An Overview of Financial System

Session 2
 Session Objective
• Why do we need financial institutions?
 Direct Finance
• Borrowers borrow funds directly from lenders
in financial markets by selling them securities
which are claims on the borrower’s future
income or assets.
 Why do we need FMs?
A Micro Take
• Meg, the baker, has saved $1,000 this year
• No borrowing or lending is possible because there are
no financial markets.
• She holds on to the $1,000 and will earn no interest.
• Carl, the carpenter, has a productive use for $1,000
• He needs it to purchase a new tool that will shorten
the time it takes him to build a house,
• He will be earning an extra $200 per year.
• If Meg could get in touch with Carl, she could lend him
the $1,000 at a rental fee (interest) of $100 per year
 Pareto Improvement
• When an economic action leads to a net
welfare gain without making anyone being
worse off
• Both Meg and Carl are better off
• As both would be earning $100 extra.
• No one’s income falls for the other to earn
more
• Relate it to Pareto Optimality
 Holes in our story..
• What if Meg and Carl hate each other?
• Or, Meg wants Carl to pay her $150 and Carl refuses?
• Or, they do not know each other?
• Search cost for the borrower and lender exceeds
$100…
• What if Carl can pay the loan back after 5 years but
Meg wants it back within the year?
• What if Meg does not trust Carl to pay her back?
 Why do we need Financial Intermediaries?

• If there are financial intermediaries,

• Then,
• Meg and Carl do not have to know each other
• There is no search cost: the market is there
• Meg can choose to lend for a year and Carl
can choose his loan repayment plan
 Advantages of Indirect Finance
• Fin Institutions allow funds to move from
people who lack productive investment
opportunities to people who have such
opportunities.
• They are critical for producing an efficient
allocation of capital which contributes to
– higher production and
– efficiency for the overall economy
 Transaction costs
•Cost associated with exchange of
goods or services and incurred in
overcoming market imperfections
•We’ll only deal with incomplete
information in this course
•Transaction costs cover a wide
RONALD COASE
range
– communication charges
– legal fees,
– informational cost of finding the
price, quality, and durability, etc.,
– transportation costs 

OLIVER WILLIAMSON
 Transaction costs
• TC is time and money spent in carrying out financial
transactions
• TC are a major problem for people who have excess
funds to lend
• Carl the carpenter needs $1,000 for his new tool
• Meg knows that it is an excellent investment
opportunity
• She has the cash and would like to lend him the
money
• But to protect her investment, she has to hire
services of Sasha, a lawyer to write up the loan
contract
 Transaction costs
• The contract specifies how much interest Carl will
pay Meg, when he will make these interest
payments, and when will he repay her the
principal.
• Obtaining the contract will costs Meg $500
• When she figures out the TC she realizes that she
can’t earn enough from the deal
• She would be spending $500 to make $100
• What happens then?
 Financial Intermediaries & TC
• Financial intermediaries substantially reduce TC
• Economies of scale
• Reduction in transaction costs per dollar of
transactions as the size (scale) of transactions
increases.
• A bank hires a lawyer to produce an airtight loan
contract
• Uses it over and over again in all its loan transactions
• Lowers the per unit TC
 Financial Intermediaries & TC

