CHAPTER 8The Economics of Financial Intermediation

Direct vs. Indirect Finance• Finance is the process of shifting excess funds from

savers to borrows.• Savers and borrowers may connect directly in equity and

debt markets – issuance of stocks and bonds.• Substantial amount of funds are intermediated through

institutions.

Domestic Financing ProfileTotal domestic financing equals the sum of total domestic credit provided by the banking

sector, total local currency (LCY) bonds outstanding, and total equity outstanding. Percentage shares are computed to show the relative importance of each type of domestic

financing.

Stock market capitalization is used as a proxy for total equity outstanding.

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External vs. Internal Finance• Internal finance is the retention & re-investment of profits

by firms. Perhaps the main source of finance for commercial investment.

• External finance is raising funds through borrowing or issuance of securities.

• Issuance of new equity of securities is a small part of external finance…

But foregone dividends of shareholders is a large part of internal finance.

Historical Growth of Asian LCY Bond Market

This indicator shows the absolute amount of local currency (LCY) bonds outstanding in USD, categorized as government and corporates. Government bonds include obligations of the central government, local governments, and the central bank. Corporates comprise both

public and private companies including financial institutions and international organizations. Financial institutions comprise both private and public sector banks and other financial

institutions.

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DEFAULT RISK

Uncertainty vs. Asymmetric Information

• Bond issuers and investors both face uncertainty about a wide variety of factors that might impact likelihood of repayment or value of repayment. This creates risk.

• Risk is a negative characteristic that might reduce the price of bonds or increase the premium on bonds.

Default Risk: Bonds by Rating

• A bond is in default if the issuer misses a payment of interest or principal.

• Though all bonds involve some risk, for all practical purposes, are default-free. In the $US bond market, U.S. Treasury bonds are the benchmark default free bond. In HK, Exchange Fund bonds play this role. (Be careful, not all government debt is risk-free).

• Bond rating agencies (Moody’s and Standard & Poor’s assess default risk for bonds).

• A bond with a significant probability of default must pay a higher return to compensate purchasers for the risk.

Market Rating DateCN AA- 12/16/2010HK AAA 12/16/2010ID BB+ 4/28/2014JP AA- 4/27/2011KH B+ 2/19/2008KR A+ 9/19/2014MY A- 7/26/2013PH BBB 5/8/2014SG AAA 5/3/2013TH BBB+ 12/11/2012VN BB- 6/6/2012

Default Risk and Asymmetric Information• Key risk characteristic of bonds is default risk. • Default – Bond issuer fails to make a required coupon or

face value payment.• Default risk depends on conditions faced by bond issuer.• Bond issuer almost certainly more knowledgable about

own conditions than potential buyer.

Asymmetric Information

• Asymmetric Information A condition that occurs when one party to a transaction has more information about the good tha does the other.

• In bond/financial markets, borrowers have some information about their opportunities or activities that they do not disclose to lenders, creditors or insurers.

Adverse Selection• Asymmetric information causes least desirable counter-

parties to a transaction are most attracted to the transaction.• People with bad used cars are most likely to want to sell their cars. • Sick people are the most likely to want to buy health insurance. • Untrustworthy borrowers are most likely to want to borrow.

Lemon Problem: Bond Market

• Some firms have risky prospects (lemons) and some firms have safe prospects (creampuffs).

• Bond buyers cannot distinguish between them. They offer bond prices which are an average of the price of creampuff bonds and lemon bonds. [Another way of putting this is that interest rates are an average of creampuff and lemon rates].

• Potential borrowers with creampuff prospects may finance their own projects.

Raising Interest Rates May Not Compensate for Risks in Bond Markets

• Only borrowers with lemon prospects will join bond markets.

• Typically we think bond buyers might take riskier assets if they were offered a higher interest rate.

• But if savers demand a higher interest rate under asymmetric information this will only exacerbate the lemon problem if higher interest rates drive creampuff borrowers out of the market.

Adverse Selection: The Bond Market

Consider a bond market with three types of bond sellers.

1. Safe: Financing a safe, low-return project. Can only pay 7.5% interest rate but will never default.

2. Speculative: Financing a high risk/high return project will pay a 15% interest rate, but a high probability of default.

3. Crooks: Will offer to pay any interest rate, but will never repay.

Assume that 75% of bond issuers are safe, 20% of bond issuers are speculative, and just 5% are crooks.

Discount Bonds• Investments are financed with discount bonds, in this case,

paper that will pay 100 after 1 year. Price of the bond is PB.

• Gross interest rate is 1+i =100/PB .

• Bond buyers will pay:• 97 for a discount bond issued by a borrower identified

as safe; • 90 for a bond issued by a borrower identified as

speculative• 0 for bond issued by a crook.

• If they cannot distinguish, they will pay a value equal to the expected value of the pool.

Bond Buyers• In this pool, the expected value is (.75*97)+(.2*90)+(0.05*0) = 90.75 which implies a yield to maturity of i = .102.

• We can use the statistical concept of expected value to answer these questions.

• Expected payoff to a project with two possible outcomesPayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2

Expected Value

Borrower Investorwill Pay will pay or get

Share at Most at Most at least

Safe 0.75 7.50% 97 1.030928 3.09%Speculative 0.2 15% 90 1.111111 11.11%Crook 0.05 Anything 0 ∞

Unknown Type 90.75 1.101928 10.19%

Bond market breaks down!• Rate of interest offered by uninformed investor is attractive to speculative borrowers but to expensive for safe borrowers.

• They will drop out of the market. As bond buyers begin to realize the riskiness of pool is changing, they will reassess price that they will pay for bonds.

