Why Do Banks Exist Economics 639 American University

Why Do Banks Exist? Economics 639 / American University / Fall 2015

Why Does It Matter? • Federal Reserve and Federal government provided unprecedented support for banks during financial crisis-cum-recession on assumption banks are “special. ” • Are they really? 2 - 22

Intermediaries Minimize Transactions Costs • Financial intermediaries like savings & loans, mutual funds, and banks link borrowers (especially firms) and savers (households). • In theory, borrowers and savers could seek each other out and strike deals without intermediaries, but in real world, process is groping/inefficient. Example: Consider what typical saver must do without using intermediary. 3 - 22

Intermediaries Minimize Transactions Costs • Saver must locate firm needing funds and assess creditworthiness. • Then, saver and firm must bargain over how much will be invested, for how long, and at what rate of return. – Saver want securities with small denominations that pay off soon. – Firm prefers selling large-denomination securities with long maturities. • If saver and firm overcome these problems and strike deal, saver must still monitor firm until repaid. TAKE AWAY Intermediaries minimize transactions costs serving as barriers between savers and borrowers. 4 - 22

Intermediaries Minimize Transactions Costs Intermediaries provide these specific transactions services to link borrowers and savers: 1. Size transformation: Buying large securities and offering savers small accounts. 2. Liquidity transformation: Holding illiquid “securities” like bank loans – which can be hard to sell because of lemon’s problems – and offering liquid “securities” (deposits). 3. Diversification: Holding large portfolio of securities with imperfectly correlated returns to reduce saver risk. 5 - 22

Intermediaries Minimize Transactions Costs Problem • Nonbank financial intermediaries like mutual funds can provide transactions services. • Explaining why banks exist apart from other intermediaries requires another angle. That Angle: Asymmetric Information! 6 - 22

Banks Solve Information Problems Moral Hazard Banks lower costs arising from moral hazard and adverse selection. First, moral hazard. • As noted, manager has inside information about payoffs from firm capital projects, so monitoring is costly for bondholders* who provide funding. • Moreover, information about bonds used to fund projects has public good dimension, thereby weakening incentives for bondholders* to monitor. *Issue for stockholders, too. But, as noted, our focus is on bonds because banks debt is a substitute for public debt. 7 - 22

Banks Solve Information Problems Moral Hazard Free-Rider Problem: Information in securities markets has public good dimension. • When one investor monitors firm, others investors benefit whether they monitor or not. • But each investor ignores benefits to others when deciding whether to monitor. So, each investor will decline to monitor because personal is too small, even though total return to all investors can be quite large. • Everyone better off if someone monitored, yet no one does so, hence, “too little” monitoring. RESULT More difficult for firms to issue bonds, which complicates pursuit of attractive capital projects! 8 - 22

Banks Solve Information Problems Moral Hazard To combat problem, firms add features to bonds to contain moral hazard – such as covenants. But, inflexible nature of these features can create other problems. Bond Covenant Example • Covenant requires minimum level of net worth, with violation causing technical default. ‒ Pro: Threat of default successfully disciplines management. 9 - 22

Banks Solve Information Problems Moral Hazard Bond Covenant Example (continued) • Covenant requires minimum level of net worth, with violation causing technical default. ‒ Con: Firm with healthy prospects might break covenant because of temporary factor beyond management control, like recession. Everyone benefits if manager had breathing space to recover and respond. But, transactions costs and information asymmetries make renegotiation difficult. WORST CASE SCENARIO Bankruptcy from severe, but temporary, shock causes everyone to lose from failure to re-negotiate. Bank lending has flexibility to avoid this! 10 - 22

Banks Solve Information Problems Moral Hazard SOLUTION: Banks as delegated monitors! • Bank loan enable firm to replace bondholders with single lender, thus providing more flexibility. Large investment in firm also makes bank more willing to monitor and renegotiate contracts than individual bondholders. • Replacing bondholders with one lender also reduces duplication and, hence, total monitoring costs. • Bank monitoring also preserves borrower confidentiality that might be compromised if project details were shared with capital market (particularly important for easily copied projects, like new marketing campaign). 11 - 22

Banks Solve Information Problems Moral Hazard BUT…delegating monitoring to bank does not eliminate information asymmetry! When households lend to firms indirectly through banks (rather than directly through bonds), they have not found magic wand to eliminate information problems. • Bank itself is agent of depositors, delegated to monitor on their behalf. • Bank insiders know more than depositors about bank’s current revenues, problem areas in loan portfolio, competence of bank management, etc. 12 - 22

Banks Solve Information Problems Moral Hazard Paradox: If households use banks to avoid monitoring problems associated with direct lending, but simply end up with another difficult-to-monitor agent, how do bank loans improve over buying bonds? 13 - 22

