Financial Intermediation

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1 Financial Intermediation The last time you bought an apple at the grocery store did wonder at all who grew the apple? Probably not. You deal with the grocery store, a fruit intermediary among other things, not the farmer who grew the apple. A bank is a financial intermediary and is in many ways like the grocery store. When you take out a loan from a bank to buy a house or car or something else, you do think very hard about whose funds you are borrowing. You may even think that you are borrowing the bank's funds, and in a way you are right. You are borrowing the bank's funds in the same way that you are buying the grocery store's apple, but both the bank and the grocery store are middlemen. Ultimately, you are buying the apple from the farmer and you are borrowing funds from the depositors of the bank. Grocery stores facilitate the exchange between you and the farmer, while banks facilitate the loan between you and the depositors of the bank. A bank, or more generally a financial intermediary, is a financial middleman in the same way that a grocery store is a food middleman or a retail store, like a Walmart, is a manufacturing middleman. Direct vs. Indirect Lending A middleman is not necessary to make a trade. For example, you can trade directly with a farmer at your local farmer's market. Similarly, borrowers and lenders can meet directly. For example, this direct meeting occurs when the Treasury auctions off new issues of Treasury securities directly to the public. 1 Large, well-established firms can also sell bonds or issue stock to the public. Often these sales are facilitated by investment banks. Investment banks offer advice to firms seeking financing in the securities market and underwrites the new securities. For example, a firm may want to raise $10,000,000 by issuing new bonds. An investment bank, or more likely a group of investment banks, will underwrite or guarantee the selling price of the bonds. For example, the firm may want to sell 10,000 bonds with a given face value and coupon rate. The investment bank or banks would underwrite these bonds for $1,000 each. The investment bank or banks would then undertake to sell these bonds. If they are able to raise 1 For more detail on Treasury auctions see

2 2 more that $10,000,000, they get to keep the difference. On the other hand, if they fall short of the $10,000,000, the investment bank or banks suffers the loss. Indirect finance uses a financial middleman as described above. Banks are perhaps the most familiar financial intermediary. Other financial intermediaries are savings and loan associations, credit unions, and mutual savings banks. Deposits in savings, time, and checkable deposits are the main source of funds for these depository intermediaries and they use these funds to make business and consumer loans and to finance mortgages. Insurance companies and pension funds also provide intermediation services. These contractual savings institutions generate funds from premiums and employee and employer contributions respectively. They use these funds to purchase corporate bonds and stock and government bonds. The so-called investment intermediaries are finance companies and mutual funds. Finance companies raise funds by issuing commercial paper, bonds, and stock and use these funds to make consumer and business loans that are typically designed for a specific market. For example, General Motors, Ford, and Chrysler all have associated finance companies: General Motors Acceptance Corporation, Ford Motor Credit Company, and Chrysler Financial Corporation. Mutual funds are intermediaries that allow savers to pool their funds in order to get the benefits of large, specialized portfolio management. The Guiding Facts for Financial Markets There are five salient features of financial markets that we want to understand. The first is the distribution of sources of funds. Loans are by far the most important source making up roughly 60% of the total. Securities market sources, bonds and stocks, make up about a third; bonds account for about 30% funds, while stocks account for only about 2% of funds raised. In addition to the distribution of sources, it is important to note that banks are the primary source of loans. When a loan contract is written it specifies how much is borrowed, the interest rate, the frequency and length of the payment period. These contracts typically have two other important features. First, loans usually require collateral. The ownership of the collateral shifts to the lender in the event that the borrower fails to meet the requirements of the loan contract. Second, loans usually involve restrictive covenants. These covenants restrict the borrowers behavior

3 3 after the loan is made. For example, when you take a out a mortgage to buy a home you must carry insurance on the home and the degree to which you can renovate your home without the permission of the lender is restricted. Who can bypass the loan market and raise funds directly from the sale of bonds or stock? It turns out that only large, well-established firms have access to the securities market; and when they use these markets it is overwhelmingly to issue new bonds, not new stock. Table 1 summarizes these guiding facts Table 1 Guiding Facts for Financial Markets loans - 60% bonds - 30% stocks - 2% most loans are from banks most loans require collateral most loans have restrictive covenants only large, well-established firms have direct access to financial markets Transactions Costs and Economies of Scale When people consider borrowing money to buy a house they have a couple of options. The first option is to make the rounds of the friends and family to ask each of them how much they are willing to lend. The average price of a home in Ohio is somewhere around $140,000. If you have saved a sufficient amount to put 20% of the buying price up as cash, your friends and family will still have to come up with $112,000. Suppose you are fortunate enough to have wealthy friends and family so that this sum is feasible. Even in this happy circumstance your problem is not yet solved. To make things concrete suppose you can raise the funds from ten people. You must now negotiate ten contracts. It is unlikely that either you or your lenders are experts in mortgage law, so you will have to learn about the legal issues involved. Your ten lenders may not settle for the same

