Module 5
Financial Intermediation Assignment
a. The Role of Financial Intermediaries
Markets are remarkably effective at coordinating the behavior of millions of
firms and households in an economy. And financial markets are among the most
important markets of all; they price economic resources and allocate them to their
most productive uses. In many countries over the past 25 years, the value of stock and
bond markets has come to rival or even surpass the value of outstanding loans through
financial intermediaries. But as we will see, intermediaries, including banks and
securities firms, continue to play a key role in both these types of finance.
To see the lessons from the table, take the example of France, in the first row.
The value of the French stock market (the value of the shares of all companies listed
on the exchanges) is equivalent to 63.3 percent of that country’s GDP (column A); the
value of French debt securities is 45.2.percent of GDP (column B). Adding columns A
and B tells us that, in France, securities finance equals 108.5 percent of GDP. That
exceeds the amount of credit extended by French banks and other intermediaries—
86.7 percent of GDP (column C). The final column, D, reports the ratio of loans to
securities. For France, the result is 0.80, which means that financing via securities
markets was somewhat larger than loans. For the advanced economies in the table, the
range of that ratio is between 0.78 and 1.30, so the French case is not unusual. In
many emerging markets, the ratio is somewhat lower because in recent decades their
stock markets have expanded notably. However, domestic private debt securities play
only a small role in most emerging market economies, which underscores the costs
and challenges of developing this alternative to loan and stock finance.
The most significant difference among the emerging economies lies in the
scale of loans they have undertaken, which varies greatly from one country to another.
For instance, in Argentina, the total amount of loans is relatively modest, constituting
less than 15 percent of the country's Gross Domestic Product (GDP). This contrasts
sharply with China, where the scale of loans is exceptionally large, exceeding 100
percent of its GDP. This disparity illustrates the wide range of economic strategies and
financial practices adopted by emerging economies, reflecting their unique economic
conditions, policy choices, and developmental stages. In Argentina, the lower
percentage of loans relative to GDP might indicate more conservative borrowing
practices or a more constrained access to international credit markets. Meanwhile,
China's high loan-to-GDP ratio could be indicative of aggressive investment in
infrastructure, extensive state-led development projects, or a more leveraged
economic growth model. This variation in loan scales highlights the diverse fiscal
landscapes and the different challenges and opportunities faced by emerging
economies as they strive for growth and development on the global stage.
These data highlight the importance of intermediaries. Banks are still critical
providers of financing around the world, although bank lending may not be the
dominant source of financing that it once was. And intermediation is not limited to
bank lending. Intermediaries determine which firms can access the stock and bond
markets. Just as banks decide the size of a loan and the interest rate to be charged,
securities firms set the volume and price of new stock and bond issues when they
purchase them for sale to investors. And other intermediaries, like mutual funds, help
individual investors sort among the thousands of stocks and bonds that are issued to
develop a diversified portfolio with the desired risk characteristics. Why are financial
intermediaries so important? The answer has to do with information. To understand
the importance of information in the role financial intermediaries play in the
economy, consider the online company eBay. This virtual auction house may seem an
unlikely place to start, but while eBay deals primarily with physical objects, it faces
some of the same information problems as financial firms. As an online intermediary,
eBay provides a mechanism through which almost anyone can auction off almost
anything.
As of late 2018, eBay, one of the world's largest and most diverse online
marketplaces, had approximately 1.2 billion items listed for sale on its platform,
which can be accessed at www.ebay.com. These listings encompass an incredibly
broad range of products, catering to virtually every conceivable need and interest. The
items for sale include everything from inexpensive $5 dinner plates, perfect for
everyday use, to highly valuable million-dollar antiques that attract collectors and
enthusiasts from around the globe. The variety and scale of items available on eBay
are a testament to the platform's ability to connect sellers and buyers across vast
distances and diverse markets.
What is particularly remarkable is that these items are not just listed; they are
actively bought and sold. In the single year of 2018 alone, eBay reported a staggering
total transaction value of nearly $95 billion. This immense figure underscores the
platform's significant role in the global e-commerce landscape. The transactions were
conducted by an impressive user base, with more than 175 million active users
engaging with the platform throughout the year. These users come from different
backgrounds and regions, reflecting eBay's widespread appeal and accessibility.
The sheer volume of transactions and the extensive user engagement highlight
the dynamic nature of eBay's marketplace. It serves as a crucial hub for both casual
shoppers and serious collectors, providing a space where everyday items coexist with
rare and valuable treasures. This unique blend of products and users creates a vibrant
and constantly evolving online marketplace. The platform's ability to facilitate such a
high volume of transactions also points to its robust infrastructure and the trust it has
built among its users over the years.
Furthermore, eBay's success in 2018 is indicative of broader trends in e-
commerce, where online shopping continues to grow as a preferred method for
acquiring goods. The convenience of browsing and purchasing items from the comfort
of one's home, coupled with the vast selection available on platforms like eBay, has
significantly transformed consumer behavior. eBay's substantial transaction value and
extensive user base in 2018 provide a clear example of how digital marketplaces are
reshaping the retail landscape, offering unparalleled opportunities for both buyers and
sellers in the modern economy.
While millions of items are for sale on eBay, if you look carefully you’ll
notice an absence of financial products. You can purchase collectible coins and paper
currency on eBay, but you can’t borrow. There are no listings for Samantha’s student
loan, Chad’s car loan, Chloe’s credit card balance, or Mort’s mortgage—at least, not
yet. And though you can buy defaulted bond certificates, like the Reading Railroad
(which was purchased on eBay), you can’t buy or sell bonds on which the issuer is
still making payments. People are selling cars and even real estate on eBay, but no
one is auctioning off checking account services.
Think for a moment about why eBay doesn’t auction off mortgages. First,
Mort might need a $100,000 mortgage, and not many people can finance a mortgage
of that size. The people who run eBay could try to establish a system in which
100.people sign up to lend Mort $1,000, but it would be extremely complex and
cumbersome. Imagine collecting the payments, figuring out how to repay the lenders,
and writing all the legal contracts that go with the transaction. Just as important,
before offering to finance Mort’s mortgage, lenders would want to know something
about Mort and the house he’s proposing to buy. Is Mort accurately representing his
ability to repay the loan? Does he really intend to buy a house with the loan? The
questions are nearly endless.