• The Local Bank hires Sasha for $5,000 to draw

up an airtight loan contract
• They use it for 2,000 loans at a cost of $2.50
per loan
• The Local Bank finds it profitable to lend Carl
the $1,000 at the interest of 5% p.a. to be
payable at the end of 1 year. Why?
 Financial Intermediaries & TC
• Low TC for a financial intermediary means that
it can provide its customers with liquidity
• Banks provide depositors with checking
accounts that enable them to pay their bills
easily
• Depositors can earn interest on checking and
savings accounts
 Financial Intermediaries & TC
• The Local bank offers an interest rate of 2%
• So Meg feels that keeping the $1000 in the
bank is a better deal for her
• She gets $1020
 A Short Detour
• Carl runs a ponzi scheme
• A ponzi scheme is an investment
scheme that lures new investors
by offering very high payouts
• Borrow from Meg to pay back
Paul and so on
• Older lenders’ trust gives Carl a
good image
• Misuses lenders’ trust and
absconds with everyone’s money
• Meg loses her $1000 CHARLES PONZI
 Risk Sharing
• Low TC of financial institutions helps reduce the exposure of
investors to risk on returns
• Fin Institutions create and sell assets with risk characteristics
that people of different risk profile are comfortable with
• They then use the funds they acquire by selling these assets
to purchase other assets that may be again be of different
risk profiles
• Earning a profit on the spread between the returns
• This process is also called asset transformation because in
risky assets are turned into safer assets for investors
 Risk Sharing
• Financial intermediaries also promote risk sharing by helping
individuals to diversify
• Thus lowering the amount of risk to which they are exposed
to
• Low TC allow financial intermediaries to do this by pooling a
collection of assets into a new asset and then selling it to
individuals
• Diversification entails investing in a portfolio of assets whose
returns do not always move together, with the result that
overall risk is lower than for individual assets.
• “Don’t put all your eggs in one basket”
 Asymmetric Information
• In financial markets, one party has more information
• This is called asymmetric information
• Carl who wants to take the loan has better information
about the potential returns and risks associated with
his investment scheme
• Meg who is a baker by profession doesn’t know the
risks in carpentry market
• Lack of information creates problems in the financial
system on two fronts: before the transaction is entered
into and after
 Adverse Selection
• Adverse selection is the problem created by asymmetric information
before the transaction occurs.
• It occurs when,
• Potential borrowers who are most likely to produce an adverse
outcome—the bad credit risks—are the ones who most actively seek
out a loan
• Thus are most likely to be selected
• Borrowers with very risky investment projects have much to gain if their
projects are successful, so they are the most eager to obtain loans
• Because probability of giving loans to bad credit risks is higher, lenders
may decide not to lend
• Along with bad creditors, good ones also lose out
Why does adverse selection occur?
• Meg has two neighbours
• Carl and Sally
• She can make a loan to either of them
• Carl is conservative
• He borrows only when he has an investment he is quite sure will
• pay off
• Sally, by contrast, is an inveterate gambler
• She has just come across a get-rich-quick scheme that will make her a
millionaire if she can just borrow $1,000 to invest in it.
• Unfortunately, as with most get-rich-quick schemes, there is a high
• probability that the investment won’t pay off and that she will lose the
$1,000
 Why does adverse selection occurs?
• Which of Meg’s neighbours is more likely to call her for a loan?
• Sally, of course, as she has so much to gain if the investment
pays off
• If Meg knows Sally well she would not want to make a loan to
Sally because there is a high probability that her investment will
turn sour and she will be unable to pay Meg back
• If Meg doesn’t know her neighbours well, she is more likely to
lend to Sally than to Carl as Sally hounds her more
• Meg might decide not to lend to either of them, even though
Carl, who is an excellent credit risk, might need a loan for a
worthwhile investment
 Moral Hazard
• Moral hazard is the problem created by asymmetric
information after the transaction occurs
• Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable
(immoral) from the lender’s point of view,
• This is because they make it less likely that the loan will be
paid back
• Moral hazard lowers the probability that the loan will be
repaid
• Lenders may decide that they would rather not make a loan
• Meg doesn’t have enough information about Carl
 Moral Hazard
• Meg lends $1,000 John, who needs the money to purchase a computer so he can set
up a business typing students’ term papers
• Meg gets an interest of $200
• Once she makes the loan, John is more likely to slip off to the track and play the
horses.
• If he bets on a 20-to-1 long shot and wins, he is able to pay Meg back live with the
remaining $18,800
• If he loses, as is likely, Meg doesn’t get paid back
• John has an incentive to go to the track because his gains ($18,800) if he bets correctly
are much greater than the cost to him (his reputation) if he bets incorrectly
• If Meg knows what John is up to, she will prevent him from going to the track, and he
will not be able to increase the moral hazard.
• But it is hard and costly for Meg to keep track of John
• If she chooses to do so she incurs a cost of $300
• If Meg knew this she would not lend to John
 Try your hand at this problem
• Harry Potter works at the Ministry of Magic. If he
buys a flying car today for $5,000, it is worth $10,000
in extra income next year to him because it enables
him to take up a side job with his best friend Ronald
Weasely.
• Should Harry take out a loan from Dolores Umbridge
at a 90% interest rate if no one else will give him a
loan?
• Will Harry be better or worse off if the probability of
his earning the extra $10,000 is 0.5?
 Principal Agent Problems
• Another way of describing the moral hazard
problem is that it leads to Principal Agent
Problems
• One party in a financial contract has incentives
to act in its own interest rather than in the
interests of the other party.
• John is tempted to go to the track and gamble
at Meg’s expense
 Managing Risk in Financial Institutions

