. Isil Erel 30
 How does this loan contract work?

  For this loan contract to work, the lender must always

put the firm into liquidation if any offer is made to repay
less than the full face value of the loan -
  Regardless of whether he thinks a bad outcome (L)
has occurred or the borrowers are simply not being
truthful.

  This contract is incentive compatible — it has provided

the borrower with the incentive to repay the loan if he
can.
  The only way the borrower makes any money on the
transaction is if the outcome is good (H) and by being
truthful (in which case it will get to keep an amount
equal to V – f). Financial Institutions, Prof. Isil Erel
31
 What does this tell us about the kinds of
contracts that will arise when monitoring
is not possible?

  They will be debt contracts with fixed face values;

  Covenants of the debt contracts will be written
tightly;
  The debt contracts will be inflexible: If the
covenants of the loan are violated the firm will be
placed into bankruptcy, period.

Financial Institutions, Prof. Isil Erel 32

 Introduce Monitoring
  With monitoring, the lender can tell whether or not the
borrower is actually in a position to pay and use the
threat of liquidation to induce the borrower to pay as
much as possible.

  Specifically, the lender can now accept a payment of $1

when V = $1 (the value of the project in a Low outcome),
which before would have triggered a bankruptcy.

  The borrower will not be worse off repaying $1 than

going through liquidation.

Financial Institutions, Prof. Isil Erel 33

 Why don’t lenders engage in monitoring?
  If there are a few large lenders, monitoring may make
sense. But if there are many potential lenders, each with
only a relatively small amount to invest, it is likely to be too
costly, both individually and collectively.
  Example: Suppose the firm borrows $1 million and there are
10,000 investors, each with $100 to invest. If the monitoring
cost is $200, no one will monitor — too expensive.

  There is a free rider problem. Why should an investor

monitor (and incur the expense) when he or she knows
that someone else is monitoring?
  In this case, it is possible that insufficient monitoring will
occur. 34
 Banks as Delegated Monitors
  Investors could delegate the monitoring function to a
single market participant (we’ll call it a bank), saving each
lender the cost of doing it on his or her own.

  With monitoring, the bank can tell whether or not the

borrower is actually in a position to pay. Therefore, it can
accept a partial payment on a loan.
  Therefore, it may no longer be necessary to
automatically throw a firm into bankruptcy when the
firm is unable to pay the full face value of the loan.

Financial Institutions, Prof. Isil Erel 35

 Who will monitor the monitors (banks)?

  Hasn’t the delegation of the monitoring function merely

added one more market participant that will have to be
monitored to the transaction?

  Lenders (depositors) will face every problem in monitoring

banks that they would face in directly monitoring non-bank
borrowers. In effect, monitoring of banks is not possible .

  This has two implications.

Financial Institutions, Prof. Isil Erel 36

 Implications
  A. Bank liabilities will generally take the form of debt
instruments with a fixed face value — the kind of contract
shown above to be feasible when monitoring is not
possible. This provides the same incentives to banks as
faced by the firms that borrow from banks.

  Banks in fact do fund themselves principally with debt

instruments. Debt instruments (deposits, subordinated
debt, and other borrowed funds) represent about 90%
of the total liabilities of banks insured by the FDIC.

Financial Institutions, Prof. Isil Erel 37

 Implications (Continued)

  B. Banks will be forced to diversify their assets.

  If they do not, they will be just as risky as their loan

customer (in which case there is no point in using a
bank as an intermediary.)

  Diversification can significantly reduce the bank’s

probability of default against the depositors!

Financial Institutions, Prof. Isil Erel 38

 Bank Diversification is Crucial!
  Suppose the bank makes — and monitors — a single loan,
with the same distribution of returns as above.
  When the project returns $1 in a Low outcome, the bank
can monitor and collect $1 without forcing the borrower
into liquidation.
  However, the depositors would now force the bank into
liquidation:
  Deposits are tightly-written debt contracts that provide
for automatic liquidation whenever the borrower (in this
case the bank) cannot pay the full face value of the
deposit.
  Otherwise, depositors will not be able to earn the
required 5% return on their deposits.
39
 Bank Diversification is Crucial!
(Continued)
  In other words, depositors act just like lenders in a
situation in which monitoring is not possible.