Financial intermediaries exist so that individual lenders don’t have to worry
about getting answers to all of these questions. Most people take for granted the
ability of the financial system to shift resources from savers to investors, but when
you look closely at the details, you’re struck by how complicated the task is. It’s
amazing the enterprise works at all. Lending and borrowing involve both transactions
costs, like the cost of writing a loan contract, and information costs, like the cost of
figuring out whether a borrower is trustworthy. Financial institutions exist to reduce
these costs (1) pooling the resources of small savers; (2) providing safekeeping and
accounting services, as well as access to the payments system; (3).supplying liquidity
by converting savers’ balances directly into a means of payment whenever needed; (4)
providing ways to diversify risk; and (5) collecting and processing information in
ways that reduce information costs. As we go through these, you’ll see that the first
four have to do with lowering transactions costs. That is, by specializing and
providing these services to large numbers of customers, a financial firm can reduce
the cost of providing them to individual customers.
As in other fields, experts possess the ability to perform tasks more efficiently
and effectively than non-experts, often accomplishing these tasks at a lower cost. This
principle applies across various domains, highlighting the value of specialized
knowledge and experience. Experts leverage their deep understanding, refined skills,
and practical insights to navigate complex problems and optimize processes, leading
to superior outcomes. Their proficiency reduces the likelihood of errors and enhances
productivity, which, in turn, translates to cost savings.
A prime example of this is the fifth function on the list, which is the collection
and processing of information. This function is so critical and multifaceted that it
warrants separate, detailed consideration. Information collection and processing form
the backbone of decision-making in many industries. Experts in this field utilize
advanced methodologies, sophisticated tools, and a systematic approach to gather
accurate and relevant data. They are adept at filtering through vast amounts of
information, discerning valuable insights, and presenting them in a coherent and
actionable manner.
The expertise required for effective information processing includes statistical
analysis, data mining, and an understanding of the specific context in which the
information will be applied. For instance, in fields like market research, financial
analysis, or scientific research, experts employ rigorous techniques to ensure data
integrity and relevance. They understand the nuances of data interpretation, which
helps in drawing meaningful conclusions that can guide strategic decisions.
Moreover, the importance of information collection and processing extends
beyond mere data handling. It involves understanding the sources of information,
ensuring data quality, and applying ethical standards to maintain confidentiality and
integrity. Experts are trained to recognize biases, validate findings, and update
information as new data becomes available. Their role is crucial in transforming raw
data into strategic intelligence that organizations can use to gain a competitive edge,
improve operations, and better serve their customers.
In essence, the function of collecting and processing information exemplifies
the critical role of expertise in modern industries. It underscores how specialized
skills not only enhance the quality and efficiency of tasks but also contribute to
broader organizational success. By delving deeper into this function, we can
appreciate the complexities involved and the value that experts bring to the table in
managing and interpreting information. This, in turn, highlights the broader theme of
how expert intervention can lead to more effective and cost-efficient outcomes in
various fields.
While we will not discuss international banks in any depth, it is worth
mentioning that they provide an additional set of services that complements those
offered by your neighborhood bank. International banks handle transactions that cross
national borders. That may mean taking deposits from savers in one country and
providing them to investors in another country. It may also mean converting
currencies in order to facilitate transactions for customers who do business or travel
abroad.
The most straightforward economic function of a financial intermediary is to
pool the resources of many small savers. By accepting many small deposits, banks
empower themselves to make large loans. So, for example, Mort might get his
$100,000 mortgage from a bank or finance company with access to a large group of
savers, 100 of whom have $1,000 to invest. Similarly, a government or large company
that wishes to borrow billions of dollars by issuing bonds will rely on a financial
intermediary to find buyers for the bonds. To succeed in this endeavor—pooling
people’s savings in order to make large loans—the intermediary must attract
substantial numbers of savers. This means convincing potential depositors of the
institution’s soundness. Banks are adept at making sure customers feel that their funds
will be safe. In the past, they did so by installing large safes in imposing bank
buildings. Today, they rely on their reputations, as well as on government guarantees
like deposit insurance.
Goldsmiths were the original bankers. To keep their gold and jewelry safe,
they had to construct vaults. Soon people began asking the goldsmiths to store gold
for them in return for a receipt to prove it was there. It didn’t take long for someone to
realize that trading the goldsmith’s receipts was easier than trading the gold itself. The
next step came when the goldsmith noticed that there was quite a bit of gold left in the
vault at the end of the day, so that some of it could safely be lent to others. The
goldsmiths took the resources of those with gold to spare—the savers of the day—and
channeled them to individuals who were short—the borrowers. Today, banks are the
places where we put things for safekeeping—not just gold and jewelry, but our
financial wealth as well. We deposit our paychecks and entrust our savings to a bank
or other financial institution because we believe it will keep our resources safe until
we need them. When we think of banks, safekeeping is only one of several services
that immediately come to mind. The others are Internet and mobile access, automated
teller machines, credit and debit cards, checkbooks, and monthly bank statements. In
providing depositors with these physical and electronic services, a bank gives them
access to the payments system—the network that transfers funds from the account of
one person or business to the account of another.
The bank plays a crucial role in the financial ecosystem by providing
depositors with multiple avenues to access their funds and manage their financial
transactions. One of the primary services banks offer is enabling depositors to get
cash into their wallets quickly and conveniently. This can be done through a network
of ATMs and branch locations, making it easy for individuals to withdraw cash as
needed.
Moreover, banks facilitate the finalization of payments through various
methods such as credit cards, debit cards, and checks. Credit cards allow customers to
make purchases on credit, providing the flexibility to pay for goods and services over
time while often earning rewards or cashback. Debit cards, on the other hand, enable
customers to make transactions directly from their checking accounts, ensuring that
they spend only the money they have available. Checks, although used less frequently
in the digital age, still offer a reliable method for making payments, particularly for
larger amounts or when electronic methods are not preferred.
Banks' specialization in handling payment transactions allows them to offer
these services at a relatively low cost. They have developed efficient systems and
infrastructure to process a high volume of transactions quickly and securely. This
efficiency translates into cost savings for customers, who benefit from lower fees and
more competitive rates. By spreading the costs over a large number of transactions,
banks can achieve economies of scale, further reducing the expenses associated with
each individual transaction.
