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Chapter 11
The Economics of
Financial Intermediation
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Economics of Financial Intermediation:
The Big Questions
1. What are financial intermediaries and
what do they do?
2. What information problems exist in
financial relationships and how do
intermediaries help solve them?
11-2
Economics of Financial Intermediation:
Roadmap
• Role of Financial Intermediaries
• Information Asymmetries
and Information Costs
• Financial Intermediaries
and Information Costs
11-3
Financial Intermediaries
• Businesses whose assets and liabilities
are primarily financial instruments
• Economic growth requires a wellfunctioning financial system.
11-4
Financial and
Economic Development
11-5
• 40% of world’s population lives on less than
$2/day
• Most people have no access to traditional
banking
• Microfinance offers small loans, often to
groups who are collectively responsible for
repayment
11-6
Role of Financial Intermediaries:
Importance of Indirect Finance
11-7
Preliminaries:
eBay
• Roughly 15 million items for sale
• 100 million registered users
• No one is auctioning checking account
services or mortgages.
11-8
Preliminaries:
eBay
• Imagine someone wants $100,000 mortgage.
• Could offer 1000 shares of $100 each on eBay
• But
– Is the borrower accurately representing their ability
to repay?
– Will the borrower really take the funds and
purchase a house?
11-9
Role of Financial Intermediaries:
Problems They Solve
• Lower transactions costs
• Reduce information costs
11-10
Role of Financial Intermediaries
Pool the resources
of small savers
Put together the 100
savers with $1000
each and create a
$100,000 mortgage
11-11
Role of Financial Intermediaries
1. Pool savings
2. Accounting, Safekeeping, and
Access to the Payments System
– Hold funds safely
– Monthly Statements,
keep track of deposits and withdrawals
and help us manage our financial lives
– ATMs – way to get cash
11-12
Role of Financial Intermediaries
1. Pool savings
2. Accounting, Safekeeping and
Access to the Payments System
3. Liquidity
– Pay interest at the same time that they give you
emergency access.
– Can do it because not everyone will need it at the
same time.
11-13
Role of Financial Intermediaries
1. Pool savings
2. Accounting, Safekeeping and
Access to the Payments System
3. Liquidity
4. Risk sharing
– Your deposit is distributed into small share of
many loans
– Access to standard portfolio diversification
11-14
Role of Financial Intermediaries
1. Pool savings
2. Accounting, Safekeeping
and Access to the Payments System
3. Liquidity
4. Risk sharing
5. Information services
– Bank is an information warehouse.
– Collecting and processing standardized financial
information.
11-15
Role of Financial Intermediaries:
Summary
11-16
• Credit card interest rates are often very high?
• People who use them often have bad credit
or no credit history at all, so lenders assume
the worst about borrower.
• This is adverse selection.
11-17
Information Asymmetries
and Information Costs
• Asymmetric Information:
Borrowers know more about themselves
than lenders do
• Why does eBay work?
– Have to trust seller’s representation of the item in
order to bid
– Winning bidder has to trust that seller will send
the item once payment is received.
11-18
Information Asymmetries:
eBay (again)
• Solution to the information problem
– Feedback forum
– Buyer’s insurance
11-19
eBay’s feedback rating system awards
+1 point for each positive comment
0 points for each neutral comment
-1 point for each negative comment
The Star Chart
Stars are awarded to eBay members for achieving 10 or more feedback points. Here's what the different stars mean:
Yellow Star (
Blue Star (
) = 10 to 49 points
) = 50 to 99 points
Turquoise Star (
Purple Star (
Red Star (
Green Star (
) = 100 to 499 points
) = 500 to 999 points
) = 1,000 to 4,999 points
) = 5,000 to 9,999 points
Yellow Shooting Star (
Turquoise Shooting Star (
Purple Shooting Star (
Red Shooting Star (
) = 10,000 to 24,999 points
) = 25,000 to 49,999 points
) = 50,000 to 99,999 points
) = 100,000 or more points
11-20
Information Asymmetries:
Two Problems
• Adverse selection: Can’t distinguish
good borrowers from bad ones before
making a loan.
• Moral hazard: Can’t monitor whether
borrower is doing what they claimed
once they receive the funds.
11-21
Information Asymmetries:
Adverse Selection
• The market for lemons:
– Used car buyers can’t tell good from bad cars.
– Will at most pay the expected value of good and
bad cars.
– Sellers know if they have a good car, and won’t
accept less than the value.
– Good car sellers will withdraw cars from the market.
– Market has only the bad cars.
11-22
Adverse Selection
in Financial Transactions
• If you can’t tell good from bad companies
– stocks of good companies are undervalued,
– owners will not want to sell them.
• If you can’t tell good from bad bonds
– owners of good companies will have to sell
bonds for too low a price
– owners won’t want to do it.
11-23
Solving the
Adverse Selection Problem
• Used cars
– Consumers reports, car dealers with
reputations, warranties and mechanics
• Financial Markets
– Information disclosure
– Collateral and Net worth
11-24
• If you can’t make a 20% down payment when
you buy a house, you may be forced to get
PMI
• With a smaller investment in the house, the
lender views you as high risk
• PMI is insurance for the lender if you default
11-25
• Deflation is when prices are declining
• When prices fall, firm revenue falls
• Borrowers continue to owe the same dollar amount
even if prices fall
• Deflation lowers borrower net worth, making it more
difficult to overcome the problems caused by
information asymmetries
11-26
Information Asymmetries:
Moral Hazard
• How can your boss be sure that you
are working as hard as you can?
• Problem arises when we can’t observe
people’s actions – can’t distinguish poor
performance from bad luck.
11-27
Moral Hazard
in Equity Finance
• How do you know if a companies
managers will work hard?
• Solutions are hard to find
– Force managers to own a significant
portion of the firm.
– Try to align stockholder and manager
interests by giving managers stock options
11-28
Moral Hazard
in Debt Finance
• Debt contracts encourage managers to
take too much risk since they get the
upside benefits but don’t face the
downside costs.
• Solutions include covenants that are
requirements for certain types of
performance.
11-29
• In developing countries it can be
difficult to get legal title to land
• Without legal title, you can’t use
something as collateral
• Strong property rights are essential to a
well-functioning financial system.
11-30
Negative Consequences
of Information Costs
11-31
Financial Intermediaries
and Information Costs
• Screening and Certification to
Reduce Adverse Selection
– Collect & evaluation borrower information
– Intermediaries have reputations to maintain
• Monitoring to reduce moral hazard
– Checkup on borrowers
11-32
How Companies
Finance Growth
• Information asymmetries make it difficult to
– Issue stocks
– Issue bonds
– Obtain Loans
• Result is that they use internal funds.
11-33
How Companies
Finance Growth
11-34
• At prosper.com borrowers look for lenders
directly
• Can they overcome the adverse selection
and moral hazard problems that seem to
plague all financial arrangements?
• Have a look and see if it’s working.
11-35
Chapter 11
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008