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Fundamentals of Banking

Fundamentals of Banking. ECO 473 - Money & Banking Dr. D. Foster. Asymmetric Information & Banking. Direct & Indirect Finance. Most external financing is done through intermediaries. Banks Reduce Transaction Costs. Banks reduce the cost of acquiring assets. Many costs are fixed.

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Fundamentals of Banking

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  1. Fundamentals of Banking ECO 473 - Money & BankingDr. D. Foster Asymmetric Information & Banking

  2. Direct & Indirect Finance Most external financing is done through intermediaries.

  3. Banks Reduce Transaction Costs • Banks reduce the cost of acquiring assets. • Many costs are fixed. • Bank assets are highly liquid. • Economies of scale. • e.g., using standard loan contracts as legal fees are averaged over many loans • Transactions costs are very low for lines of credit.

  4. Adverse Selection • Those most eager to make a deal are the least desirable to the other party. • Bad risks want loans. • Firms with lots of risk want to sell bonds. • Risk drives up interest rate & drives out low risk borrowers. • If this problem persists …

  5. Moral Hazard • Post-contractual change in behavior that puts other party at increased risk. • Will borrower really be prudent and repay? • Will company really be prudent and max. profits? • Does insurance reduce vigilance? • Markets cannot form if this persists.

  6. Principal-Agent Problems • The action of the agent is contrary to the desires of the principal. • Workers shirk at their jobs. • Managers are also agents - they work for owners- shareholders. • Can bond-holders and stock-holders really monitor the firm? • Problems: Enron, Arthur Anderson

  7. How do Banks Deal with Asymmetries? • Screen borrowers. • Avoids free rider problems with information. • Requirements for collateral and net worth. • Shifts risk to the borrower; avoids adverse selection. • Also, mitigates moral hazard. • Imposing covenants and monitoring. • Reduces moral hazard. • Variable interest rates and credit rationing. • Some tolerance for risk. Should the government get involved with asymmetries?

  8. Cases involving asymmetric information Enron -- Stock price: $83 Feb 2001; $0.21 Dec 2001 -- Business: trading energy futures -- Overvalued assets; hid losses -- Downfall took Arthur Andersen -- Employee with 401k in Enron lose out Bernie Madoff -- Wall Street banker since 1960s -- Prominent philanthropist -- Client losses = $50 billion -- “Ponzi” scheme began in 1991 -- “Model” unreplicated; targeted charities

  9. Fundamentals of Banking ECO 473 - Money & BankingDr. D. Foster Asymmetric Information & Banking

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