In addition to facilitating payments, banks serve as financial intermediaries,
which is another critical aspect of their role in the economy. Financial intermediaries,
such as banks, help reduce the costs of financial transactions by acting as a bridge
between savers and borrowers. They pool funds from depositors and lend them to
individuals and businesses in need of capital. This process not only makes it easier for
borrowers to access the funds they need but also provides depositors with a safe place
to store their money and earn interest.
Banks also offer various other financial services that add value to their
customers' lives. These services include savings accounts, which help individuals save
for future goals, and investment products, which provide opportunities for growing
wealth. Additionally, banks provide financial advice and planning services, helping
customers make informed decisions about their finances.
The role of banks in the financial system is indispensable, as they help ensure
the smooth functioning of the economy by providing essential services that facilitate
commerce and personal financial management. By efficiently managing payment
transactions and acting as intermediaries, banks help reduce the overall costs of
financial transactions, contributing to a more stable and accessible financial
environment for everyone.
This is not a trivial matter. It would be a disaster if we didn’t have a
convenient way to pay for things. By giving us one, financial intermediaries facilitate
the exchange of goods and services, promoting specialization. Remember that in
efficient economies—those that manage to get the most output from a given set of
inputs—people and companies concentrate on the activities at which they are best and
for which their opportunity cost is lowest. This principle of comparative advantage
leads to specialization so that each of us ends up doing just one job and being paid in
some form of money. But as specialization increases, more and more trading must
take place to ensure that most of us end up with the goods and services we need and
want. The more trading, the more financial transactions; and the more financial
transactions, the more important it is that those transactions be cheap. If getting hold
of money and using it to make payments were costly, that would put a damper on
people’s willingness to specialize. Financial intermediaries, by providing us with a
reliable and inexpensive payments system, help our economy function more
efficiently.
Beyond safekeeping and access to the payments system, financial
intermediaries provide bookkeeping and accounting services. They help us manage
our finances. Just think about your financial transactions over the past few months. If
you work, you were paid, probably more than once. If you rent an apartment or own a
home, you paid the rent or mortgage and probably the electric and gas bills. You paid
your phone bill. Then there’s transportation. If you have a car, you may have made a
loan payment. You surely paid for gasoline and possibly for a repair. You purchased
food, too, both at the grocery store and in various restaurants. And don’t forget the
movies and books you bought, perhaps through your mobile phone or tablet. As you
get older, you may shoulder the expense of having children, along with saving for
their education and your retirement. The point is, our financial lives are
extraordinarily complex, and we need help keeping track of them. Financial
intermediaries do the job: They provide us with bookkeeping and accounting services,
noting all our transactions for us and making our lives more tolerable in the process.
Before we continue, we should note that providing safekeeping and
accounting services, as well as access to the payments system, forces financial
intermediaries to write legal contracts. Writing individualized contracts to ensure that
each customer will maintain a checking account balance as required, or repay a loan
as promised, would be extremely costly. But a financial intermediary can hire a
lawyer to write one very high-quality contract that can be used over and over again,
thus reducing the cost of each use. In fact, much of what financial intermediaries do
takes advantage of what are known as economies of scale, in which the average cost
of producing a good or service falls as the quantity produced increases. As we will see
later, information is subject to economies of scale just as other goods and services are.
Financial intermediaries provide liquidity in a way that is both efficient and
beneficial to all of us. To understand the process, think about your bank. Two kinds of
customers visit the bank: those with funds, who want to make deposits, and those in
need of funds, who want to make withdrawals or take out loans. Depositors want easy
access to their funds—not just the currency they withdraw every week or so but the
larger amounts they may need in an emergency. Borrowers don’t want to pay the
funds back for a while, and they certainly can’t be expected to repay the entire amount
on short notice. In the same way that an insurance company knows that not all its
policyholders will have automobile accidents on the same day, a bank knows that not
all its depositors will experience an emergency and need to withdraw funds at the
same time. The bank can structure its assets accordingly, keeping enough funds in
short-term, liquid financial instruments to satisfy the few people who will need them
and lending out the rest. And because long-term loans usually have higher interest
rates than short-term money-market instruments—for instance, commercial paper and
U.S. Treasury bills— the bank can offer depositors a higher interest rate than they
would get otherwise.
Even the bank’s short-term investments will do better than an individual
depositor’s could, because the bank can take advantage of economies of scale to lower
its transactions costs. It isn’t much more expensive to buy a $1 million U.S. Treasury
bill than it is to buy one worth only $1,000. By collecting funds from a large number
of small investors, the bank can reduce the cost of their combined investment,
offering each individual investor both liquidity and a better rate of return. Pooling
large numbers of small accounts in this way is very efficient. By doing so, an
intermediary offers depositors something they can’t get from the financial markets on
their own. The liquidity services financial intermediaries provide go beyond fast and
easy access to account balances. Intermediaries offer both individuals and businesses
lines of credit, which are similar to overdraft protection for checking accounts. A line
of credit is essentially a preapproved loan that can be drawn on whenever a customer
needs funds. Home equity lines of credit, credit card cash advances, and business lines
of credit are examples.
Like a deposit account, the line of credit provides a customer with access to
liquidity, offering a flexible financial resource to meet various needs. However, unlike
a traditional deposit account where the customer can only withdraw funds up to the
amount they have deposited, a line of credit allows withdrawals that can exceed the
existing deposit balances. This feature makes lines of credit an attractive option for
individuals and businesses seeking a reliable source of funds to cover unexpected
expenses, manage cash flow, or invest in opportunities as they arise.
To offer this service profitably and efficiently, a financial intermediary, such as
a bank or credit union, must specialize in liquidity management. This involves
carefully designing and managing its balance sheet to ensure it can meet the demands
of customers who may need to draw on their lines of credit suddenly and
substantially. Effective liquidity management requires a deep understanding of the
patterns of withdrawals and deposits, as well as the ability to predict and prepare for
potential liquidity needs.
Banks must maintain a sufficient level of liquid assets, such as cash or easily
sellable securities, to cover these sudden withdrawals without jeopardizing their
overall financial stability. They achieve this by diversifying their asset portfolios,
balancing short-term and long-term investments, and maintaining access to various
funding sources. Additionally, banks often set up contingency plans and liquidity
reserves to handle unexpected spikes in withdrawals or economic downturns.
