WHY DO BANKS EXIST



Why Do Banks Exist?

Overview lecture

I. Minimize Transactions Costs

A. Depository intermediaries like savings and loans, mutual funds, and banks link ultimate borrowers, especially firms, and ultimate savers, the households of the economy.

1. While borrowers and savers might seek each other out and strike deals without going through intermediaries, traditional banking theory says that this will be a groping and inefficient process.

a) Example: Consider what a typical saver would have to do to invest her money in some firm without using an intermediary. First, she would have to locate a firm that needs money and determine whether it is creditworthy. Then, she and the firm would have to bargain over how much money she will invest, for how long, and at what rate of return. She would probably prefer to buy securities with small denominations that pay off quickly so that her money isn’t all tied up. The firm, on the other hand, would most likely rather sell just a few large securities, and it may need money for a project that will not pay off until sometime far in the future. Suppose the firm and the saver overcome all of these problems and actually strike a deal. Then, she still has to keep a close watch on the firms until she is paid back.

2. Intermediaries minimize transactions costs (search costs, negotiation costs, and enforcement costs) that serve as barriers between savers and firms.

B. Transactions services provided by intermediaries to match borrowers and savers:

1. Size transformation: buying large securities and offering savers small accounts.

2. Liquidity transformation: holding securities (like bank loans) that are hard to sell (lemon’s problem) while offering securities that are highly liquid (deposits).

3. Diversification: holding a large portfolio of securities with returns that are not perfectly correlated reduces risk for savers.

C. Problem: Nonbank financial intermediaries like mutual funds can provide transactions services. Explaining why banks exist apart from other financial institutions requires another angle: information problems

II. Solve Information Problems

A. Solve Moral Hazard Problems (Delegated Monitoring)

1. Agency problems: managers have inside information about the payoffs from investment projects for their firms. This information problem makes it difficult for bondholders and stockholders to monitor.

2. Holders of marketable securities have little incentive to monitor.

a) Information is costly to collect

b) Free rider problem: monitoring is a public good. When an investor supervises the firm, all other investors benefit whether the monitor or not. But each investor will ignore the benefits he provides others when he decides whether monitoring is worth the time and the trouble. Thus, every investor may decide that his personal gains from monitoring are too small, even when the total gains to all investors are quite large. Everyone would be better off if someone else chose to monitor, yet no one may be willing to do so. In this sense, too little monitoring occurs in securities markets

3. Managerial incentive schemes and bond covenants reduce but do not eliminate agency problems.

a) Bond contracts are inflexible: bond contracts with the possibility of costly default discipline management. But a firm (especially a new firm in a new market) with healthy future prospects might miss a payment or break a covenant due to temporary factors due to a temporary factor beyond the control of management (a recession). Both managers and investors would benefit if managers could request some breathing space to recover and respond. But, when no investor is willing to monitor the firm, the firm’s managers cannot easily convince investors that a reprieve is not being used merely to delay the day of reckoning. Thus, opportunities for timely renegotiation of the contract will be lost. Instead, with the threat of default in mind, managers will attempt to fulfill the terms of the contract, even when this means cutting back on projects that are fundamentally profitable.

i) Worst case scenario: bankruptcy due to severe but temporary shock. Everybody loses from failure to negotiate.

4. Banks act as delegated monitors:

a) By borrowing from a bank, the firm replaces many small lenders with as a single lender thus providing more flexibility. Since a bank, for example, makes large investments in firms, it will be more willing to monitor and renegotiate contracts than would a group of individual investors.

b) Replacing many small lenders with one lender also reduces duplication and, hence, total monitoring costs. This is especially true if economies of scale exist in monitoring.

c) Bank monitoring will also preserve borrower confidentiality, confidentiality that would be compromised if the borrower had to share the details of his project with the capital market. Confidentiality is especially important if the project is easily copied, like a new marketing campaign.

5. But, bank loans do not replace all securities:

a) bank monitoring certifies to the market that the firm is behaving efficiently, thereby making other securities marketed by the firm more attractive (i.e., lowering their costs).

b) Banks have agency problems, as well. When savers lend to firms indirectly through a bank, they have not found a magic wand that makes agency problems disappear. The bank itself is an agent of its depositors, delegated to monitor on their behalf. Bank insiders know more than depositors about the bank’s current revenues, about problem areas in the loan portfolio, about the efficiency of bank management, etc.

c). Solutions to bank agency problems

i) Debt contracts with costly default, incentives schemes to align managers and stockholders interests, bank regulation. These don’t do that much to lower overall agency costs.

ii) Diversification: While the agency costs of indirect lending help to explain why bank loans don’t always replace direct securities, they also seem to pose a paradox. If depositors place their funds with banks to avoid the agency costs of direct lending, but simply end up with another agent who is difficult to monitor, how can bank loans ever be an improvement over direct lending?

