1 Macro: role & types of financial intermediation
“Savers have money, borrowers borrow money.”
1.1 Why does financial intermediation exist?
1. There are important differences in the needs & objectives between funding suppliers (eg savers) and funding
demanders (eg borrowers)
2. There are important markets imperfections such as transaction costs, information asymmetries, …
1.1.1 Differences in needs/objectives
Funding supply:
- Minimalisation of risks (credit, transformation, market, operational)
- Minimalisation of transaction costs
- Maximalisation of liquidity (access to your money ST preference)
- Maximalisation of returns
- …
Funding demand:
- Availability of funding
at a specific moment in time
for a specific period
for a certain volume
- Minimalisation of costs
- …
Differences in needs/objectives create difficulties and entailing costs to match supply & demand. These difficulties and
costs increase with the presence of market imperfections.
1.1.2 If you minimise market imperfections, you minimise entailing costs (zie pwp)
Market imperfections such as information asymmetries lead to transaction costs & potentially damaging consequences.
1. Transaction costs:
Information gathering – initial & ongoing
Contract negotiation & writing
Enforcement of contracts
…
2. Potential damaging consequences
Adverse selection
Principal-agent problems: moral hazard
Free-rider problems
…
1
,Adverse selection
Example of adverse selection: The lemon’s problem applied to bank loans (Stiglitz & Weiss, '81):
- A bank only has imperfect information wrt the risk profile of individual borrowers. There are 80% of good borrowers
and 20% of bad borrowers.
- The interest rate charged on the loan will have an impact on the type of customers (in terms of risk profile & appetite)
When interest rates are low, customers with risk profiles will want to borrow.
When interest rates are high, customers with risk profiles will want to borrow.
- As a consequence:
higher interest rates do not automatically translate into higher returns, given that the risk profile increases.
Interest rates can be considered a ‘screening’ device
- At the interest rate r* the return π is maximised. The increase in credit costs eliminates the
increase in interest income above that level
- At r* the demand for credits can still be higher than the supply Stiglitz & Weiss advise to
do ‘credit rationing’: Within the group of homogenous borrowers, only part of them will get
a loan…
- Conclusion: an increase in interest rates potentially leads to adverse selection given that
only higher-risk customers remain.
- It also works both ways as it can result in customers taking more risks given that the higher
interest they need to pay forces them to take more risks (or increase efforts) …
The principle agent problem
- Principal agent problems: "An agency relationship is a contract under which one or more persons (the principal)
engage another person (the agent) to perform some service on their behalf which involves delegating some decision
making authority to the agent." (Jensen & Meckling (1976))
- Financial contracts have a ‘fiduciary’ nature. They are dependent on future actions with an uncertain outcome (
TRUST).
eg: saver puts money on an account hoping/trusting to be paid an interest rate and be able to get their money
back.
eg: bank borrows money to a company hoping/trusting that they will generate sufficient cash flows to repay the
loan.
- So financial contracts are principal-agent relations whereby
The principal transfers powers to the agent
Agent & principal do not always have the same objectives (= agency problem)
- Example of an agency problem = moral hazard: If the borrower ex-post behaves differently than what was ex-ante
agreed
Eg: increasing the risk profile of an investment project after the loan was agreed. (‘Asset substitution’ or ‘risk
shifting’ problem). This increases the expected return for the shareholder and reduces that of the debtholder.
- Example: To start a business, an entrepreneur borrows money with an annual interest expense of 50. He’s thinking
about either a bakery or a bar. A bakery has a pay-off of 60 when wheather is good and 50 when weather is bad. A bar
has a pay-off of 100 when wheather is good and 10 when weather is bad. The probability of good weather is 50%.
What will the entrepreneur prefer?
- Agency problem -- Banks want as little credit risk as possible measured as EAD * PD * LGD
EAD = Exposure At Default – How much (in euro) is at stake the moment the customer defaults?
PD = Probability of Default – What is the probability (in %) that the customer will default in the coming period?
LGD = Loss Given Default - What % of the loan is lost in case of a default? = 1 – how much can be recovered)
- How to ensure that the agent (=firm) handles in the interest of the principal (=bank)?
• Monitoring: Controlling annual accounts, requesting periodic reports, consulting specialised advisories (Standard
& Poor's; Graydon,…), keeping close contacts (relationship banking)
o Monitoring expenses by the principal: necessary, yet not always efficient nor effective as the agent has more
information & expertise
o Monitoring expenses by the agent: provide (verified) data
2
, • Ensuring enforceability
o Actions by the principal challenging in design & enforcement
Loan conditions (Berger & Udell,1988) such as: Shorten contract maturity (revolving credits), Include
collateral & guarantees, Debt covenants (eg activity restrictions, financial targets,...)