Moreover, offering lines of credit involves assessing the creditworthiness of
customers to minimize the risk of default. Financial intermediaries conduct thorough
credit evaluations, reviewing customers' financial histories, credit scores, and
repayment capacities. This assessment helps in setting appropriate credit limits and
interest rates that reflect the risk profile of each customer, ensuring that the service
remains profitable while meeting customer needs.
In addition to managing the inherent risks, banks and financial institutions
must also navigate regulatory requirements related to liquidity and capital adequacy.
Regulatory bodies mandate certain liquidity ratios and stress-testing procedures to
ensure that financial intermediaries can withstand economic shocks and maintain
solvency. Compliance with these regulations is critical to maintaining the trust of
customers and the stability of the broader financial system.
The ability to offer lines of credit effectively also depends on the technological
infrastructure of the financial institution. Advanced banking systems and software
enable real-time monitoring of account balances, transaction activities, and liquidity
levels. This technological capability allows banks to respond swiftly to changes in
liquidity demands and to optimize their financial operations.
Furthermore, financial intermediaries often provide customers with various
tools and resources to manage their lines of credit responsibly. This includes offering
online banking platforms, mobile apps, and financial advisory services that help
customers track their spending, understand their credit usage, and plan their finances.
By promoting responsible credit usage, banks can reduce the risk of defaults and
enhance customer satisfaction.
Overall, the provision of lines of credit is a complex and dynamic aspect of
financial services that requires expertise in liquidity management, risk assessment,
regulatory compliance, and technological integration. By excelling in these areas,
financial intermediaries can offer valuable liquidity solutions to their customers,
helping them navigate financial challenges and seize opportunities with confidence.
All financial intermediaries provide a low-cost way for individuals to diversify
their investments. Mutual fund companies offer small investors a low-cost way to
purchase a diversified portfolio of stocks and eliminate the idiosyncratic risk
associated with any single investment. Many of the mutual funds based on the
Standard & Poor’s 500 Index require a minimum investment of as little as a few
thousand dollars. Because the average price of each stock in the index usually runs
between $40.and $60, a small investor would need more than $20,000 to buy even a
single share of stock in each of the 500 companies in the index (not to mention the
fees the investor would need to pay to a broker to do it). Thus, the mutual fund
company lets a small investor buy a fraction of a share in each of the 500 companies
in the fund. And because mutual fund companies specialize in this activity, the cost
remains low.
One of the biggest problems individual savers face is figuring out which
potential borrowers are trustworthy and which are not. Most of us do not have the
time or skill to collect and process information on a wide array of potential borrowers.
And we are understandably reluctant to invest in activities about which we have little
reliable information. The fact that the borrower knows whether he or she is
trustworthy, while the lender faces substantial costs to obtain the same information,
results in an information asymmetry. Very simply, borrowers have information that
lenders don’t. By collecting and processing standardized information, financial
intermediaries reduce the problems information asymmetries create. They screen loan
applicants to guarantee that they are creditworthy.
Financial institutions engage in the practice of monitoring loan recipients to
ensure that the borrowed funds are utilized according to the agreed-upon purposes.
This vigilance is crucial because it helps mitigate risks and ensures that the loan
serves its intended function, whether it is for business expansion, home purchase,
education, or any other specified use. This monitoring process involves various
methods and strategies to track the borrower’s use of funds, adherence to the loan
terms, and overall financial health.
To understand how this monitoring process works and the broader
implications it has for the financial system, it is essential to delve into the concept of
information asymmetries in more detail. Information asymmetry occurs when one
party in a transaction has more or better information than the other. In the context of
lending, the borrower typically has more information about their intentions, financial
health, and ability to repay the loan than the lender does. This imbalance can lead to
several issues, including adverse selection and moral hazard.
Adverse selection refers to the problem that occurs before the loan agreement
is made. It happens when borrowers who are more likely to default are the ones most
eager to obtain loans. Because lenders cannot perfectly distinguish between high-risk
and low-risk borrowers, they might end up lending to individuals or businesses that
have a higher probability of defaulting. This issue is particularly pertinent in markets
where credit assessments are not thorough or where financial records are opaque.
Moral hazard, on the other hand, arises after the loan has been issued. This
occurs when borrowers engage in riskier behavior than they would have if they had
not received the loan, knowing that the lender bears part of the risk. For example, a
business might take on high-risk projects with the borrowed funds, hoping for high
returns, because the downside risk is partially shouldered by the lender.
To combat these issues, financial institutions implement robust monitoring
systems. These systems can include regular financial reporting requirements, site
visits, and audits. For instance, a lender might require a business to submit quarterly
financial statements to track its financial health and ensure that the loan is being used
as intended. For personal loans, banks might track major purchases or conduct
periodic reviews of the borrower’s credit usage and payment history.
In addition to direct monitoring, financial institutions often use covenants in
loan agreements to protect their interests. Covenants are conditions stipulated in the
loan contract that the borrower must adhere to. These can include maintaining certain
financial ratios, restricting additional borrowing, or limiting the payment of dividends.
If a borrower breaches any of these covenants, the lender has the right to take
corrective actions, which might include demanding immediate repayment of the loan.
The implications of effective monitoring and addressing information
asymmetries are significant for the financial system. Proper monitoring reduces the
risk of default and ensures the stability of financial institutions, which in turn fosters
trust and reliability in the financial markets. By mitigating adverse selection and
moral hazard, lenders can maintain healthier loan portfolios, offer more competitive
interest rates, and extend credit to a broader range of borrowers.
Furthermore, by ensuring that loans are used for their intended purposes,
financial institutions can contribute to economic growth and stability. For example,
when business loans are used for productive investments like expanding operations or
improving technology, they can lead to job creation, increased productivity, and
overall economic development. Similarly, when personal loans are used responsibly,
they can help individuals achieve significant life goals such as homeownership or
higher education, contributing to societal well-being.
In summary, the practice of monitoring loan recipients is a critical function
that helps financial institutions manage risks associated with lending. By
understanding and addressing information asymmetries, lenders can protect their
interests, ensure the proper use of funds, and contribute to the stability and growth of
the financial system. This complex interplay between monitoring, risk management,
and economic impact underscores the importance of transparency, accountability, and
diligent oversight in financial transactions
b. Information Asymmetries and Information Costs
Information plays a central role in the structure of financial markets and
financial institutions. Markets require sophisticated information to work well; when
the cost of obtaining that information is too high, markets cease to function.