• To be profitable, financial institutions must

overcome the adverse selection and moral
hazard problems
• Possible Solutions
– Already discussed in Session 1
 Financial Panic
• Asymmetric information can lead to the widespread collapse of
financial intermediaries
• Providers of funds to financial intermediaries may not be able to
assess whether the institutions holding their funds are sound
• If providers have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both
sound and unsound institutions.
• The possible outcome is a financial panic that produces large
losses for the public and causes serious damage to the economy
• To protect the public and the economy from financial panics, the
governments may resort to any of the six regulatory measures
 Preventing Financial Panic
• Restriction of entry – banking license limited
• Disclosure: Transparency i.e., reporting
• Restriction on assets and activities
– restrictions on what financial intermediaries are
allowed to do and what assets they can hold
 Preventing Financial Panic
• Deposit insurance
– The government can insure people’s deposits so that they do not
suffer great financial loss if the financial intermediary that holds
these deposits should fail.
• In India Deposit Insurance and Credit Guarantee
Corporation (DICGC) a subsidiary of the RBI insures all bank
deposits, such as saving, fixed, current, recurring deposits for
up to the limit of Rs. 100,000 of each deposits in a bank
• In the US, the Federal Deposit Insurance Corporation (FDIC),
insures each depositor at a commercial bank, savings and loan
association, or mutual savings bank up to a loss of $250,000
per account
 Preventing Financial Panic
• Limits on Competition
– Some are of the opinion that unbridled competition
among financial intermediaries promotes failures
that will harm the public
– Although the evidence is extremely weak, state and
federal governments at times have imposed
restrictions on the opening branches at additional
locations
 Preventing Financial Panic
• Restrictions on Interest Rates
– For decades after 1933, banks were prohibited from paying
interest on checking accounts. In addition, until 1986, the Federal
Reserve System had the power under Regulation Q to set
maximum interest rates that banks could pay on savings deposits.
– These regulations were instituted because of the widespread
belief that unrestricted interest rate competition helped
encourage bank failures during the Great Depression.
– Evidence did not seem to support this view, and Regulation Q for
interest rate regulation was abolished
– In India, we are gradually moving towards lower rates of interest
 Removing Entry Barriers in Indian Banking
sector
• In early January 1993, the RBI Central Board
approved the proposal to give license to new
private banks
• C Rangarajan, RBI Governor, felt it was an
opportune time to open up the banking sector
• Rationale: liberalization
• Efficiency and competitiveness should be
extended to the financial sector dominated by
sluggish state-run banks.
• RBI granted in-principle approvals to the top three
Indian financial institutions then — UTI, ICICI and
IDBI
• The logic
– quasi-state institutions were a better bet
• Later, six more licences were given
– including to a group of professionals led by Ramesh Gelli,
who promoted GTB Bank which ran into trouble years
later
– In the two years between 1999-2000 and 2000-01, the
bank's capital market exposure went up to around 30 per
cent of its total assets
– GTB could not recover in time
• Governor Bimal Jalan’s tenure: 1997 and 2003
• Some of these new-age banks had started
performing well — using technology and offering
vastly superior customer service
• All this had a knock-on impact on the staid state-
owned banks
• In the second round of licensing (2002-03) new
applications’ approval was delegated to an external
committee headed by former RBI Governor I G Patel
• Just two licences were issued in 2003-04 — one to
Kotak Mahindra, and the other to Rabo Bank, the
Yes Bank of today.
• 2010-11
• The RBI under D Subbarao handed over this task to a
committee headed by former Governor Bimal Jalan
• Tougher norms helped keep off many aspirants
• Corporate houses were kept out
• Committee and the RBI settled for just two — IDFC,
an institution-backed firm, and Bandhan Financial
Services — from among 25 applicants in 2014.
• The new Governor, Raghuram Rajan, defended the
conservative stance, given the backdrop of concerns
over governance.