The theory of financial intermediation

1. The theory of financial intermediation

2. Why do financial markets exist? Financial markets facilitate the flow of funds from saving-surplus agents with no profitable use of their funds to saving-deficit agents with profitable projects at their disposal.

3. Graphically

4. Some important questions Does the transfer occur directly between agents or through financial intermediaries? What are some of the deterrents of direct financing? Why do financial intermediaries (FIs) exist? What are some of the key differences between FIs such as banks, venture capital firms, and credit rating agencies? What determines the form of finance (e.g., debt, equity etc.)?

5. Direct funding Funds are provided by ultimate investors to the firm in need of financing (no intermediaries such as banks and VCs are used). Preferred form of funding when investors and the firm are more or less symmetrically informed about the prospects of the project to be funded. Also, more commonly used when moral hazard problems (e.g., incentive to steal from investors) are less severe. Examples for direct funding include capital market transactions (bond and equity issuance).

6. Problems with direct finance Think about a simple world where M investors have excess funds to jointly provide financing to an entrepreneur E�s project. Before making a decision to fund the project, the investors should be convinced to the value/quality of the project. Suppose E knows more about project quality than each of the investors and wants to undertake the project even if its NPV<0. (E gains some private and non-pecuniary benefits of control from the project) In this scenario, how do investors decide whether the project is worth investing in?

7. Screening When there is asymmetric information between E and the investors regarding project quality, investor can discover E�s private information by gathering information (i.e., screening). Gathering information is costly. Suppose it costs each investor C to screen E. Assuming investors do not communicate with each other, the aggregate screening cost amounts to MxC. If MxC is high, then investors may be deterred from funding even positive NPV projects. This is referred to as the �duplication of effort� problem.

8. Free-Rider Problem Duplication of effort is not the only problem associated with direct financing. If investors are atomistic (each funds a small portion of the project) no investor has the incentive to screen E because the cost of screening (C) is likely to be less than the benefit from screening since the benefits are shared by all M investors. Therefore, unless there is an investor who holds a relatively large stake in the project who will find it incentive compatible to screen the project (ex ante and ex post), there will be no funding for E�s project. This is the well-known free-rider problem.

9. Delegating to an information agent To make funding of positive NPV projects possible, investors may delegate screening (ex ante) and monitoring (ex post) to a financial intermediary that is specialized in producing information at a low cost. Credit rating agencies such as S&P and Moody�s, research analysts at brokerage firms are examples of such intermediaries. Two problems associated with this sort of intermediation: RELIABILITY PROBLEM: Difficult to convince investors to the value/quality of information that the intermediary generates. APPROPRIABILITY PROBLEM: This model of intermediation may not be viable if investors can freely share information reducing the intermediaries profits.

10. Solution One mechanism to deal with the reliability and appropriability problems (or delegation costs) is to have the intermediary invest its own equity in the project. 10% of risk-weighted bank assets consists of equity. It�s common practice in the VC and PE industries for general partners (or fund managers) to supply about 2% of the funds. Another mechanism is reputation. For example, underwriters do not take equity stakes in bonds or shares that they sell, but their repeated interaction with investors motivate them to tell the truth (sometimes!) about the quality of securities that they help issuers sell.