The problems of debt finance arise when a borrower with basically healthy prospects cannot make current payments. If the borrower has many separate projects in different market, however, it is very unlikely that all projects will go bad at once, unless the borrower is particularly inefficient or inept. Similarly, if a bank faithfully monitors a large portfolio of loans that includes different firms in many different markets, the probability of many firms facing troubles at once is quite small. And this probability falls as the bank’s portfolio grows larger and more diversified.

Even with diversification, the threat of bankruptcy forces the bank to monitor. If a bank is lackadaisical about the soundness of its loan portfolio, then many loans are likely to go bank and the bank will be unable to pay its depositors. But as long as the bank does monitor, the revenues from a large loan portfolio will tend to be stable. By monitoring, the bank reduces the likelihood of bankruptcy for its borrowing firms, and by holding a diversified portfolio, it lowers its own probability of bankruptcy. Thus, indirect lending through a delegated monitor that is well-diversified actually reduces the wasted time and effort of premature bankruptcy proceedings.

6. Banks have a comparative advantage in monitoring (uncollateralized loans) because:

a) Single lender: as discussed before, monitoring and renegotiation are likely to be more efficient with a single lender than with multiple lenders (reduction in total monitoring costs and greater ease of renegotiation).

i) If this story is correct, banks will not have an edge as lenders in financial markets for long. Finance companies, stockbrokers, insurance companies could perform the single lender function.

b) History as lender: bank is better able to screen loans because it has loaned to the same borrower in the past.

i) If this story is correct, banks have an edge as lenders in financial markets because of the industry’s long history as commercial lenders, but they may lose this edge gradually to alternative institutions.

c) Informational economies of scope with lending (checking account hypothesis): bank is better able to monitor because of an informational economy of scope between lending and checking. Specifically, access to transactions of borrowers through their checking accounts gives the bank additional information that enables it to monitor the loan. If this is the case, then institutions that are legally permitted to issue checking accounts would have a unique edge.

i) Informational economies of scope between checking and loan monitoring are greatest for small firms doing business exclusively in local markets. The checking accounts of such firms contain a detailed history of firm cash flows. The checking account of a large firm with subsidiaries across the country (and, hence, many other checking accounts) contains a great deal less information.

B. Solve Adverse Selection Problems

1. Bank “Seals of Approval”: As noted above, bank monitoring certifies to the market that the firm is behaving efficiently. Hence, when firms obtain bank loans (or other services from a bank), they receive a “seal of approval.” This seal makes other securities marketed by the firm more attractive (i.e., lowering their costs).

a) As we shall see, the stock price of firm X rises when news that a bank has loaned money to firm X hits the market. The bank loan is a “signal” to the market that the firm is sound. The market values the signal because the bank presumably has inside information about the firm. Hence, the bank loan helps overcome the information asymmetry between the market (outsiders) and the firm’s management (insiders).

b) In short, households and firm value the delegated monitoring services provided by banks. Households enjoy higher returns because of lower agency costs in lending and firms enjoy lower costs of marketing other securities because of the “seal of approval” that comes with bank monitoring. (Not to mention, the value of the funds obtain from banks.)

2. Liquidity Insurance: The economy offers illiquid projects with high returns and liquid projects with low returns. Obtaining high returns means running the risk of suffering a “liquidity shock.” If the probability of suffering a liquidity risk were publicly observable, it would be insurable. Agents could invest in illiquid projects and take out “liquidity insurance policies.” Because liquidity risk is privately observable, however, such policies are not available. Banks plug the hole in asset markets by pooling funds obtained from depositors and investing principally in the illiquid, high return project. Banks also invest some funds in the liquid project so that they have sufficient funds to cover the needs of “liquidity shocked” agents. Because banks invest funds in the high return project, they can offer depositors a higher return than that obtainable from direct investment in the illiquid project.

a) This argument is a new and improved version of the “liquidity transformation” transactions service provided by intermediaries.

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