FI Summary

• Financial intermediation

  A process which involves surplus units depositing funds with financial institutions who then lend to deficit units
• Main functions of a Financial Intermediary


  • Brokerage function
  • Asset transformation function (Qualitative Asset Transformation function)
• Brokerage function


  • Match transactors and provide transaction and other services - nature of claims not changed
  • Reduce transaction costs
  • Remove information costs
• Asset transformation function (Qualitative Asset Transformation function)


  • Financial intermediaries hold long-term, high-risk, large-denomination claims issued by borrowers and finance this by issuing short-term, low-risk, small-denomination deposit claims to depositors
  • Makes deposits attractive to savers than the lending directly to corporations in terms of lower monitoring costs, lower liquidity costs and lower price risk
  • Maturity Transformation
  • Liquidity Transformation
• Components of Asset Transformation


  • Asset diversification function
  • Asset evaluation function
• Asset diversification function


  • With a small sum, depositors can spread his risk to many borrowers
• Asset evaluation function


  • Borrowers have more information than the depositors (Asymmetries of information)
  • Difficult for depositor to evaluate the borrower directly
  • Banks takes on the evaluation role on behalf of the depositors
• Distinguishing features of a Financial Intermediary


  • Main category of liabilities (deposits) are specified for a fixed sum which is not related to the performance of a portfolio
  • Deposits are typically short-term and of a much shorter term than their assets
  • A high proportion of their liabilities can be withdrawn on demand
  • Liabilities and assets are largely not transferable

  
• Reasons why Financial Intermediation is preferred over Direct Financing by the individual saver


  • Transaction costs
  • Liquidity insurance
  • Information-sharing coalitions
  • Delegated monitoring
• Components of transaction costs relating to lending

  • Search costs
  • Verification costs
  • Execution cost
  • Monitoring costs
  • Enforcement costs

  
• When the transaction cost including the borrower, the saver and bank (Tb1+ Ts1 + C) is lower than the all in cost paid by the saver and borrower before introduction of the bank (Tb + Ts)


  It makes sense for the bank to act as the Financial Intermediary
• How the bank achieves lower transaction cost as compared to direct financing


  • Use of distribution channels to reduce search cost for customers
  • Banks helps lower monitoring cost
  • Standard forms reduce negotiation cost
  • Economies of scale
  • Economies of scope
• Liquidity


  Individuals are unsure of their future liquidity requirements in the face of unanticipated events, and hence they maintain a pool of liquidity
• How a bank reduces the overall liquidity requirements of all the individuals as a pool


  • Assumption that since shocks are not perfectly correlated across individuals, not everyone needs money at the same time
  • Portfolio theory suggests that the total liquid reserves needed by a bank will be less than the aggregation of the reserves required by individual consumers acting independently
  • By holding a small pool of money, bank can allow individuals who need money early to withdraw first while those who do not need their money can withdraw later
• Liquidity Insurance


  The bank's assurance to the surplus unit that they can have access to their funds as and when they need it
• Borrower is likely to have more information than the lender about the risks of the project for which they receive funds (Information Asymmetry)
• Problems of Information asymmetry

  • Adverse Selection (Before loan is made) - Increases the probability that bad credit risks will get loans, lenders may decide not to give any loans, even to good credit risks
  • Moral Hazard (by Borrower after loan is made) - Borrowers are more likely to behave differently when using borrowed funds rather than when using their own funds
• How banks help in bridging the savers and borrowers since there is information asymmetry

  • Bank is able to afford the cost of good quality information through economies of scale
  • Surplus units can benefit from good quality information if they place their funds with the bank for lending to deficit units
• Why a lender needs to monitor a borrower


  • Information collection before and after a loan is granted, including screening of loan applications - to ensure collectability of loans
  • Examining the borrower's ongoing creditworthiness
  • Ensuring that the borrower adheres to the terms of the contract
• Why a bank is able to perform the monitoring function better than an individual saver


  • Efficiency - Privileged information, Provide credibility, Possess economies of scale, Exposed to higher level of risk by banks – more incentive to get good information
  • Expertise - Have specialist, Developed reputational capital as monitors of credit risk, Regulators are monitoring the banks
• Delegated monitoring


  Not all savers have the time, inclination or expertise to monitor borrowers for default risk. FI provide a solution by pooling funds from suppliers (e.g. household savers) and investing in the financial claims of corporations. Therefore the surplus units appoint the FI as delegated monitors due to the FI's efficiency and expertise.
• For delegated monitoring to be feasible, the cost of delegated monitoring (monitoring via intermediary) must be less than the minimum of: (a) costs without monitoring, and (b) total costs of direct monitoring by multiple lenders
• Conditions under which the borrower would prefer direct financing