4 4 contract. Some lenders may be willing to make a loan for thirty years, but others may only want to extend a loan for five years. This difference implies that you will have to refinance at least a part of your loan. Other details of the contract may suit one lender but not another. For example, some lenders may request notification if you decide to build on to your house and may want the authority to veto your decision. If all of these complications are met, your house payments will have to be sent to ten different locations. In short, there are very high transactions cost in forming a mortgage loan. We have describes some of the headaches involved in writing contracts. Another formidable transactions cost would arise if your family and friend were not sufficiently wealthy to fund your home purchase. In that case you would have to find strangers from whom to borrow. This search would involve writing advertising copy and deciding how to best air your commercials. These endeavors add another layer of transactions costs. A fundamental role of financial intermediaries is to reduce average transactions costs. Financial intermediaries reduce transactions costs in two ways. To illustrate first consider the expertise required to negotiate and write and contracts. Suppose the cost of acquiring these skills, the time and dollars spent on legal and on-the-job training, is $30,000. Once you have obtained this training you can write and negotiate as many contracts as time and circumstances allow. If you use your skills on just ten contracts, then the transactions cost per contract is $3,000. On the other hand, if you negotiate and write 10,000 contracts, then the average transactions cost per contract is $3. Obviously, the more contracts you write and negotiate, the smaller will be the average transactions cost. Declining average cost occurs in this case because the large cost of training is spread over a larger number of contracts. A similar advantage accrues to size in the search of potential lenders. If you must search for strangers from whom to borrow, advertising and reputation are critical. Potential lenders must know you are a willing borrower and are able to repay the principal and interest on the loan. Suppose to get the word out you buy some time on the local radio station for $500. The average transactions cost per contract from advertising will be $500/#contracs. Again, the more contracts you write and negotiate, the smaller will this average be because the cost of advertising is spread over a larger number of contracts. A second potential source of declining average costs are the gains from specialization. In your quest for a loan you are writing and negotiating contract, you are writing advertising copy,

5 5 and you may also be doing radio commercial. In a large operation these tasks could be specialized. One set of people write and negotiate contracts. In performing this repeated task they are likely to become more efficient at it. Similarly, a different set of people specialize in advertising and they become more efficient at that task. The increased efficiency of each task lowers average costs. When average costs decline as output, which in this case is the number of loan contracts written, increases, economists say that there are economies of scale. When there are significant economies of scale and the size of the market is sufficiently large, firms will arise. Figure 1 illustrates economies of scale. If the market for loans is very small, say 5 loans per year, it will not be efficient for a firm to form. The market is not large enough to allow a sufficient exploitation of economies of scale. On the other hand, if there 10,000 contracts per year, a firm will appear to take advantage of economies of scale. average cost Figure ,000 In our example, these firms will be called financial intermediaries. Like any intermediary, these firms facilitate a trade between the ultimate parties; in this case the ultimate lender and the ultimate borrower. That is to say, the firm will borrow from one set of people and lend to a different set of people. Examples with which you are no doubt familiar are banks, savings and loans, and credit unions. These intermediaries borrow by accepting checkable deposits, savings deposits, or time deposits from their customers and then lend these deposits to others as home mortgages, car loans, short-term business loans, or the like. # of contracts

