Banking and Financial
Intermediation
Fall 2023, Block 2
1
,Lecture 1 – Financial Intermediaries: rationale and
risks
Asynchronous lecture: finish it alone
The special role of FIs
- Need of friction: adverse selection (screening), moral hazard (monitoring)
A world without FIs (= financial intermediaries)
Equity and debt is directly served to households (=net savers) by corporations or firms
(=net borrowers). On the other side, cash is directly served to corporations or firms by
households.
When FI are useless
In a perfect world FIs are redundant: Modigliani-Miller result
Assumptions:
• complete markets
• symmetric information and so on…
However, the real world is plagued by frictions, also known as agency costs
Problems in a world without FIs
1) Adverse Selection
• Prior to purchasing a firm’s debt or equity, investors may not know the quality of
the firm
• Example:
• Good firm is worth $10, bad firm is worth $4
• A rational investor would pay the average $7
• The poorest (adverse) quality firms have the greatest incentive to issue securities.
Good firms find inconvenient to issue securities since they have to be sold at
discount
2) Moral Hazard
• After purchasing a firm’s securities, investors needs to monitor the firm’s
managers
• Managers may have the incentive to spend investors’ money on excessively risky
projects or perquisite consumption
• Managers may also exert less effort than promised
3) Maturity and Liquidity
• The firm’s debt or equity may have characteristics that may not be attractive to
investors
2
, • Most important characteristic is maturity and liquidity
• Example: debt and equity may not be sufficiently liquid, as they have to be
liquidated on spot at current prices (price risk)
Problems in a world without FIs
Summing up:
• Lower level of fund available (investors would prefer not to lend or firm not to
borrow)
• Higher information costs (economies of scale reduce costs of screening and
monitoring firms)
• Less liquidity in the economy
• Higher price risk for investors
A world with FIs
Major Functions of FIs
1) Broker
• As a broker, the FI provides information about the quality of security issued
• When there are costs for screening the quality of the firm’s securities, the broker
reduces such costs through economies of scale
• This is an efficient way to produce information and to reduce the adverse selection
problem
2) Asset Transformer
• The FI transforms primary securities (e.g., loans, bonds, stocks) issued by firms into
secondary securities (e.g., bank deposit). In this way a FI solves two problems:
o A) The FIs acts as a delegated monitor to efficiently produce information on
the firm’s ongoing activities and reduce moral hazard. The average
monitoring cost is lower for FIs since they exploit economies of scale
(Diamond, 1984)
o B) The FIs can provide maturity intermediation: the maturities of its assets
differ from the maturities of its liabilities
3
, § FIs create liquidity: household hold securities with very short maturity,
like demand deposits, where price risk is almost absent (Diamond
and Dybvig, 1983)
Other Services provided by FIs
• Transmission of monetary policy
• Credit allocation (areas of special need such as home mortgages, farms, and small
businesses)
• Payment services (FedWire and CHIPS, check clearing, cash)
• Intergenerational wealth transfers or Time intermediation (life insurance and pension
funds)
• Denomination intermediation (mutual funds)
Regulation
The important services banks provide make them worth of receiving special regulatory
attention
The troubles affecting banks have negative externalities on the rest of the economy
Examples:
• A bank failure may destroyhousehold savings and restrict firm’s access to credit
with contagiouseffects on the rest of the economy (lower sales, production,
employment)
• Failure of large interconnected banks may cause the failure of other banks
(systemic risk) making them to be too big to fail
Examples of too-big-to-fail
• Bear Stearns (March 2008)
o Were about to fail but got bailout
o NY Fed arranged a purchase by JP Morgan Chase with the Fed guaranteeing
$29 billion in losses
• AIG (September 2008)
o The government had to buy a 79% stake
o AIG was heavily involved in the credit default swap market and would have
brought down many banks
• Citigroup (2 bailouts through the TARP)
o Received $25 billion in October 2008, then another $20 billion in November
2008
Regulations
Regulation must impose private costs:
• No more than 10 percent of equity to single borrower
• On site examinations can be long and costly
• Capital requirements (equity more expensive than deposits)
• Banks can be forced to invest in the communities in which they take deposits
Regulation gives also benefits:
• Access to the discount window and deposit insurance
4
Intermediation
Fall 2023, Block 2
1
,Lecture 1 – Financial Intermediaries: rationale and
risks
Asynchronous lecture: finish it alone
The special role of FIs
- Need of friction: adverse selection (screening), moral hazard (monitoring)
A world without FIs (= financial intermediaries)
Equity and debt is directly served to households (=net savers) by corporations or firms
(=net borrowers). On the other side, cash is directly served to corporations or firms by
households.