Information costs make the financial markets, as important as they are, among the
worst functioning of all markets. The fact is, the issuers of financial instruments—
borrowers who want to issue bonds and firms that want to issue stock—know much
more about their business prospects and their willingness to work than potential
lenders or investors—those who would buy their bonds and stocks. This asymmetric
information is a serious hindrance to the operation of financial markets. Solving this
problem is one key to making our financial system work as well as it does. To
understand the nature of the problem and the possible solutions, let’s go back to eBay.
Why are the people who win online auctions willing to send payments totaling nearly
$95 billion a year to the sellers? An amazing amount of trust is involved in these
transactions. To bid at all, buyers must believe that an item has been described
accurately. And winners must be sure that the seller will send the item in exchange for
their payments, because the normal arrangement is for the seller to be paid first.
How can buyers be sure they won’t be disappointed by their purchases when
they arrive, assuming they arrive at all? The fact that sellers have much more
information about the items they are selling and their own reliability creates an
information asymmetry. Aware of this problem, the people who started eBay took two
steps. First, they offered insurance to protect buyers who don’t receive their
purchases. Second, they devised a feedback forum to collect and store information
about both bidders and sellers. Anyone can read the comments posted in the forum or
check an overall rating that summarizes their content. Sellers who develop good
reputations in the feedback forum command higher prices than others; buyers who
develop bad reputations can be banned from bidding. Without this means of gathering
information, eBay probably could not have been successful. Together, the buyers’
insurance and the feedback forum make eBay run smoothly.1 The two problems eBay
faced arise in financial markets, too. In fact, information problems are the key to
understanding the structure of our financial system and the central role of financial
intermediaries. Asymmetric information poses two important obstacles to the smooth
flow of funds from savers to investors. The first, called adverse selection, arises
before the transaction occurs. Just as buyers on eBay need to know the relative
trustworthiness of sellers, lenders need to know how to distinguish good credit risks
from bad. The second problem, called moral hazard, occurs after the transaction. In
the same way that buyers on eBay need reassurance that sellers will deliver their
purchases after receiving payment, lenders need to find a way to tell whether
borrowers will use the proceeds of a loan as they claim they will. The following
sections will look at both these problems in detail to see how they affect the structure
of the financial system.
The 2001 Nobel Prize in Economics was awarded to George A. Akerlof, A.
Michael Spence, and Joseph E. Stiglitz “for their analyses of markets with asymmetric
information.” Professor Akerlof’s contribution came first, in a paper published in
1970 titled “The Market for ‘Lemons.’”2 Akerlof’s paper explained why the market
for used cars—some of which may be “lemons”—doesn’t function very well. Here’s
the logic. Suppose the used-car market has only two cars for sale, both 2017 model
Honda Accords. One is immaculate, having been driven and maintained by a careful
elderly woman who didn’t travel much. The second car belonged to a young man who
got it from his parents, loved to drive fast, and did not worry about the damage he
might cause if he hit a pothole. The owners of these two cars know whether their own
cars are in good repair, but used-car shoppers do not.
Let’s say that potential buyers are willing to pay $20,000 for a well-
maintained car, but only $10,000 for a “lemon”—a car with lots of mechanical
problems. The elderly woman knows her car is a “peach.” It’s in good condition and
she won’t part with it for less than $20,000. The young man, knowing the poor
condition of his car, will take $8,000 for it. But if buyers can’t tell the difference
between the two cars, without more information they will pay only the average price
of $15,000. (A risk-averse buyer wouldn’t even pay that much.) That is less than the
owner of the good car will accept, so she won’t sell her car and it disappears from the
market. The problem is that if buyers are willing to pay only the average value of all
the cars on the market, sellers with cars in above-average condition won’t put their
cars up for sale. Only the worst cars, the lemons, will be left on the market. In
summary, buyers’ inability to uncover the hidden attributes of the vehicles for sale
undermines the used-car market as a whole. Information asymmetries aside, people
like to buy new cars, and when they do, they sell their old cars.
People who can’t afford new cars, or who would rather not pay for them, are
looking to buy good used cars. Together, these potential buyers and sellers of used
cars provide a substantial incentive for creative people to solve the problem of
adverse selection in the used-car market. Some companies try to help buyers separate
the peaches from the lemons. For instance, Consumer Reports has long provided
information about the reliability and safety of particular makes and models. More
recent is the CARFAX service, which provides potential car buyers the detailed
history, including reported accidents and airbag deployments, of a specific used
vehicle. Car dealers may try to maintain their reputations by refusing to pass off a
clunker as a well-maintained car. For a fee, a mechanic will check out a used car for a
potential buyer. Finally, many car manufacturers offer warranties on the used cars
they have certified. We have found ways to overcome the information problems
pointed out by Professor Akerlof, and as a result both good and bad used cars sell at
prices much closer to their true value. So long as there exists a technology that lets
buyers determine, at a reasonable cost, the hidden attributes of used cars for sale, the
market works.
When it comes to information costs, financial markets are not that different
from the used-car market. In the same way that the seller of a used car knows more
about the car than the buyer, potential borrowers know more about the projects they
wish to finance than prospective lenders. And in the same way that information
asymmetries can drive good cars out of the used-car market, they can drive good
stocks and bonds out of the financial market. To see why, let’s start with stocks. Think
about a simple case in which there are two firms, one with good prospects and one
with bad prospects. If you can’t tell the difference between the two firms, you will be
willing to pay a price based only on their average quality. The stock of the good
company will be undervalued. Because the managers know their stock is worth more
than the average price, they won’t issue it in the first place. That leaves only the firm
with bad prospects in the market. And because most investors aren’t interested in
companies with poor prospects, the market is very unlikely to get started at all.
The same thing happens in the bond market. Remember that risk requires
compensation. The higher the risk, the greater the risk premium. In the bond market,
this relationship between risk and return affects the cost of borrowing. The more risky
the borrower, the higher the cost of borrowing. If a lender can’t tell whether a
borrower is a good or bad credit risk, the lender will demand a risk premium based on
the average risk. Borrowers who know they are good credit risks won’t want to
borrow at this elevated interest rate, so they will withdraw from the market, leaving
only the bad credit risks. The result is the same as for used cars and stocks: Because
lenders are not eager to buy bonds issued by bad credit risks, the market will
disappear.