  • When the borrower has good credit risk, established reputation, good prospects for growth
• Bank run


  A bank run occurs when a large number of bank customers simultaneously withdraw their deposits because they believe the bank is, or might become, insolvent
• What makes banks vulnerable to runs


  • Asset Transformation Function - Financing long-term assets (e.g. loans) through short-term deposits is the source of potential fragility of banks, because they are exposed to the possibility that a high number of depositors will decide to withdraw their funds for reasons other than their own liquidity needs
  • Liquidity transformation function - The deposits are liquid and thus can be withdrawn at any time while the assets of the bank are illiquid
• How the features of a deposit contract contribute to a bank run


  • Non-time deposits are payable on demand
  • Claims to fixed amounts regardless of the performance of the bank's assets
  • Funds are given to depositors on a first-come, first-served basis (Sequential service constraint) - Customers are therefore subject to likely default on the last redemption claim serviced
• Theory on bank runs


  • Banks offer highly liquid and low price-risk contracts to savers on the liability side, while holding relatively illiquid and higher price-risk assets
  • Under ordinary circumstances, savers' unpredictable needs for cash are unlikely to occur at the same time, so the bank expects only a small fraction of withdrawals in the short term
  • Sequential service constraint - The bank will be able to pay the first depositors who demand their money back, but if all others attempt to withdraw too, the bank will go bankrupt and the last depositors will be left with nothing
  • Self-fulfilling prophecies - Each depositor's incentive to withdraw her funds depends on what she expects other depositors to do
  • Nash Equilibrium - If enough depositors expect other depositors to withdraw their funds, then they all have an incentive to rush to be the first in line to withdraw their funds irrespective of the outcome to the bank
• Main arguments for implementing bank regulations


  • Systemic (the whole financial system) Stability
  • Protection of payment system
  • Consumer Protection
  • Depositor Protection
  • Unregulated private actions create outcomes whereby social marginal costs are greater than private marginal costs
  • Regulated banking leads to lower cost
• Problems deposit insurance gives rise to


  • Under full insurance, depositors lack incentives to monitor a bank's activities, because they will suffer no losses if the bank fails
  • Banks are tempted to take on excessive asset risk and to hold lower reserves
• How capital mitigates excessive risks taken by banks


  • Capital provides a buffer intended to absorb losses while permitting the bank to continue operating, and thus preventing default
  • Capital provides confidence for depositors and other creditors
• Measures of capital adequacy


  • Gearing ratio = Debt / Equity
  • Risk asset ratio = Capital / Risk Adjusted Assets

  
• 1988 Capital Adequacy Accord of the Basle Committee


  Also known as Basle I, use the risk–assets ratio to determine the adequacy of a bank's capital

  
• Ratios proposed under Basle I


  • Total risk-based capital ratio = Total capital (Tier I + Tier II) / Credit risk-adjusted assets = at least 8%
  • Tier I (core) capital ratio = Core capital (Tier I) / Credit risk-adjusted assets = 6% min

  
• What is included in Tier I and Tier II under Basel I


  • Tier 1 capital includes common stockholders' equity, non-cumulative perpetual preferred stock and minority interest in equity accounts of consolidated subsidiaries
  • Tier II capital includes loan loss reserves (up to a specified maximum), perpetual preferred stock, hybrid debt/equity instruments, subordinated debt, and revaluation reserves

  
• Main criticism of Basle I


  • Risk weights were rather unsophisticated and inadequately related to default risk
• Basle I


  Use the risk–assets ratio to determine the adequacy of a bank's capital

  
• Ratio proposed under Basle I


  1. Total risk-based capital ratio = Total capital (Tier I + Tier II) / Credit risk-adjusted assets = at least 8%

  2. Tier I (core) capital ratio = Core capital (Tier I) / Credit risk-adjusted assets = 6% min

  
• Tier I capital includes


  • common stockholders' equity
  • non-cumulative perpetual preferred stock
  • minority interest in equity accounts of consolidated subsidiaries
• Tier II capital includes


  • loan loss reserves (up to a specified maximum)
  • perpetual preferred stock
  • hybrid debt/equity instruments
  • subordinated debt
  • revaluation reserves

  
• Main criticism of Basle I


  • Risk weights were rather unsophisticated and inadequately related to default risk
  • The most serious objection related to the uniform 100 per cent weighting applied to commercial loans
  • The capital requirement is additive across loans, with no reduction in capital requirements arising from greater diversification of a bank's loan portfolio
  • Differences in taxes and accounting rules could mean that measurement of capital varies widely across countries