• The pool will now be 80% speculative and 20% crooks. The expected value of bonds in this pool is (.8*90)+(.2*0)=72 implying a yield of i = .3889. This is too much for speculative borrowers.

• Only crooks will stay in the market. Ultimately the bond market will disappear.

Reducing Adverse Selection Through Information Gathering1. Information Gathering – Bond rating agencies perform the

function of analyzing possibility of repayment.Free Rider Problem – Gathering information about firms is costly, but once gathered it can be shared very cheaply. Information firms do not receive funds from all who benefit from their services. Information may be underprovided by markets.

2. Government Regulation – One solution to the free rider problem is for the government to issue rules requiring sellers of securities to provide honest information about their firms.

3. Financial Intermediation – Banks specialize in acquiring information and reducing monitoring costs. Typically, they do not share information so do not face the free rider problem as severely. Since financial intermediaries engage in financial transactions repeatedly, their reputation is at stake if they abuse asymmetric information.

Asymmetric Control and Moral Hazard

• Financial transactions are often characterized by asymmetric control. Two parties to a transaction may both have a stake in the outcome but one party’s actions may have a disproportionate impact on the outcome.

• Moral hazard is the temptation for the party with disproportionate control to benefit themselves at the expense of other party.

Debt• Speculative Investments – Owners may get upside benefits, share downside risks with investors

Moral Hazard: One Example• Lender lends $100 to borrower at 5% interest.

Borrower can choose between two investment projects each of which require an upfront pay-off of $100.

• Project A is a risky project but potentially lucrative. With an 80% probability, project A will generate 0 payoff. With a 20% probability project A will generate a $205 payoff.

• Project B is a non-risky project which will generate a pay-off of $110 with an 80% probability and a pay-off of $95 with an 20% probability.

Two Projects

Three Questions

1. Which project will A choose if he is risk-neutral.

2. Which project would B choose if he is risk-neutral

3. Which project is most advantageous to a risk-neutral society.

Which project is socially beneficial?

• Expected payoff to project A is.8∙$0 +.2·$205 = $41

Since cost is $100, the expected payoff to project A is less than the cost. To a risk neutral or risk averse society this project will be bad.

• Expected payoff to project B is.8∙$110 +.2·$95 = $107

Since cost is $100, the expected payoff to project B is more than cost. To a risk neutral society this project is good (though the risk might be to large for a sufficiently risk-averse society).

Pay-offs, Project A

• With 80% probability, the payoff to the project will be $0 so both the borrower and lender get $0.

• With 20% probability, the pay-off to the project will be $205, so the lender will be repaid $105 and the borrower will keep $205-$105 = $100.

• The expected payoff to the project for the lender will be .2∙$105+.8∙0=$21.* The expected payoff to project A for the borrower is .2∙$100+.8∙0=$21.

*The lender would not lend if they believed the borrower would conduct project A.

Payoffs, Project B

• With 20% probability, the payoff to the project will be $95, so the lender will only be repaid $95 and the borrower keeps $0.

• With 80% probability, the payoff to the project will be $110, so the lender is repaid $105 and the borrower keeps $5.

• The expected payoff to the project for the lender will be .2∙$95+.8∙$105 =$103*. The expected payoff to project A for the borrower is .2∙$0+.8∙$5=$4

*Note that this is greater than the money lent, the lender makes positive returns.

Which project will be undertaken?

• If the borrower has control of the funds, then he will choose project A. The expected value of the payment to him is higher for the riskier project. This is because the lender takes all of the downside of a risky investment and none of the upside.

• The lender of course prefers the reverse. He would choose the socially beneficial project B.

• This example demonstrates the problem of moral hazard in debt markets. Because he shares none of the downside, the borrower will choose inefficiently risky projects once he has control of the funds.

Restrictive Covenants• Debt agreements place restrictions on activities of

borrowers. • Restrict spending of funds• Require maintenance of minimum net worth• Require maintenance of value of collateral

• Free Rider Problem: For a bond with many owners, it may not be worth the trouble for any one of them to ensure contracts are enforced.

Collateral/Net Worth• Most debt is backed by some sort of collateral. In the

case of default, lender takes possession of some physical or financial asset of relatively clear value.

• Lenders will only lend to firms with a high net worth. This means lenders can make claims on the outstanding assets of companies in the case of debt default.

Net Worth Example• If borrowers have their own capital invested as well as

borrowed funds, they are much less likely to engage in risky behavior.

• Go back to 1st Moral hazard example. Assume that the lender is only willing to lend $50 and the borrower must kick in $50 on their own.

Pay-offs, Plan A (Pt. 2)

• With 80% probability, the payoff to the project will be $0 so both the borrower and lender get $0.

• With 20% probability, the pay-off to the project will be $205, so the lender will be repaid $52.5 and the borrower will keep $205- $52.5 = $152.5

• Expected pay-off to the borrower is $30.5, less than the $50 that they must kick in.

Payoffs, Project B

• With 20% probability, the payoff to the project will be $95, so the lender will be repaid $52.5 and the borrower keeps $42.5.

• With 80% probability, the payoff to the project will be $110, so the lender is repaid $52.5 and the borrower keeps $57.5.

• The expected payoff to the project for the lender will be =$52.5*. The expected payoff to project Afor the borrower is .2∙$42.5+.8∙$57.5=$54.5

Financial Intermediaries and …• Adverse Selection: Banks specialize in evaluating

borrowers and avoid the free rider problem by holding their own loans.

• Moral Hazard: Banks use their economies of scale to act as delegated monitors for their depositors.

Conclusion• A key role for banks is to solve problems associated with

asymmetric information by evaluating borrowers and monitoring them.

• Solutions to moral hazard problems rely on effective legal foundations.

• Banks are especially important for emerging markets.