From a social perspective, the fact that managers might avoid issuing stock or
bonds because they know the market will not value their company correctly is not
good. It means that the company will pass up some good investments. And because
some of the best investments will not be undertaken, the economy won’t grow as
rapidly as it could. Thus, it is extremely important to find ways for investors and
lenders to distinguish well-run firms from poorly run firms. Well-run firms need to
highlight their quality so they can obtain financing more cheaply. Investors need to
distinguish between high- and low-risk investments so they can seek compensation
corresponding to the level of risk they are taking on. The question is how to do it.
Recall how buyers and sellers in the used-car market developed ways to address the
problem of distinguishing good from bad cars. The answer here is similar. First,
because the problem is caused by a lack of information, we can create more
information for investors. Second, we can provide guarantees in the form of financial
contracts that can be written so a firm’s owners suffer together with the people who
invested in the company if the firm does poorly. This type of arrangement helps
persuade investors that a firm’s stocks and bonds are of high quality. And as we will
see later, financial intermediaries can do a great deal to reduce the information costs
associated with stock and bond investments.
One obvious way to solve the hidden attributes problem is to generate more
information. This can be done in one of two ways: government-required disclosure,
and the private collection and production of information (like CARFAX for used
cars). In most advanced economies, public companies—those that issue stocks and
bonds that are bought and sold in public financial markets—are required to disclose
voluminous amounts of information. For example, in the United States the Securities
and Exchange Commission requires firms to produce public financial statements that
are prepared according to standard accounting practices. Corporations are also
required to disclose, on an ongoing basis, information that could have a bearing on the
value of their firms. And since August 2000, U.S. companies have been required to
release to the public any information they provide to professional stock analysts.
What about the private collection and sale of information? You might think
that this would provide investors with what they need to solve the adverse selection
problem, but unfortunately it doesn’t work. While it is in everyone’s interest to
produce credible proof of the quality of a company’s activities, such information
doesn’t really exist. In a limited sense there is private information collected and sold
to investors. Various research services like Moody’s, Value Line, and Dun and
Bradstreet collect information directly from firms and produce evaluations. These
reports are not cheap. For example, Value Line charges nearly $600 a year for its
weekly publication. To be credible, the companies examined can’t pay directly for the
research themselves, so investors have to. And while some individuals might be
willing to pay, in the end they don’t have to and so they won’t. Private information
services face what is called a free-rider problem. A free rider is someone who doesn’t
pay the cost to get the benefit of a good or service, and free riding on stock market
analysis is easy to do. Even though these publications are expensive, public libraries
subscribe to some of them. Reporters for The Wall Street Journal and other periodicals
read them and write stories publicizing crucial information. And individual investors
can simply follow the lead of people they know who subscribe to the publications. Of
course, all these practices reduce the ability of the producers of private information to
actually profit from their hard work.
While government-required disclosure and private information collection are
crucial, they haven’t solved all the hidden attributes problems that plague investors
and the firms they invest in. Fortunately, other solutions exist. One is to make sure
that lenders are compensated even if borrowers default. If a loan is insured in some
way, then the borrower isn’t a bad credit risk. There are two mechanisms for ensuring
that a borrower is likely to repay a lender: collateral and net worth. Collateral is said
to back or secure a loan. Houses serve as collateral for mortgages; cars, as collateral
for car loans. If the borrower fails to keep up with the mortgage or car payments, the
lender will take possession of the house or car and sell it to recover the borrowed
funds. In circumstances like these, adverse selection is less of a concern; that’s why
collateral is so prevalent in loan agreements. When banks make loans without
collateral—unsecured loans, like credit card debt—they typically charge very high
interest rates. Adverse selection is the reason. Net worth is the owner’s stake in a firm,
the value of the firm’s assets minus the value of its liabilities. Under many
circumstances, net worth serves the same purpose as collateral. If a firm defaults on a
loan, the lender can make a claim against the firm’s net worth. Consider what would
happen if a firm with a high net worth borrowed to undertake a project that turned out
to be unsuccessful. If the firm had no net worth, the lender would be out of luck.
Instead, the firm’s owners can use their net worth to repay the lender.
The same is true of a home mortgage. A mortgage is much easier and cheaper
to get when a homebuyer makes a substantial down payment. For the lender, the risk
is that the price of the home will fall, in which case its value will not be sufficient to
fully compensate the lender in the event of a default. But with a large down payment,
the homeowner has a substantial stake in the house, so even if the price falls, the
mortgage can likely be repaid even if the borrower defaults. From the perspective of
the mortgage lender, the homeowner’s equity serves exactly the same function as net
worth in a business loan. The importance of net worth in reducing adverse selection is
the reason owners of new businesses have so much difficulty borrowing money. If
you want to start a bakery, for example, you will need financing to buy equipment and
cover the rent and payroll for the first few months. Such seed money is very hard to
get. Most small business owners must put up their homes and other property as
collateral for their business loans. Only after they have managed to establish a
successful business and have built up some net worth in it, can they borrow without
pledging their personal property.
The phrase moral hazard originated when economists who were studying
insurance noted that an insurance policy changes the behavior of the person who is
insured. Examples are everywhere. A fire insurance policy written for more than the
value of the property might induce the owner to arson; a generous automobile
insurance policy might encourage reckless driving. Employment arrangements suffer
from moral hazard, too. How can your boss be sure you are working as hard as you
can if you’ll get your paycheck at the end of the week whether you do or not? Moral
hazard arises when we cannot observe people’s actions and so cannot judge whether a
poor outcome was intentional or just a result of bad luck. Thus, a lender’s or
investor’s information problems do not end with adverse selection. A second
information asymmetry arises because the borrower knows more than the lender about
the way borrowed funds will be used and the effort that will go into a project. Where
adverse selection is about hidden attributes, moral hazard is about hidden actions.
Moral hazard plagues both equity and bond financing, making it difficult for all but
the biggest, best-known companies to issue either stocks or bonds successfully. Let’s
look at each type of financing and examine the ways people have tried to solve the
problem of moral hazard.