When FI are useless
In a perfect world FIs are redundant: Modigliani-Miller result
Assumptions:
• complete markets
• symmetric information and so on…
However, the real world is plagued by frictions, also known as agency costs
Problems in a world without FIs
1) Adverse Selection
• Prior to purchasing a firm’s debt or equity, investors may not know the quality of
the firm
• Example:
• Good firm is worth $10, bad firm is worth $4
• A rational investor would pay the average $7
• The poorest (adverse) quality firms have the greatest incentive to issue securities.
Good firms find inconvenient to issue securities since they have to be sold at
discount
2) Moral Hazard
• After purchasing a firm’s securities, investors needs to monitor the firm’s
managers
• Managers may have the incentive to spend investors’ money on excessively risky
projects or perquisite consumption
• Managers may also exert less effort than promised
3) Maturity and Liquidity
• The firm’s debt or equity may have characteristics that may not be attractive to
investors
2
, • Most important characteristic is maturity and liquidity
• Example: debt and equity may not be sufficiently liquid, as they have to be
liquidated on spot at current prices (price risk)
Problems in a world without FIs
Summing up:
• Lower level of fund available (investors would prefer not to lend or firm not to
borrow)
• Higher information costs (economies of scale reduce costs of screening and
monitoring firms)
• Less liquidity in the economy
• Higher price risk for investors
A world with FIs
Major Functions of FIs
1) Broker
• As a broker, the FI provides information about the quality of security issued
• When there are costs for screening the quality of the firm’s securities, the broker
reduces such costs through economies of scale
• This is an efficient way to produce information and to reduce the adverse selection
problem
2) Asset Transformer
• The FI transforms primary securities (e.g., loans, bonds, stocks) issued by firms into
secondary securities (e.g., bank deposit). In this way a FI solves two problems:
o A) The FIs acts as a delegated monitor to efficiently produce information on
the firm’s ongoing activities and reduce moral hazard. The average
monitoring cost is lower for FIs since they exploit economies of scale
(Diamond, 1984)
o B) The FIs can provide maturity intermediation: the maturities of its assets
differ from the maturities of its liabilities
3
, § FIs create liquidity: household hold securities with very short maturity,
like demand deposits, where price risk is almost absent (Diamond
and Dybvig, 1983)
Other Services provided by FIs
• Transmission of monetary policy
• Credit allocation (areas of special need such as home mortgages, farms, and small
businesses)
• Payment services (FedWire and CHIPS, check clearing, cash)
• Intergenerational wealth transfers or Time intermediation (life insurance and pension
funds)
• Denomination intermediation (mutual funds)
Regulation
The important services banks provide make them worth of receiving special regulatory
attention
The troubles affecting banks have negative externalities on the rest of the economy
Examples:
• A bank failure may destroyhousehold savings and restrict firm’s access to credit
with contagiouseffects on the rest of the economy (lower sales, production,
employment)
• Failure of large interconnected banks may cause the failure of other banks
(systemic risk) making them to be too big to fail
Examples of too-big-to-fail
• Bear Stearns (March 2008)
o Were about to fail but got bailout
o NY Fed arranged a purchase by JP Morgan Chase with the Fed guaranteeing
$29 billion in losses
• AIG (September 2008)
o The government had to buy a 79% stake
o AIG was heavily involved in the credit default swap market and would have
brought down many banks
• Citigroup (2 bailouts through the TARP)
o Received $25 billion in October 2008, then another $20 billion in November
2008
Regulations
Regulation must impose private costs:
• No more than 10 percent of equity to single borrower
• On site examinations can be long and costly
• Capital requirements (equity more expensive than deposits)
• Banks can be forced to invest in the communities in which they take deposits
Regulation gives also benefits:
• Access to the discount window and deposit insurance
4