Banks Solve Information Problems Moral Hazard SOLUTION? Diversification! • If bank faithfully monitors large portfolio of loans to different firms in different markets, probability of all borrowing firms simultaneously defaulting is small. • And probability falls as bank’s loan portfolio grows larger and more diversified. IMPLICATION Bank cannot credibly claim it cannot honor depositor claims because so many borrowers defaulted (i. e. , depositor monitoring costs significantly lower). 14 - 22

Banks Solve Information Problems Moral Hazard Diversification Solves Bank Agency Problem: • Note: Even with diversification, bank must monitor loans. – If bank neglects loan portfolio, many loans could go bad, thereby making it impossible to pay off depositors. • Upshot: By monitoring, bank reduces bankruptcy probability for borrowing firms, and by holding diversified loan portfolio, lowers its own bankruptcy probability. Bank comparative advantage in lending traceable to lower monitoring and renegotiation costs! Diamond (1984) 15 - 22

Banks Solve Information Problems Adverse Selection On top of serving as delegated monitors, banks solve adverse-selection problems: • Long history gives banks comparative advantage screening loan applicants. • So bank lending decisions act as “seals of approval” that make firm’s marketable securities more attractive. Empirical Regularity: Stock price of firm X rises when news bank lent money to firm X becomes public. ‒ Bank loan “certifies” firm soundness; market values signal because banks can sort credit risks. (If bank already has relationship with firm, market values signal because bank has inside information from ongoing relationship with firm. ) 16 - 22

Banks Solve Information Problems Adverse Selection Liquidity Insurance… …Another Adverse-Selection Angle Economy offers two types of capital projects: 1. Liquid projects with low returns. 2. Illiquid projects with high returns Early liquidation leaves zero salvage value, so investment in illiquid/high return project risks of big losses from “liquidity shocks. ” Were probability of liquidity shocks publicly observable, households could invest in illiquid projects to get high returns and buy liquidity-insurance policies. 17 - 22

Banks Solve Information Problems Adverse Selection Liquidity Insurance… …Another Adverse-Selection Angle (continued) • PROBLEM: But liquidity risk is privately observable, so conventional insurance companies do not offer policies. • SOLUTION: Banks sell liquidity insurance, offering savers return above liquid project as well as liquidity on demand. – Banks take deposits and invest bulk in high-return, illiquid projects and small residual in liquid projects to cover routine withdrawals. – Approach works as long as withdrawals uncorrelated. Diamond-Dybvig 1983 18 - 22

Why Banks Exist? Application Traditional Justification for Deposit Insurance: • “Demandable at par on first come, first served basis” (DPFCFS) nature of deposits contains different type of moral hazard, but creates exposure to banks. – Banks can transform risk profile quickly (“asset shifting”), imposing losses on claimholders. – Threat of massive depositor withdrawals disciplines bank. • But DPFCFS nature of deposits exposes banks to runs. • Runs generate macroeconomic externalities by causing collapse of money supply (→ AD and real output↓). 19 - 22

Why Banks Exist? Application New Twist on Justification for Deposit Insurance: Adverse Selection a la Diamond-Dybvig • Event persuades households massive deposit withdrawals from banking system possible. • Collective household response – correlated withdrawals – could cause solvent but illiquid banks to fail (by forcing sale of illiquid projects at big losses). • Threat of losses from bank failures causes households to start withdrawing deposits in case runs start, but household reaction, ironically, sparks runs. • Runs cause massive sale of illiquid projects with huge losses. So, on top of fall in real output (from money-stock decline), economy loses value of illiquid projects. 20 - 22

Why Banks Exist? Application New Twist on Justification for Deposit Insurance: Adverse Selection a la Diamond-Dybvig (continued) RESULT: Households rationally react to event that could cause bank runs/failures by withdrawing deposits en masse and causing failures (self-fulfilling prophecy). • Banks plug hole in asset markets (i. e. , sell liquidity insurance) but expose economy to “run risk” because DPFCFS nature of deposits necessary to prevent asset shifting. • To preserve value of illiquid projects, liquidity access, and stable macro-economy, government must somehow convince households deposits are safe, no matter what. 21 - 22

Why Banks Exist? Application Justification for Deposit Insurance: Adverse Selection a la Diamond-Dybvig (continued) SOLUTION: Federal deposit insurance Successful policy must convince households deposits are risk-free, thereby removing incentive to run. • State-underwritten deposit insurance won’t work because every such system in U. S. history imploded. • Discount Window won’t because Fed has discretion (i. e. , might not insulate households from losses on deposits). • Federal deposit insurance credible because of power to (i) tax large diversified economy, and (ii) print money. 22 - 22