If you buy a stock, how do you know the company that issued it will use the
funds you have invested in the way that is best for you? The answer is that it almost
surely will not. You have given your funds to managers, who will tend to run the
company in the way most advantageous to them. The separation of your ownership
from their control creates what is called a principal–agent problem, which can be
more than a little costly to stockholders. Witness the luxurious offices, corporate jets,
limousines, and artwork that executives surround themselves with, not to mention the
millions of dollars in compensation they pay themselves. Managers gain all these
personal benefits at the expense of stockholders. A simple example will illustrate this
point. Let’s say that your cousin Ina, who is a whiz at writing software, has an idea for
a program to speed up wireless Internet access. Together, the two of you estimate she
needs $10,000 to write the program and sell it to an interested buyer. But Ina has only
$1,000 in savings, so you will have to contribute $9,000. Family etiquette dictates that
once you’ve made the investment, you won’t be able to monitor Ina’s progress—to
tell whether she is working hard or even if she is working at all. If everything goes
well, you think you can sell the program to Microsoft for $100,000, which is 10 times
the initial investment. But Ina had better work quickly or someone else may make it to
market first and Ina’s program won’t be worth nearly as much. The difficulty in this
arrangement is immediately apparent. If Ina works hard and all goes according to
plan, she will get 10 percent of the $100,000 (that’s $10,000) and you will get the rest,
a whopping $90,000. But if Ina runs into programming problems or spends part of the
time surfing instead of working, someone else may bring the product to market first,
reducing the value of Ina’s software to $10,000. The problem is, Ina’s decision to go
surfing would cost her only $9,000, but it would cost you $81,000! And because you
wouldn’t be able to tell why the venture failed, you’re unlikely to part with your
$9,000 in the first place.
Solutions to the moral hazard problem in equity finance are hard to come by.
Information on the quality of management can be useful, but only if owners have the
power to fire managers— and that can be extremely difficult. Requiring managers to
own a significant stake in their own firm is another possibility. If Ina comes up with
the entire $10,000, then there is no separation between ownership and control and no
question whether Ina will behave in the owner’s interest—she is the owner. But
people who have good ideas don’t always have the resources to pursue them. Ina
doesn’t have the $10,000 she needs. During the 1990s, a concerted attempt was made
to align managers’ interests with those of stockholders. Executives were given stock
options that provided lucrative payoffs if a firm’s stock price rose above a certain
level. This approach worked until managers found ways to misrepresent their
companies’ profitability, driving up stock prices temporarily so they could cash in
their options. Accounting methods have been reformed in an attempt to reduce such
abuses, but at this writing, no one has devised a foolproof way of ensuring that
managers will behave in the owners’ interest instead of their own.
c. Financial Intermediaries and Information Cost
The problems of adverse selection and moral hazard make securities finance
expensive and difficult to get. These drawbacks lead us immediately to loans and the
role of financial institutions. Much of the information that financial intermediaries
collect is used to reduce information costs and minimize the effects of adverse
selection and moral hazard. To reduce the potential costs of adverse selection,
intermediaries screen loan applicants. To minimize moral hazard, they monitor
borrowers. And when borrowers fail to live up to their contracts with lenders,
financial intermediaries penalize them by enforcing the contracts. Let’s look more
closely at how financial firms screen and monitor borrowers to reduce information
costs. And then we will conclude with a quick look at how firms finance growth and
investment.
To get a loan, whether from a bank, a mortgage company, or a finance
company, you must fill out an application. As part of the process, you will be asked to
supply your Social Security number. The lender uses the number to identify you to a
company that collects and analyzes credit information, summarizing it for potential
lenders in a credit score. Your personal credit score tells a lender how likely you are to
repay a loan. It is analogous to eBay’s feedback forum rating or to an expert
appraiser’s certification of the authenticity and condition of an original painting. The
credit rating company screens you and then certifies your credit rating. If you are a
good credit risk with a high credit score, you are more likely than others to get a loan
at a relatively low interest rate. Note that the company that collects your credit
information and produces your credit score.charges a fee each time someone wants to
see it. This overcomes the free-rider problem.
Banks can collect information on a borrower that goes beyond what a loan
application or credit report contains. By noting the pattern of deposits and
withdrawals from your account, as well as your use of your debit card if you have
one, they can learn more about you than you might like. Banks monitor both their
individual and their business customers in this way. Again, the information they
collect is easy to protect and use. The special information banks have puts them in an
almost unique position to screen customers and reduce the costs of adverse selection.
This expertise helps explain another phenomenon, the fact that most small and
medium-size businesses depend on banks for their financing.
Financial intermediaries’ superior ability to screen and certify borrowers
extends beyond loan making to the issuance of bonds and equity. Underwriters—large
financial institutions, like Goldman Sachs, JPMorgan Chase, and Morgan Stanley—
screen and certify firms seeking to raise funds directly in the financial markets.
Without certification by one of these firms, companies would find it difficult to raise
funds. Large intermediaries go to great lengths to market their expertise as
underwriters; they want people to recognize their names the world over, just as
everyone recognizes Coca-Cola. A can of Coke, the best-selling soft drink in the
world, is instantly recognizable, whether the fine print is in English, Chinese, Arabic,
or Swedish. Financial institutions have applied this concept, which marketing people
call branding, to their certification of financial products. If JPMorgan Chase, a well-
known bank and securities firm, is willing to sell a bond or stock, the brand name
suggests that it is a high-quality investment.
If someone weren’t watching over your shoulder, you might take the money
you borrowed for a business project and fly off to Tahiti. To address the risk that
sellers might take the money and run, eBay developed buyers’ insurance. In the
financial world, intermediaries insure against this type of moral hazard by monitoring
both the firms that issue bonds and those that issue stocks. Car dealers provide an
interesting example of how this process works. Dealers have to finance all those shiny
new cars that sit on the lot, waiting for buyers to show up. One way to do this is with
a bank loan that is collateralized by the cars themselves. But the bank doesn’t
completely trust the dealer to use the loan proceeds properly. Every so often, the bank
manager will send an associate to count the number of cars on the lot. The count tells
the manager whether the dealer is using the borrowed funds properly. In monitoring
the dealer this way, the bank is enforcing the restrictive covenants contained in the
loan contract. Because banks specialize in this type of monitoring, they can do it more
cheaply than individual borrowers and lenders.