  So, undiversified bank lending (modeled here as a loan

to a single borrower) does not work. Without
diversification, the bank will be liquidated as often as the
borrower would be, and nothing is gained.

40
 How do we know that diversification
can solve this problem?
  Suppose the bank makes two loans, $1 million each.

  The borrowers’ returns are independently distributed, but

otherwise just like that of the single borrower considered
above. Each loan has a 0.8 probability of returning $1.4
million, and a 0.2 probability of returning $1 million.

  The bank attracts $2 million in deposits from 20,000

depositors. The deposits are unmonitored debt. Let D
represent the face value (principal plus interest) of bank
deposits per loan. There are $2D in total deposits.

Financial Institutions, Prof. Isil Erel 41

 How do we know that diversification
can solve this problem?
  The bank lends to two borrowers under a debt contract
with a face value (principal and interest) of F ($ F million).
It monitors and collects F when the project returns $1.4
million, and monitors to collect $1 million when the
project is worth only $1 million.

  There are three possible outcomes:

1. Neither loan defaults.
2. One loan defaults.
3. Both loans default.
Financial Institutions, Prof. Isil Erel 42
 Three Possible Outcomes
  Neither loan defaults (both pay F) with probability
P2 = 0.8*0.8 = 0.64
  One loan defaults (One pays $1, one pays F) with
probability 2P(1-P) = 2* 0.8 *0.2 = 0.32
  Note that there are two ways that only one loan can
default. One of them is that loan A defaults and loan
B pays in full; the probability of which is (1 – P)P.
  Both loans default (both pay $1) with probability
(1-P)2 = 0.2 * 0.2 = 0.04

  Assume that liquidating the bank consumes γ of its

assets.
Financial Institutions, Prof. Isil Erel 43
 Can the bank survive the default of one
loan, on which it collects $1?
  If the bank defaults only if both loans default at once,
that means that bank’s probability of collapse is reduced
to only 0.04. Huge reduction from 0.2 to 0.04!
  If it can, then total payments to depositors
= $2D with probability 0.96;
= γ2 with probability 0.04 (default).
  Then the bank should promise to repay to depositors:
0.96*($2D) + 0.04*γ2 = $2*(1.05)
  2D = (2*1.05 – 0.04*γ2)/0.96
  Then, 2D = 2.1875 if recovery ratio (γ)=0
Financial Institutions, Prof. Isil Erel 44
 Can we find a loan face value F
that satisfies this system?
  When one loan defaults and the other pays the face value
F (with probability= 0.32), the bank’s earnings are 1 + F.
  Then, 1 + F must be equal at least to $2.1875 !

  What about monitoring cost?

  Recall that the cost of monitoring $1 loan = 0.0002
($200 for $1 million of loan).
  Thus monitoring is worthwhile if
  0.32*(1+F - 2.1875) ≥ 2 * 0.0002
  Then, F ≥ 1.18875.

Financial Institutions, Prof. Isil Erel 45

 Remember that without bank
monitoring, f would be

  Recovery rate, γ Face value of loan, f

1.00 $1.0625
0.50 $1.1875
0.25 $1.25
0.00 $1.3125

Financial Institutions, Prof. Isil Erel 46

 Bank Profits

Payoff
2F - 2D = 1.18875*2 – 2.1875 =
0.19

1+F- 2D = 2.18875 – 2.1875 =

0.00125

0 (default)

Expected Bank Profit

= 0.64 *0.19 +0.32*0.00125+0.04*0 – 2 * 0.0002 = $0.1216
Financial Institutions, Prof. Isil Erel 47
 All parties are better off!

  Expected profit of the bank is positive!

  We could alternatively calculate F such that
expected bank profit is at least equal to zero.

  The borrower pays 18.875% to the bank instead of

paying 31.25% directly to the lender!

  Lenders (depositors) get 5% return in both situations.

Financial Institutions, Prof. Isil Erel 48

 Implications

(1)  Banks can operate with a diversified portfolio with a low

(though nonzero) probability of default. Hence,
diversification makes bank deposits safer than bank
loans.
(2)  This arrangement permits only a few agents (banks) to
engage in monitoring; thousands of depositors need not
monitor on their own (which is probably too costly for
them to do anyway).

(3)  Banks monitor loans, but will finance themselves with

unmonitored debt.

Financial Institutions, Prof. Isil Erel 49