Example of covenant based on financial ratios: if the ration of debt/EBITDA increases above 4, the
debt needs to be reimbursed
o Actions by the agent = signalling trust – must be credible:
Providing collateral & guarantees
Devise bonding mechanisms to align interests
bonus systems, Put reputation at stake, Participate (put your money where your mouth is…)
free-rider problems
free-rider problems = Others benefit from actions (information gathering, enforcement,...) at
no cost. Eg financial news.
- Risk of ‘Prisoner’s dilemma’ – imagine you can lend money to one student
If both do research together, both have an expected pay-off of 3
If one person does research, everybody makes 5, but it costs 5 to do the research
If nobody does anything, both have an expected pay-off of 1
- Outsourcing to a trusted party makes sense when this is more cost-efficient
- To more than one could make sense to avoid switching costs
1.1.3 Pros and cons of financial intermediation
- Imperfections such as transaction costs & information asymmetries result in difficulties to match funding supply &
demand directly.
- Role of financial intermediation = provide efficient mechanism to optimally allocate & match supply & demand
Price determination
Liquidity provision
Minimisation of costs
Risk reduction (diversification, hedging,...)
…
Funding suppliers: funding demands
1. Larger liquidity 1. Flexibility in timing and size
2. Lower risks 2. Lower (transaction) costs
3. Lower transaction costs
Society:
A) More efficient funding allocation
B) Better/more access to funding for (productive) investments
But important role for financial stability & consumer protection
1.1.4 Advantages attributes to banks
Banks are specialized in matching needs through the transformation in terms of
- Size: ultimate diversification
- Maturity: eg: short-term sight accounts are transformed into mortgage loans
- Risk profile through diversification, screening & monitoring, buffering
Berger & Udell (1998): “Under relationship lending, information is gathered by a financial institution through continuous
contact with the firm and entrepreneur in the provision of financial services. This information is then used to help make
additional decisions over time about the evolution of contract terms and monitoring strategies.“
- Advantages of relationship banking = lower information asymmetries & transaction costs leading to (?) lower funding
cost & better access in good & bad times (lower risk of “credit constraints”).
- ? Because it also leads to higher bargaining power & switching costs needs to be managed
3
“Savers have money, borrowers borrow money.”
1.1 Why does financial intermediation exist?
1. There are important differences in the needs & objectives between funding suppliers (eg savers) and funding
demanders (eg borrowers)
2. There are important markets imperfections such as transaction costs, information asymmetries, …
1.1.1 Differences in needs/objectives
Funding supply:
- Minimalisation of risks (credit, transformation, market, operational)
- Minimalisation of transaction costs
- Maximalisation of liquidity (access to your money ST preference)
- Maximalisation of returns
- …
Funding demand:
- Availability of funding
at a specific moment in time
for a specific period
for a certain volume
- Minimalisation of costs
- …
Differences in needs/objectives create difficulties and entailing costs to match supply & demand. These difficulties and
costs increase with the presence of market imperfections.
1.1.2 If you minimise market imperfections, you minimise entailing costs (zie pwp)
Market imperfections such as information asymmetries lead to transaction costs & potentially damaging consequences.
1. Transaction costs:
Information gathering – initial & ongoing
Contract negotiation & writing
Enforcement of contracts
…
2. Potential damaging consequences
Adverse selection
Principal-agent problems: moral hazard
Free-rider problems
…
1
,Adverse selection
Example of adverse selection: The lemon’s problem applied to bank loans (Stiglitz & Weiss, '81):
- A bank only has imperfect information wrt the risk profile of individual borrowers. There are 80% of good borrowers
and 20% of bad borrowers.
- The interest rate charged on the loan will have an impact on the type of customers (in terms of risk profile & appetite)
When interest rates are low, customers with risk profiles will want to borrow.
When interest rates are high, customers with risk profiles will want to borrow.
- As a consequence:
higher interest rates do not automatically translate into higher returns, given that the risk profile increases.
Interest rates can be considered a ‘screening’ device
- At the interest rate r* the return π is maximised. The increase in credit costs eliminates the
increase in interest income above that level
- At r* the demand for credits can still be higher than the supply Stiglitz & Weiss advise to
do ‘credit rationing’: Within the group of homogenous borrowers, only part of them will get
a loan…
- Conclusion: an increase in interest rates potentially leads to adverse selection given that
only higher-risk customers remain.