Many financial intermediaries (other than banks) hold significant numbers of
shares in individual firms. When they do, they find ways to monitor the companies’
activities. For example, the California Public Employee Retirement System
(CalPERS) manages more than $300 billion in assets, the income from which is used
to pay retired employees’ pensions. About 1.6 million “members” of CalPERS depend
on the fund’s managers to carefully monitor its investments. Before buying a
company’s stock, CalPERS’s managers do a significant amount of research on the
firm; once they have purchased the shares, they monitor the firm’s activities very
closely. In some cases, they place a representative on the company’s board of
directors to monitor and protect CalPERS’s investment firsthand. In the case of some
new companies, a financial intermediary called a venture capital firm does the
monitoring. Venture capital firms (like Kleiner Perkins or Draper Fisher) specialize in
investing in risky new ventures in return for a stake in the ownership and a share of
the profits. To guard against moral hazard and ensure that the new company has the
best possible chance of success, the venture capitalist keeps a close watch on the
managers’ actions.
Finally, the ever-present threat of a corporate takeover serves as a powerful
incentive for managers to act in the best interests of the stockholders and bondholders.
This mechanism of market discipline ensures that company executives remain vigilant
and focused on maximizing shareholder value. If managers fail to diligently protect
and enhance the interests of the shareholders, they risk becoming targets for
acquisition by other companies. These potential acquirers, seeing an opportunity to
improve the company's performance and value, can purchase the firm and
subsequently replace the underperforming management team with their own people
who are more aligned with the shareholders' goals.
The fear of a hostile takeover thus acts as a check on managerial complacency
and inefficiency. Managers are constantly aware that poor performance or neglect of
shareholders' interests can lead to the company's acquisition by another entity. This
external pressure compels them to strive for operational excellence, cost-efficiency,
and strategic initiatives that drive up the stock price and overall company value. It
serves as a deterrent against managerial misconduct and ensures that the executive
team remains accountable.
In the 1980s, the concept of takeovers became particularly prominent with the
rise of firms that specialized in such aggressive acquisition tactics. These firms, often
referred to as corporate raiders, actively sought out companies with undervalued
assets or inefficient management. By leveraging financial instruments such as junk
bonds, these corporate raiders were able to amass significant capital to fund their
takeover bids. Once they acquired control of the target company, they would typically
implement radical changes to unlock value, streamline operations, and improve
profitability.
One notable example of a corporate raider from this era is Carl Icahn, who
became famous for his aggressive takeover strategies. Icahn and others like him
played a crucial role in reshaping corporate America during the 1980s, highlighting
the impact of market discipline on managerial behavior. The threat of takeover
spurred many managers to preemptively make the necessary changes to avoid
becoming targets, thus indirectly benefiting shareholders.
The influence of takeover threats extends beyond merely replacing inefficient
managers. It also encourages existing management to engage in more transparent and
shareholder-friendly practices. This can include increasing dividend payouts, share
buybacks, and improving corporate governance structures. By aligning their actions
more closely with the interests of shareholders, managers can reduce the likelihood of
becoming acquisition targets and maintain their positions within the company.
Furthermore, the threat of takeovers contributes to a dynamic and competitive
business environment. Companies are motivated to continuously innovate and
improve to remain attractive to investors and avoid the risks associated with
underperformance. This competitive pressure fosters a culture of excellence and
accountability across industries, leading to better overall economic efficiency and
growth.
In conclusion, the threat of a corporate takeover is a critical component of
market discipline that helps ensure managers act in the best interests of stockholders
and bondholders. The fear of losing control of the company and being replaced
motivates managers to prioritize shareholder value and operational efficiency. The rise
of corporate raiders in the 1980s exemplifies how this mechanism can drive
significant changes in managerial behavior and corporate governance. By
understanding and leveraging the dynamics of takeover threats, shareholders can
better safeguard their investments and promote a more effective and accountable
corporate management landscape.
Today, this approach has evolved into the fundamental business model of
private equity firms. These firms specialize in acquiring companies, improving their
operations, and then selling them for a profit. A few private equity firms, such as Bain
Capital and Kohlberg Kravis Roberts (KKR), have grown to become very large and
influential entities within the financial sector. These firms manage vast sums of
capital, often raised from institutional investors like pension funds, endowments, and
wealthy individuals, and they wield significant influence over the businesses they
acquire.
The strategy of private equity firms typically involves buying out companies
that they believe are undervalued or have significant potential for operational
improvements. Once these firms acquire a company, they often install their own
management teams or advisors who have the expertise to execute turnaround
strategies and drive efficiency. This practice of placing their own people in key
management positions is a critical component of their business model and is
instrumental in mitigating the moral hazard problem.
Moral hazard occurs when the managers of a company do not bear the full
consequences of their actions, leading them to potentially take undue risks or act in
ways that are not aligned with the best interests of the owners or investors. By putting
their own trusted and experienced people in charge of the acquired firm, private
equity owners can ensure that management decisions are closely aligned with their
goals and interests. This alignment reduces the likelihood of reckless behavior or
mismanagement, as the new managers are directly accountable to the private equity
owners and are often incentivized through performance-based compensation
structures.
The process of eliminating the moral hazard problem involves several steps.
First, private equity firms conduct thorough due diligence before acquiring a
company. This involves a detailed analysis of the company's financial health,
operational processes, market position, and potential risks. By gaining a deep
understanding of the business, private equity firms can develop a clear strategy for
improvement and identify the right management team to implement this strategy.
Once the acquisition is complete, private equity firms typically work quickly
to implement their turnaround plans. This might involve restructuring the company's
operations, cutting unnecessary costs, optimizing supply chains, and improving
product offerings. The new management team, often composed of individuals with a
proven track record in similar industries or turnaround situations, is tasked with
executing these changes effectively.
The presence of the private equity firm's own people in the management team
also facilitates better oversight and control. Regular performance reviews, strategic
planning sessions, and financial reporting ensure that the company stays on track and
meets its targets. This level of oversight helps prevent the moral hazard problem by
ensuring that management actions are continually monitored and evaluated against the
firm's objectives.
Moreover, private equity ownership often brings access to valuable resources
and networks that can further support the acquired company's growth. This includes
access to additional capital for investment, strategic partnerships, and industry
expertise. By leveraging these resources, the new management team can drive
significant improvements and enhance the company's overall value.
In summary, the approach of placing their own people in charge of acquired
firms has become a cornerstone of the private equity business model. By addressing
the moral hazard problem, private equity firms can ensure that management actions
are closely aligned with their strategic goals, leading to more effective and efficient
operations. This model has proven successful for many private equity firms, enabling
them to generate substantial returns for their investors while revitalizing and growing
the businesses they acquire. The success of prominent private equity firms like Bain
Capital and KKR underscores the effectiveness of this approach and its impact on the
broader financial and business landscape.
