Chapter Eleven

The Economics of Financial

Intermediation
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Learning Objectives
an understanding of
1. How intermediaries promote
efficiency.
2. The central role of information
costs.
3. Incentive problems in finance.

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Introduction
Financial institutions serve as
intermediaries between savers and
borrowers,
These institutions pool funds from people
and firms who saves and lend to borrowers.
Intermediaries investigate the financial
condition and the best investment
opportunities.
Intermediaries they reduce investment risk
and economic volatility.

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Introduction
a common measure of financial activity--the
ratio of credit extended to real GDP per capita.
not any rich countries with very low levels of
financial development.
the flow of information problems and learn
how financial intermediaries attempt to solve
them.

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The Role of Financial

Intermediaries
Financial markets are important
because they price economic
resources and allocate them to their
most productive uses.
Intermediaries, including banks and
securities firms, continue to play a
key role in both direct and indirect
finance.
Table 11.1 illustrates the importance
of different channels of finance.

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The Role of Financial

Intermediaries

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The Role of Financial

Intermediaries
From the table we can see:
To make comparisons across countries of
vastly different size, we measure everything
relative to GDP.
There is no reason that the value of a
country's stock market, bonds outstanding,
or bank loans cannot be bigger than its GDP.

When you add up all the types of

financing, direct and indirect, as a
percentage of GDP, the numbers will
generally sum to more than 100 in an
advanced economy.
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The Role of Financial

Intermediaries
These data highlight the importance of
intermediaries.
Banks are still critical providers of financing
around the world.
Intermediaries determine which firms can
access the stock and bond markets.
Banks decide the size of a loan and interest
rate to be charged.
Securities firms set the volume and price of
new stocks and bond issues when they
purchase them for sale to investors.
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The Role of Financial

Intermediaries
Financial intermediaries are
important because of information.
Lending and borrowing involves both
transactions costs and information
costs.
Financial institutions exist to reduce
these costs.

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The Role of Financial

Intermediaries

In their role as financial

intermediaries, financial institutions
perform five functions:
1.Pooling the resources of small savers,
2.Providing safekeeping and accounting
services, as well as access to payments
system,
3.Supplying liquidity by converting savers
balances directly into a means of payment
whenever needed,
4.Providing ways to diversify risk, and
5.Collecting and processing information in
ways that reduce information costs.
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Pooling Savings
The most straightforward economic
function of a financial intermediary is to
pool the resources of many small savers.
-- By accepting many small deposits,
Banks:
Are a place for safekeeping.
Access to the payments system -- the
network that transfers funds
Specialize in handing payments

the intermediary:
Must attract substantial numbers of savers,
Must convince potential depositors
reduce the costs of financial transactions.
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Safekeeping, Payments System

Access, and Accounting
facilitate the exchange of goods and
services.
This principal of comparative advantage
leads to specialization
by providing us with a reliable and
inexpensive payments system,
also help us manage our finances.
They provide us with bookkeeping and
accounting services,
to write legal contracts
do takes advantage of economies of scale,
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Providing Liquidity
1. Liquidity is a measure of the ease and cost
that an asset can be turned
2. Financial intermediaries offer us the ability
to transform assets into money
3. keep enough funds in short-term, liquid
financial instruments to satisfy
4. the bank can reduce the cost of the
investment, offering each individual
investor liquidity and
5. offer both individuals and businesses lines
of credit, which provides liquidity.
6. must specialize in liquidity management.
7. it can sustain sudden withdrawals
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Diversifying Risk
enable us to diversify our
investments and reduce risk.
Banks take deposits from
thousands of individuals and
make loans.
provide a low-cost way for
individuals to diversify.

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Collecting and Processing

Information
the lender faces substantial costs to obtain
that information, results in an information
asymmetry.
Borrowers have information that lenders dont.

reduce the problems that information

asymmetries
Markets require sophisticated information to
work well.
Issuers of financial instruments know more
about their business prospects and
willingness to work
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Information Asymmetries
and Information Costs
Asymmetric information is a
serious hindrance
It poses two important obstacles
1. Adverse selection arises
Lenders need to know how to
distinguish good credit risks from bad.

2. Moral hazard occurs

Will borrowers use the money as they
claim?
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 The Madoff scandal was a classic

Ponzi scheme:
Investors fail to screen and monitor
the managers
A faade of public respectability
contributes to the success of a Ponzi
scheme,
Everyone acted as if someone else
was monitoring, so they could enjoy
the free ride.
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Adverse Selection
Used cars and the market for lemons:
Used car buyers cant tell good cars from bad.
Sellers have a good car, wont accept less than
the true value.
If buyers are only pay average value, good car
sellers will withdraw
Then the market has only the bad cars.

solve the asymmetrical information

problem.
Consumer Reports
More recently CARFAX
You can also hire a mechanic to look over
beginning to offer certified used cars,
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Solving the Adverse

Selection Problem

If you cant tell good from bad companies

Stocks or bonds of good companies are
undervalued, and
Owners will not want to sell them.

the problems of adverse selection are not

good.
Some companies will pass up good
investments.
Economy will not grow

find ways for investors and lenders to

distinguish good firms from bad firms.
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Disclosure of Information

to solve the problem of asymmetric

information is to provide more information.
public companies are required to disclose
more information.
For example, in the U.S., the Securities and
Exchange Commission (SEC) requires firms
to produce public financial statements
with the help of some unethical
accountants, found some cases to
manipulate the statements to disguise
their firms true financial condition
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Disclosure of Information
there is private information collected and
sold to investors.
To be credible, companies cannot pay for this
research,
Research services like Moodys, Value Line, and
Dun and Bradstreet collect information directly
from firms

Private information services face a freerider problem.

