Week 2

Why do banks exist?

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Week 2 Chapter 8

An Economic Analysis of the

Financial Structure

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
8.1 Identify eight basic facts about the global financial system.
8.2 Summarize how transaction costs affect financial
intermediaries.
8.3 Describe why asymmetric information leads to adverse
selection and moral hazard.
8.4 Recognize adverse selection and summarize the ways in
which they can be reduced.
8.5 Recognize the principal-agent problem arising from moral
hazard in equity contracts and summarize the methods for
reducing it.
8.6 Summarize the methods used to reduce moral hazard in
debt contracts.
Flows of Funds Through the Financial System
Sources of External Funds for Businesses
 8 Basic Facts About Financial Structure
Throughout the World
1. Stocks are not the most important sources of external
financing for businesses.
• Why is the stock market less important than other
sources of financing?
2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their operations.
• Why don’t businesses use marketable securities more
extensively to finance their activities?
3. Indirect finance is many times more important than direct
finance
• Why are financial intermediaries and indirect finance
so important?
8 Basic Facts About Financial Structure
Throughout the World
4. Financial intermediaries, particularly banks, are the
most important source of external funds used to
finance businesses.
• Why are banks so important for the financial
system?
5. The financial system is among the most heavily
regulated sectors of the economy.
• Why are banks (and financial markets) extensively
regulated?
6. Only large, well-established corporations have easy
access to securities markets to finance their activities.
• Why?
8 Basic Facts About Financial Structure
Throughout the World
7. Collateral is a prevalent feature of debt contracts for
both households and businesses.
• Secure (collateralised) debt versus unsecured debt
• Why is collateral such an important feature of debt
contracts (such as bank loans)?
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive covenants
on borrowers.
• Why are debt contracts complex and restrictive?
 8 Puzzles
1. Why is the stock market less important?
2. Why marketable securities are not used more extensively?
3. Why FIs and indirect finance so important?
4. What makes banks so important?
5. Why are financial markets extensively regulated?
6. Why do only well known corporations find it easier to raise
funds in securities market?
7. Why is collateral such important?
8. Why are debt contracts so complex and complicated?
Transaction Costs

• Transaction costs are a major problem in

financial markets.
• If an average household want to invest in stock
or bond markets than amount of his/her
investment should be high because of:
– Fees such as brokerage commission.
– Entrance to market is difficult because of
denomination restrictions
– Brokers might not bother
– Difficult to diversify the portfolio
– Legal costs
Transaction Costs
• Bundling funds together reduces the transactions
costs.
• Presence of economies of scale explains why FI’s
developed and have become such an important part
of financial system.
– Mutual funds: Is a financial intermediary that
sells shares to individuals and then invests the
proceeds in bonds or stocks.
• Expertise
– Services to inform the customer
– Provide liquidity
• Solves Puzzle 3
Asymmetric Information

• A situation where one party to a financial transaction has

better information than the other about factors relevant to
the transaction.

Moral Hazard:
Adverse Selection: Is Is the problem
the problem created created by
by asymmetric asymmetric
information before the information after the
transaction occurs. transaction occurs.

• Agency Theory: The analysis of how asymmetric

information problems affect economic behaviour.
Akerlof “lemons problem”, 1970

• George Akerlof won a Nobel price for identifying the “lemons problem”:
Lemons sold in the used-car market.
• Similar lemons problem arises in the financial markets.
The Lemons Problem

• How adverse selection influences financial structure?

• As investors does not know which firm is better due to “adverse
selection”, they are willing to pay an average price:
– That is a price that lies between the value of securities from
bad firms and the value of those from good firms.
• Good firms with undervalued securities will not come to the
market, while bad firm will be willing to sell securities.
• The securities market will not work very well because few firms
will be selling securities in it to raise debt.
• Solves Puzzle 2.
Solution to Adverse Selection Problem
• Asymmetric information can be eliminated by furnishing
lenders with full details about the individuals and firms
seeking funds.
• Private companies (i.e. S&P, Moody’s) gather information on
firms balance sheets, investment activities and sell these to
their subscribers.
• Free-rider problem: Occurs when people who do not pay for
information take advantage of the information that other
people have paid for.
• Because of free rider problem private firms may not be able
to sell enough of information to make it worth their effort to
gather information → which means less profit for these firms
 Government Regulation
• Government regulates securities market in a way to
encourage them to reveal honest information about
themselves so that investors can determine between good
and bad.
• Requirement of disclosing information on sales, assets,
earnings etc.
• Solves puzzle 5.
• Government regulation to increase information for investors is
needed to reduce the adverse selection problem, which
interferes with the efficient functioning of securities markets.
• Does this fully eliminate adverse selection?
 Financial Intermediation
• How can the financial structure help promote the flow of funds
from if there is adverse selection problem?
• Akerlof: Used car market versus Car dealers.
• A bank becomes an expert in the production of information about
firms, so that it can sort out good credits from bad ones.
• The profit that banks earns allows it to engage in this information
productivity activity.
• Banks tackles the free-rider problem because it makes private
loans.
• The banks holds mostly non-traded loans is the key to its
success in reducing asymmetric information problems in financial
markets.
• Solves puzzles 3 and 4.
Financial Intermediation
• Financial intermediation is even more important in developing
countries, as collecting information about firms is harder in such
countries.
• As the information becomes more available the lending role of
FI’s should decline (i.e. US).
• Larger firms are more likely to obtain funds from securities
market, direct finance. The better known the firm the more
information is available about its activities.
• Collateral: Reduces the consequences of adverse selection
– How?
• If a borrower defaults than the lender can sell the collateral and
cover for the loss. Solves puzzle 7.
Solutions to Moral Hazard – Equity contracts
• Equity contracts: are claims to a share in the profits and
assets of a business.
• Equity contracts are subject to a particular type of moral
hazard called the principle-agent problem.

