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Supplement
Chapters 11-13
Objectives: Chapter 11&12
1. Differentiate Adverse Selection and
Moral Hazard
2. Identify 5 different types of financial
institutions.
Unit Overview
Securities
Market
Institutions
Transactions
Costs
Asymmetric
Information
Costs
Investment
Institutions
Adverse
Selection
Moral
Hazard
Contractual
Savings
Institutions
Depository
Institutions
Government
Financial
Institutions
Moral Hazard 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.
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.
Expected Value
• We can use the statistical concept of
expected value to answer these questions.
• Expected payoff to a project with two
possible outcomes
PayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2
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 pro
ject B is more than cost. To a risk neutral society
this project is good (though the risk might be to
large for a suffiiciently risk-averse society).
Pay-off to Borrower and Lender
• 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=$20.
• 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
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 bears all of the upside of a risky investment and
none of the downside.
• 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.
Investment &
Contractual Savings
Mutual Funds
Hedge Funds
Pension Funds
Insurance
Financial Markets
1. Primary: Investment Banks
2. Secondary: Exchanges
3. Secondary: Brokers &
Dealers
Investment
Finance
Companies
Government
Mortgage
Companies
Savers
Depository Institutions
1.
2.
Banks
RLB’s & DTC’s
Borrowers
Maturity
Size
Names
Requiremen
ts
Restricted None
$500,000 GE Capital
Hang Seng
License
Finance
Banks
Deposit
3 Months
$100,000 Dao Heng
Finance
Taking
Wing Lung
Finance
Companie
s
Asymmetric Info
Banks
Depositors
Borrowers
Liqudity
Monitoring
Core Deposits vs. Managed
Liabilities
• Bank Liabilities can be divided into two parts.
1. Core Deposits – Demand Deposits, Savings
Accounts, Small Time Deposits (Retail Funds)
2. Managed Liabilities – Borrowings from Other
Banks, Securities, Large CD’s and Time
Deposits (Wholesale Funds)
• Retail funds have lower interest costs and are
thought to be more stable.
Primary Reserves
• Banks primary reserves is equal to their cash.
• Cash includes both vault cash (the actual paper currency that
banks hold) plus bank reserves at the central bank.
• In Hong Kong, banks reserves at the central bank (the HKMA)
are called Clearing Balances. These are held for the sole
purpose of clearing interbank transactions. For example, if a
depositor at Hang Seng bank writes a $100 check to a depositor
at Bank of China, the transaction will be cleared when the
HKMA deducts $100 from Hang Seng’s Clearing Balance
account and credits the BOC’s Clearing Balance account.
• In Hong Kong, primary reserves are very small.
• The primary reserve ratio is CASH
ASSETS
• Average Hong Kong primary reserve ratio is .21% in June 2001.
Secondary Reserves
• Secondary reserves are
liquid assets held by
banks.
• Secondary reserves =
Primary Reserves + Short
Maturity, Liquid Securities
+ Short-term Deposits at
Other Banks.
• Bank of East Asia has
total assets of
$181,764,933
• Secondary reserve ratios
B of EA (2001)
Mill $HK
Cash & Short
Term Funds
$43,760,587
Other Securities $4,150,218
Secondary
Reserves
$47,910,805
Secondary
Reserve Ratio
.264
Secondary Re serves
Assets
Sources of Bank Profits
• Net Interest Margin is traditionally the main
source of profits for banks.
• Non-Interest Income which includes fees
for services are also important.
• For B of East Asia, net interest income is
almost 4 times the size of non-interest
income.
Equity Multiplier
• For any firm, we can
calculate the Equity
Multiplier, as
• Average Equity Ratio in
Hong Kong Banks in July,
2001 is 10.2
• Equity Ratio for Bank of
East Asia is 9.961
EM 
ASSETS
EQUITY CAPITAL
Total Assets
Shareholde rs Funds

$181,764,933
 9.961
$18,247,501
ROA/ROE
• A measure of the
returns earned on
assets is Return on
Assets
• Owners of banks are
concerned with the payoff they earn per each
dollar originally invested
in the bank. They care
about the Return on
Equity
• Its easy to see that
equity returns are a
positive function of ROA
and leverage
PROFITS
ROA 
TOTAL ASSETS
PROFITS
ROE 
DUE TO SHAREHOLDE RS
DUE TO SHAREHOLDE RS
EQUITY CAPITAL
ROE  ROA  EM
Liquidity Measures
• Liquidity Ratio – Measure of assets due
within 1 month relative to liabilities due
within 1 month.
• Loan to Deposit Ratio – Ratio of illiquid
loans to liquid deposits. High measure of
loan-to-deposit ratio indicates high liquidity
risk.