Chapter 11: The Economics of Financial Intermediation

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In chapter 3 we were introduced to the importance of the financial sector in the allocation of funding, and thus resources, to their best uses in the economy. Recall that direct finance refers to savers and borrowers meeting directly in financial markets, while indirect finance involves the use of a financial intermediary. While the stock and bonds markets play a most important and indispensible role in this allocation of funding, we find that, in the U.S. and many other countries, indirect finance is much more important. Table 11.1 (261) highlight how indirect finance accounts for a much larger share of GDP that stock and bond markets combined.
The Role of Financial Intermediaries
So why is indirect financing so much more important? The reasons center around the power of information: how to get quality information at a reasonable cost. In this context, financial intermediaries perform 5 functions:
1. Pooling the resources of small savers
Many borrowers require large sums, while many savers offers small sums. Without intermediaries, the borrower for a $100,000 mortgage would have to find 100 people willing to lend her $1000. That is hardly efficient. Banks, for example, pool many small deposits and use this to make large loans. Insurance companies collect and invest many small premiums in order to pay fewer large claims. Mutual funds accept small investment amounts and pool them to buy large stock and bond portfolios. In each case, the intermediary must attract many savers, so the soundness of the institution must be widely believed. This is accomplished through federal insurance or credit ratings.
2. Providing safekeeping, accounting, and payments mechanisms for resources
Again, banks are an obvious example for the safekeeping of money in accounts, the records of payments, deposits and withdrawals and the use of debit/ATM cards and checks as payment mechanisms. Financial intermediaries can do all of this much more cheaply than you or I because the take advantage of economies of scale. All of these services are standardized and automated on a large scale, so per unit transaction costs are minimized.
3. Providing liquidity
Recall that liquidity refers to how easily and cheaply an asset can be converted to a means of payment. Financial intermediaries make is easy to transform various assets into a means of payment through ATMs, checking accounts, debit cards, etc. In doing this, financial intermediaries must many short term outflows and investments will long term outflows and investments in order to meet their obligations while profiting from the spread between long and short term interest rates. Again, economies of scale allow intermediaries to do this at minimum cost.
4. Diversifying risk
We have seen in chapter 5 how diversification is a powerful tool in minimizing risk for a given leven of return. Financial intermediaries help investors diversify in ways they would be unable to do on their own. Mutual funds pool the funds of many investors to purchase and manage a stock portfolio so that investors achieve stock market diversification for as little at $1000. If an investor were to purchase stocks directly, such diversification would easily cost over $15,000. Insurance companies geographically diversify in ways that a Gulf Coast homeowner cannot. Banks spread depositor funds over many types of loans, so the default of any one loan does not put depositor funds in jeopardy.
5. Collecting and processing information
Financial intermediaries are experts at collecting and processing information in order to accurately gauge the risk of various investments and to price them accordingly. Indviduals do not likely have to tools or know-how to do the same, and certainly could not do so as cheaply as financial intermediaries (once again, economies of scale are important here). This need to collect/process information comes from a fundamental asymmetric information problem inherent in financial markets.
Financial Intermediaries and Asymmetric Information
Despite their importance, your textbook author refers to financial markets as "among the worst functioning of all markets." (268) This is due the fundamental fact the borrowers and debt/stock issuers know much more about their likelihood of success than potential lenders and investors. This asymmetric information causes one group with better information to use this advantage at the expense of the less-informed group. If not controlled, asymmetric infromation can cause markets to function very inefficiently or even break down completely.
Asymmetric Information
The lack of information on one side creates problems BEFORE the loan is made and AFTER the loan. To you or I, these problems are huge, but financial intermediaries use their size and expertise to minimize them.
Before a financial instrument is bought or sold, there is the problem of adverse selection. Basically, what happens is that the worst candidates (adverse) are more likely to be selected for the transaction. People who are bad credit risks are more likely to try and get a loan than those who are good credit risks. Thus, odds are that you might end up lending to someone with a bad credit risk. Knowing that, you just decide not to lend. Again, this problem occurs because of asymmetric information: You do not have good information about a stranger's credit risk, although that stranger knows his/her own creditworthiness quite well. Banks, however, are experts at assessing credit risk and can distinguish the good from the bad. So you lend to the bank, and the bank lends to those who are good credit risks.
After a the loan is made, there is the problem of moral hazard. Once you lend someone money, you risk (the hazard) that he/she doessomething stupid to blow the money (immoral) and would be unable to pay you back. Your brother in-law claims to be investing in a restaurant franchise and will repay you with the profits, but once you lend him $10,000 he goes and blows it in Las Vegas. Knowing about this risk, you tell your brother-in-law to get lost, even though the franchise might be a good idea. Again, this is from asymmetric information: Your brother-in-law knows what he will do with the money but you can only guess. Banks are experts in monitoring and enforcing lending contracts in order to minimize the moral hazard problem.
Disclosure rules for public companies also mitigate the problems of asymmetric information. The SEC requires companies that sell securities to the public to publish quarterly financial statements and disclosure any relevant information in a timely manner. The requirement are not foolproof. As your book notes, the scandals with Enron and WorldCom, among others, demonstrate that financial statements may be manipulated in ways to deceive investors.
Note: adverse selection and moral hazard are important concepts that explain the structure and regulation of the financial sector as well as the major crises that have plagued the financial sector in the past 30 years, so take the time to understand these concepts.
Role of Financial Intermediaries in Reducing Information Costs
How do intermediaries reduce adverse selection and moral hazard? There are several ways.

• Screening. Prior to a loan being given, a bank investigates a firm's or individual's credit history and financial status. Such information is fed into sophisticated computer programs that compute a "credit score" (known as a FICO score). The higher the score, the better the borrower. Also, banks specialize in lending to certain industries, especially local industries. This makes the screening process cheaper and more accurate, although the lack of diversification does increase the risk of the bank's asset portfolio
• Monitoring. Once the loan is made, the bank must ensure that the borrower does not engage in risky activities that could lead to default. One way to prevent this is for banks to place "restrictive convenants" into the loan contract to prohibit certain activities, and then to check compliance and enforce the agreement when necessary.
• Creating long-term customer relationships. Repeat customers will not require the same effort for screening and monitoring that new customers. Also, customers have an incentive to establish a good repayment record in order to get loans from the same bank in the future.
• Collateral. Requiring a potential borrower to pledge assets to be turned over in case of default reduces credit risk in several ways. Obviously, it protects the bank from total financial loss in the event of a default. But it also screens out questionable borrowers (who will not have sufficient collateral) and reduces moral hazard problems since the borrower risks losing his/her property if a default occurs.
• Credit rationing. Riskier borrowers will be expected to pay higher interest rates to compensate for this risk. However, ONLY the riskiest borrowers are willing to pay the highest rates. This is an extreme case of adverse selection. In this case, banks may be unwilling to assume the high risk levels and simply refuse to lend to these types of borrowers. Alternatives, banks would lend out only small amounts, giving the borrower the incentive to establish a good payment record to obtain additional loans.
• Disclosure. Disclosure rules for public companies also mitigate the problems of asymmetric information. The SEC requires companies that sell securities to the public to publish quarterly financial statements and disclosure any relevant information in a timely manner. The requirement are not foolproof. As your book notes, the scandals with Enron and WorldCom, among others, demonstrate that financial statements may be manipulated in ways to deceive investor