Managers: Agents Stock Holders: Also

Firm
of the owners. called principles.

• Managers have less incentive to maximize profits.

• The principle agent problem would not arise if the owners
of the firm had complete information about what the
managers up to → asymmetric information.
Tools to solve Principle Agent Problem
• Monitoring: Auditing the firm regularly and checking on
what the management is doing.
• But monitoring can be costly which makes equity
contracts less desirable and explains in part why the
equity is not the most important element of financial
system
• Moreover, free rider problem decreases monitoring.
• Government regulation to increase information. –
standard accounting principles are enforced, strict laws to
prevent fraud of hiding and stealing profits.
• Financial Intermediation have the ability to avoid this free
rider problem. Example: Venture capital or private-equity
firm.
Tools to solve Principle Agent Problem
• Moral hazard arises with an equity contract, which is a
claim on profits in all situations, whether the firm is
making or loosing money.
• Debt contracts: do help to solve the moral hazard
problem.
– They are more attractive because the lender only
receives a fixed amount independent from firms profit
or loss.
• Therefore less monitoring is needed.
• Another reason why debt contracts dominate.
 How Moral Hazard Influences financial
structure in debt markets
• Moral hazard in debt contracts arises when borrowers have an
incentive to take on investment projects that are riskier than the
lenders would like.
• Net Worth: When borrowers have more at stake because their
net worth is high the risk of moral hazard will be reduced.
• Incentive-compatible: If a debt contract is incentive compatible
than it aligns the lenders incentives with those of borrowers.
• Monitoring and enforcement of covenants.
• Restrictive covenants are directed at reducing moral hazard
either by ruling out undesirable behaviour or by encouraging
desirable behaviour.
 Covenants
• There are 4 types of covenants.
– Covenants to discourage undesirable behaviour.
– Covenants to encourage desirable behaviour.
– Covenants to keep collateral value.
– Covenants to provide information.
– Facility agreements | NatWest Group
• One problem with covenants is that they must be monitored
and enforced.
– And these activities are costly.
• Once again we face the free rider problem.
• Banks have the ability to avoid the free-rider problem
because they make private loans.
Week 2 Chapter 9

Basics of bank balance sheet

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives
9.1 Summarize the features of a bank balance sheet.
9.2 Apply changes to a bank’s assets and liabilities on a
T-account.
Financial Intermediation “going-between”

Assets Liabilities

Video: https://www.investopedia.com/terms/f/financialinstitution.asp
The Bank Balance Sheet
Assets (Uses of Funds) Liabilities (Sources of Funds)

Assets Liabilities
Capital

Assets = Liabilities + Capital

• Sources and uses of funds.

• Bank obtain funds by borrowing and by issuing other
liabilities such as deposits.
• Then they use these funds to acquire assets such as
securities and loans – income earning assets.
• How does a bank profit?
The Bank Balance Sheet
Assets (Uses of Funds) Liabilities (Sources of Funds)

Assets Liabilities
Capital

• Charging an interest rate on their holdings of securities and

loans that is higher than the expense of their liabilities.
The Bank Balance Sheet
Assets (Uses of Funds) Liabilities (Sources of Funds)

Reserves Demand Deposits

Cash Items
Time Deposits
Securities
Borrowings
Loans
Fixed Assets Capital
Lets look at a real bank

https://www.santander.co.uk/assets/s3fs-public/documents/santander_uk_group_holdings_plc_2022_an
nual_report.pdf
Liabilities – Deposits
• Demand deposit: A demand deposit is a conventional bank
and savings account.
– You can withdraw the money anytime from a demand
deposit account without advance notice.
– Allows the owner of the account to make a payment
(using a check or a debit card)
• Time deposits: Time deposits often has a fixed time and
usually pay a fixed interest rate
– These interest-earning accounts offer higher rates
– Time deposit accounts require that money be kept in the
account for a set period of time.
Liabilities – Demand deposits
• A demand deposit is an asset for the depositor, and a liability of the
bank.
• They are usually the lowest cost sources of bank funds. Why?
• Because depositors are willing to forgo some interest in order to
have access to a liquid asset that can be used to make purchases.
• Bank’s costs of maintaining deposit accounts include
– Interest payments
– Costs incurred in servicing these accounts
▪Processing and managing debit card payments
▪Processing and storing cancelled checks
▪Preparing and sending out monthly statements
▪Providing efficient tellers, branches
▪Advertising & Marketing
Liabilities – Time Deposits
• Time deposits are one of the primary source of bank funds.