6 6 The Role of Information the lemons problem Consider the market for used cars. The standard demand and supply diagram for such a market is shown in Figure 2. The equilibrium price is $12,000 per car and the equilibrium quantity of used car transactions is 1,000 per year. However, there is an important difference between the market for used cars and many other markets. In particular, the seller of the car has more information with respect to the car's quality than does a buyer. The seller knows whether she has a high quality car or a poor quality car, a so-called "lemon". The buyer comes to the potential transaction with much less information. This creates a situation where there is asymmetric information. Borrowers are better informed that are lenders. This problem creates another. There is an adverse selection problem. The people who are stuck with lemons want to unload them, so the market will be heavy in lemons and light in quality cars. These information problems may be sufficiently large to shut quality cars completely out of the market. For example, suppose there is no way for the buyer to know whether she is about to buy a lemon or quality car. Suppose she figures that a lemon is worth $6,000, while a quality car is worth $18,000; and she believes that the market is split between lemons and quality cars. The expected value of a car is thus (1/2)$6,000 + (1/2)$18,000 = $12,000. If she is willing to take the risk of entering the market, she won't be willing to pay more than the expected value of the car $12,000. Now, if the potential sellers share her evaluation of quality cars, no seller will be willing to let go of their quality P $12,000 Figure 2 1,000 car for less than $15,000. Since she won't be willing to pay more than $12,000, no quality cars S D used cars

7 7 will be offered for sale. Our potential buyer is no fool and realizes the implications of this argument is that only lemons will be put up for sale. With this knowledge she will offer only $6,000 for a car and so only lemons will be traded. This asymmetric information leads to adverse selection and drives all of the quality cars out of the market. We know there is a used car market, so what saves it? The buyers have to trust the seller or they have to acquire more information about the car. Developing trust in the seller can be achieved in at least two ways. First, a "Used Car Dealership" can arise and the dealership can earn a reputation for fair dealing. The second way to develop trust is through warranties. It is now commonplace for dealership to sell certified used vehicles that have warranties and that put the seller's reputation on the line. Potential buyers can also study the car. There are on-line sources that help evaluate the general history of a make and model (for example, edmunds.com has information without a charge, while consumerreports.org charges a fee). If you are knowledgeable about cars you can inspect it yourself, or if you are lucky enough to know a trusted mechanic, you can have the car inspected by her. asymmetric information, adverse selection, and credit markets How is the market for credit like the market for used cars? Borrowers, like the sellers of used cars, have more information about their motives for borrowing and their ability and desire to repay the loan than do potential lenders. Thus, asymmetric information can lead to adverse selection and the types of problems encountered in the used car market. This problem is a key characteristic of credit markets. Financial intermediaries, such as banks, serve the credit market in much the same way that used car dealerships facilitate the exchange or autos. In particular, financial intermediaries find ways to trust the people to whom they loan funds. They have similar options to those found in the used car markets. First, financial intermediaries specialize in the gathering and evaluation of information about borrowers. For example, they can hire or train their own specialist in estimating the value of real estate and its development. In parts of the country, financial intermediaries may specialize in knowledge about oil drilling and refining, or about agriculture. In short, financial intermediaries gather information about potential borrower's reputation and the quality of proposed projects.

8 8 Second, financial intermediaries may want the people to whom they lend to give them something like warranties. In this setting a warrantly-like provision is collateral. Financial intermediaries may require lenders to put up assets, like a house for a home mortgage, to secure the loan. If the borrower fails to honor to debt obligations, the lender takes possession of the collateral and can regain at least some of their funds. another information problem The problems associated with asymmetric information and adverse selection occur before a loan contract is written and signed. These problems affect the pool of potential borrowers. Acquiring information, learning about borrower's reputation, and requiring collateral are ways lenders have to effectively screen applicants and improve the quality of their loan portfolio. A second set of problems occur after the contract is signed. The presence of a contract may affect the behavior of one or more of the parties involved. Economists refer to this affect on behavior as moral hazard. For example, suppose that before you have the money in hand you are sure that you want to buy a new house. However, once the loan is signed and you have the funds in hand, you may want to reward your long and diligent search for a home with a nice vacation to the Bahamas. Once you're on the island, the casinos may exert an irresistible force on your wallet, and when you return to the states the home you had planned to purchase may now be out of reach. The moral hazard problems thus presents a potential cost to lenders. To counter the moral hazard problem requires restricting the borrower's behavior and monitoring the borrower to promote compliance. Summary Financial intermediaries promote a society's welfare by lowering the cost associated with trades between borrowers and lenders. Financial intermediaries reduce the cost of matching borrowers and lenders by exploiting economies of scale associated with the spreading of cost over many units and the gains from specialization. The gains from specialization arise not only in reducing average transactions cost, but also in lowering the cost of acquiring and evaluating information and in monitoring and enforcing contracts. In the absence of financial intermediaries many loans that now occur would not be made. Without financial intermediaries the cost of matching borrowers and lenders would be prohibitively high.

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