A free-rider is someone who doesnt pay the
cost to get the benefit of a good or service.
Public libraries subscribe
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Collateral and Net Worth

Another solution for adverse selection is
to make sure lenders are compensated
with the coll.
If a loan is insured in some way, then the
borrower isnt a bad credit risk.

Collateral is something of value pledged

by a borrower to the lender.
Unsecured loans, like credit cards, are
loans made without collateral.
Because of this they generally have very high
interest rates.
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Collateral and Net Worth

The net worth is the owners stake in
a firm Net worth serves the same purpose as
collateral
If a firm defaults, the lender can claim
for the firms net worth.

From the perspective of the

mortgage lender, the homeowners
house serves the same function as
net worth
Most small business owners must put
up their homes and other property as

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Moral Hazard: Problem and

Solutions
Moral hazard arises when we cannot
observe peoples actions and
therefore cannot judge whether
a poor outcome was intentional or
just a result of bad luck.
A second, information asymmetry
arises because the borrower knows
more than the lender about the way
borrowed funds,
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Moral Hazard: Problem and

Solutions
How do we solve the problem?
the manager will use the funds in a way
that is most advantageous to them, not
you.
The separation of your ownership from
their control creates what is called a
principal-agent problem.
to align managers interests with those of
stockholders.
there is no foolproof way of ensuring managers
will behave in the owners best interest
Executives were given stock options
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Moral Hazard in Debt

Finance
When the managers are the owners,
moral hazard in equity finance
disappears.
Because debt contracts allow owners
encourage risk taking.
Lenders need to find ways to make
sure borrowers dont take too many
risks.
debt finance because lenders get the
full benefit of the upside, the
downside is limited to collateral.
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Solving the Moral Hazard

Problem in Debt Finance
Legal contracts can solve the
moral hazard problem in debt
finance.
Bonds and loans carry restrictive
covenants
to maintain a certain level of net
worth, a minimum credit rating,
For example: home mortgages
require home insurance, fire
insurance, etc.
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Negative Consequences of
Information Costs

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Financial Intermediaries and

Information Costs
Much of the information is used to:
Reduce information costs, and
Minimize the effects of adverse selection and
moral hazard.

To do this, intermediaries:
Screen loan applicants,
Monitor borrowers, and
Penalize borrowers by enforcing contracts.

The lender uses a credit score.

requests a credit score, they have to pay,
eliminating the free rider problem.
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Monitoring to Reduce Moral

Hazard
Intermediaries insure against this
type of moral hazard by monitoring
Many hold significant number of
They may place a representative

For new companies, a financial

intermediary called a venture
capital firm does the monitoring.
They specialize in investing
Finally, the threat of a takeover
helps to persuade managers to act
in the interest
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How Companies Finance Growth

and Investment
1. Wealthy countries have high levels of
financial development, and
2. Intermediaries play key roles both in direct
and indirect finance.

3. a firm can also use its own profits, can

reinvest the earnings into the firm.
4. managers have superior information
about
running makes internal finance

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How Companies Finance Growth

and Investment

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Homework
Due date next Week

11-33

1. What problem associated with

asymmetric information was central to
Bernard Madoffs success in cheating
so many investors for so long?
2. Financial intermediation is not confined
to bank lending but is also carried out
by non-bank firms such as mutual fund
companies. How do mutual funds help
overcome information problems in
financial markets?(LO1)

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3. In some countries it is very difficult for

shareholders to fire managers when they
do a poor job. What type of financing
would you expect to find in those
countries?(LO3)
4. The financial sector is heavily regulated.
Explain how government regulations help
to solve information problems, increasing
the effectiveness of financial markets and
institutions.(LO1)
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5. One of the solutions to the adverse

selection problem associated with
asymmetric information is the pledging of
collateral. However, the collateral may be
riskier than initially thought.
As an example, explain why the
collateral did not work adequately to
mitigate the mortgage securitization
problems associated with the financial
crisis of 2007-2009?
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6. If a bank has 1,000 depositors, each

of whom deposits $1,000 in the
bank, and the bank makes loans of
$10,000 each, then each depositor
has contributed:
10000/1000=10
7. How are financial intermediaries
able to reduce transactions costs?
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8. Which of the following is an example of adverse selection?

A) A homeowner with a large fire insurance policy allows the
wiring in her house to deteriorate.
B) A woman with a large life insurance policy takes up sky diving.
C) Your brother-in-law borrows $20,000 from you to open a pizza
parlor, but spends it gambling at the racetrack instead.
D) A man with a bad heart condition buys a large life insurance
policy.
9. Why do higher interest rates increase adverse selection
problems in the loan market?
A) Higher interest rates reduce the gains from economies of
scale.
B) As interest rates rise, the creditworthiness of the average loan
applicant declines.
C) Higher interest rates reduce information problems in the loan
market.
D) At higher interest rates fewer investment projects are
profitable.
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10) Moral hazard problems arise when

A) lenders have difficulty in distinguishing
between good and lemon firms.
B) when a downturn in economic activity
makes repaying loans difficult for borrowers.
C) borrowers default on loans.
D) borrowers have an incentive to conceal
information.
Answer

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