• Two types (examples):

– Transaction and interest payments are recoded in a
monthly statement book held by the owner of the
account.
▪Funds can be added or withdrawn.
– Fixed maturity length, early withdrawal is penalized.
▪Less liquid for depositors, pays higher interest.
▪More costly source for banks.
Liabilities – Borrowings
• Funds obtained from Central Bank (Fed in US, BoE in
England), other banks and corporations.
– Discount loans (also known as advances): Borrowings
from Central Bank
– Banks borrow reserves from central banks O/N.
– Other sources are parent companies (bank holding
companies),
– Loan arrangement agreements (such as REPO)
• Borrowing long-term
– Via issuance of bonds
Assets – Reserves
• A bank uses the funds that it has acquired by issuing
liabilities to purchase income earnings assets – uses of
funds.
• All banks hold some of the funds they acquire as deposits
in an account at the Central Bank.
• Reserves are these deposits plus currency that is physically
held by banks.
• Currency reserves: Also called vault cash because it is
stored in bank vaults overnight.
• Reserves does not pay interest.
– So why do banks hold reserves?
Assets – Reserves
• Required reserves: Are held because of reserve
requirements.
• Reserve requirements: For every unit of deposit at a bank,
a certain fraction must be kept as reserves.
• This fraction is called required reserve ratio.
• Banks hold additional reserves, called excess reserves,
because they are the most liquid of all bank assets and
can be used by a bank to meet its obligations when funds
are withdrawn.
Assets – Cash Items in Process of
Collection, Deposits at Other Banks
• Cash Items in Process of Collection: Funds that are not
collected by the depositor.
– For example: The check is classified as a cash item in
process of collection, and it is an asset for your bank
because it is a claim on another bank for funds that will
be paid within a few days.
• Deposits at Other Banks: Banks hold deposits in other
banks in exchange for a variety of services such as foreign
exchange transactions, and securities purchases (also
called Correspondent Banking)
• Reserves + Cash Items in Process of Collection + Deposits
at Other Banks = Cash Items.
 Assets – Securities
• A bank’s holdings of securities are an important income-
earning asset.
– They account 25% of bank assets in US.
• Securities are held in form of debt instruments for commercial
banks, because they are often not allowed to hold stocks.
• Government, state (in the US) and local government securities.
• Because of their high liquidity, short-term government
securities are called secondary reserves.
• State and local government and other securities are less
marketable and less liquid.
Assets – Loans
• Majority of bank assets are in the form of loans.
• A loan is a liability for the individual or corporation receiving
it – an asset for bank as it provides income
• Commercial loans, industrial loans, real estate loans.
• Loan are less liquid – they can not be turned to cash until
the loan matures.
• Loans have the highest default probability out of all Assets.

• So what does this mean in terms of income for bank?

• Bank earns its highest return on loans.
• Loan portfolio determines specialization of the bank.
• For example: Saving and loans and mutual saving
banks specialize in residential mortgages, while credit
unions tend to make consumer loans.
Basic Banking
• Banks make profits by selling liabilities with one set of
characteristics – liquidity, risk, size, and return.
• And using the proceeds to buy assets with a different set
of characteristics – liquidity, risk, size, and return.
• This is called Asset Transformation
• Example: Demand deposits → Mortgage Loan.
• “borrow short term lend long term”
• The process of transforming assets and providing services
is like any other production process in a firm.
• If the bank produces desirable services at low cost and
earns substantial income on its assets, it earns profits.
Financial Intermediation “going-between”

Assets Liabilities

Video: https://www.investopedia.com/terms/f/financialinstitution.asp
42
Basic Banking
• Jane has heard that the Original Four Bank provides
excellent service, so she opens a check account with a
$100.
Assets Liabilities

Vault Cash + $100 Checkable deposits + $100

Assets Liabilities

Reserves + $100 Checkable deposits + $100

 Basic Banking
• If Jane opened her account with a $100 check written on
an account at another bank – Zanzi-Bank.

Zanzi-Bank
Assets Liabilities

Reserves - $100 Checkable deposits -$100

• When a bank receives additional deposits, it gains an

equal amount of reserves; when it loses deposits, it loses
an equal amounts of reserves.
Basic Banking
• Now assume that Reserve requirement ratio is 10%.
• The banks needs to make profits! So makes loans.
• Asset transformation.
• “borrowing short lending long”

Assets Liabilities

Required Reserves + $10 Checkable deposits + $100

Excess Reserves + $90

Assets Liabilities

Loans + $90 Checkable deposits + $100

Required Reserves + $10