- It also works both ways as it can result in customers taking more risks given that the higher
interest they need to pay forces them to take more risks (or increase efforts) …
The principle agent problem
- Principal agent problems: "An agency relationship is a contract under which one or more persons (the principal)
engage another person (the agent) to perform some service on their behalf which involves delegating some decision
making authority to the agent." (Jensen & Meckling (1976))
- Financial contracts have a ‘fiduciary’ nature. They are dependent on future actions with an uncertain outcome (
TRUST).
eg: saver puts money on an account hoping/trusting to be paid an interest rate and be able to get their money
back.
eg: bank borrows money to a company hoping/trusting that they will generate sufficient cash flows to repay the
loan.
- So financial contracts are principal-agent relations whereby
The principal transfers powers to the agent
Agent & principal do not always have the same objectives (= agency problem)
- Example of an agency problem = moral hazard: If the borrower ex-post behaves differently than what was ex-ante
agreed
Eg: increasing the risk profile of an investment project after the loan was agreed. (‘Asset substitution’ or ‘risk
shifting’ problem). This increases the expected return for the shareholder and reduces that of the debtholder.
- Example: To start a business, an entrepreneur borrows money with an annual interest expense of 50. He’s thinking
about either a bakery or a bar. A bakery has a pay-off of 60 when wheather is good and 50 when weather is bad. A bar
has a pay-off of 100 when wheather is good and 10 when weather is bad. The probability of good weather is 50%.
What will the entrepreneur prefer?
- Agency problem -- Banks want as little credit risk as possible measured as EAD * PD * LGD
EAD = Exposure At Default – How much (in euro) is at stake the moment the customer defaults?
PD = Probability of Default – What is the probability (in %) that the customer will default in the coming period?
LGD = Loss Given Default - What % of the loan is lost in case of a default? = 1 – how much can be recovered)
- How to ensure that the agent (=firm) handles in the interest of the principal (=bank)?
• Monitoring: Controlling annual accounts, requesting periodic reports, consulting specialised advisories (Standard
& Poor's; Graydon,…), keeping close contacts (relationship banking)
o Monitoring expenses by the principal: necessary, yet not always efficient nor effective as the agent has more
information & expertise
o Monitoring expenses by the agent: provide (verified) data
2
, • Ensuring enforceability
o Actions by the principal challenging in design & enforcement
Loan conditions (Berger & Udell,1988) such as: Shorten contract maturity (revolving credits), Include
collateral & guarantees, Debt covenants (eg activity restrictions, financial targets,...)
Example of covenant based on financial ratios: if the ration of debt/EBITDA increases above 4, the
debt needs to be reimbursed
o Actions by the agent = signalling trust – must be credible:
Providing collateral & guarantees
Devise bonding mechanisms to align interests
bonus systems, Put reputation at stake, Participate (put your money where your mouth is…)
free-rider problems
free-rider problems = Others benefit from actions (information gathering, enforcement,...) at
no cost. Eg financial news.
- Risk of ‘Prisoner’s dilemma’ – imagine you can lend money to one student
If both do research together, both have an expected pay-off of 3
If one person does research, everybody makes 5, but it costs 5 to do the research
If nobody does anything, both have an expected pay-off of 1
- Outsourcing to a trusted party makes sense when this is more cost-efficient
- To more than one could make sense to avoid switching costs
1.1.3 Pros and cons of financial intermediation
- Imperfections such as transaction costs & information asymmetries result in difficulties to match funding supply &
demand directly.
- Role of financial intermediation = provide efficient mechanism to optimally allocate & match supply & demand
Price determination
Liquidity provision
Minimisation of costs
Risk reduction (diversification, hedging,...)
…
Funding suppliers: funding demands
1. Larger liquidity 1. Flexibility in timing and size
2. Lower risks 2. Lower (transaction) costs
3. Lower transaction costs
Society:
A) More efficient funding allocation
B) Better/more access to funding for (productive) investments
But important role for financial stability & consumer protection
1.1.4 Advantages attributes to banks
Banks are specialized in matching needs through the transformation in terms of
- Size: ultimate diversification
- Maturity: eg: short-term sight accounts are transformed into mortgage loans
- Risk profile through diversification, screening & monitoring, buffering
Berger & Udell (1998): “Under relationship lending, information is gathered by a financial institution through continuous
contact with the firm and entrepreneur in the provision of financial services. This information is then used to help make
additional decisions over time about the evolution of contract terms and monitoring strategies.“
- Advantages of relationship banking = lower information asymmetries & transaction costs leading to (?) lower funding
cost & better access in good & bad times (lower risk of “credit constraints”).
- ? Because it also leads to higher bargaining power & switching costs needs to be managed
3
