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Financial Intermediation - Theories of
Financial Intermediation
2013-2014
Contents
2
A. Learning Objectives
B. Introduction to Financial Intermediation
Functions
of FIs
C. Transaction costs
Financing
sources
D. Information asymmetry
FINANCIAL INTERMEDIATION
D1.
Information sharing coalitions

Delegated monitor
D3. Mechanism for commitment
THEORIES OF FINANCIAL
INTERMEDIATION
D2.
2013 Lillibeth Ortiz
Contents
3
A. Learning Outcomes
4
E. Liquidity insurance
F. Other Specialness
G. Past Year Exam Questions
H. Essential Readings
Critically analyse key elements of the theory

of financial intermediation with respect to
delegated monitoring
Clearly discuss and carefully contrast the
theories of financial intermediation in the
context of:
transaction
costs,
insurance,
information asymmetry, and
financing sources for borrowers.
liquidity
A. Questions
5
B. Two Types of Economic Entities

6
Why are Financial Intermediaries (FIs)

special?
Surplus units
Deficit units
Why
do we need banks?
is the role of FIs in the overall allocation
of capital?
Why do various FIs receive special regulatory
attention?
Why do governments bail out FIs?
What
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Exercise:
B. Exercise: What are the requirements
think-pairof a typical saver & borrower?
share
Savers
Requirements
2013-2014
B. Without FIs
8
Imagine a world without FIs

(Direct financing)
Borrowers
Requirements
Equity & Debt
Size
Maturity
Liquidity
Households
Corporations
(net savers)
(net borrowers)
Cash
Diagram from: Saunders & Cornett, Financial Institutions Management
Risk
B. Issues without FIs
B. With FIs
10
Without FI, fund flows are low due to the

following disincentives:
Liquidity
cost (less liquidity, longer maturity)
Information
Substantial
Large
FIs act as intermediaries between surplus &

deficit sectors
FI
Households
/ monitoring costs
Cash
price risk
Deposits/Insurance
Policies
denominations
(Brokers)
FI
(Asset
Transformers)
Corporations
Equity & Debt
(Primary securities)
Cash
(Secondary securities)
Diagram from: Saunders & Cornett, Financial Institutions Management
B. Two Functions of FIs

11

12
1.
Brokerage function
FIs
act as an agent for investors:
Provide information and
transaction services
Reduce information and transaction costs through

economies of scale
Encourage higher volume of savings
Do
not change the nature of the claim being

transacted
Source: Bhattacharya & Thakor,

Contemporary Banking Theory, 1992
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2013-2014

13

14
2.
Asset transformation (or Quantitative

Asset Transformation)
Accepts
funds from surplus units and lends to

deficit units
FIs
purchase primary securities (debt &

equities) from borrowers by selling/issuing
secondary securities (deposits & insurance) to
savers
E.g.,
Buys
claims that are more attractive to savers

than the claims directly from corporations
Alter the nature of the claims
Questions
15
banks
and sells financial assets
E.g.,
Issue
Types of financial intermediaries
insurance companies, pension funds, trusts
In this course, we refer to
B. Transformation: Balance Sheets

16
How do FIs fulfill investors requirements in

Asset Transformation?
What attributes are modified?
How are the secondary securities more
attractive?
What are the distinguishing features of
banks liabilities (e.g., deposits)?
Savers
Assets Liabilities
B. Banks Liability Characteristics

17
Bank
Assets Liabilities
Borrowers
Assets Liabilities

18
Fixed sum
Short term
Liquid can be withdrawn on demand
Mostly not transferable
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In asset transformation, FIs hold the long-term,

high risk, large denomination claims issued by
borrowers (loans) and finance this using

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19
B. True or False?
20
Asset transformation includes 2 subfunctions:

1.
Asset diversification
2.
Asset evaluation
Financial institutions intermediate between

suppliers and demanders of money.
The asset transformation function of an FI is

to issue primary financial claims to
corporations while purchasing primary
claims issued by households and other
investors.
Review Questions
21
Review Questions
22
What is/are the main reason(s) for the low

volume of direct financing transactions?
1.
2.
3.
4.
5.
Financial intermediaries fulfill which of the

following functions?
High monitoring costs

Transaction cost
Price risk
Liquidity cost
All of the above
1.
2.
3.
4.
5.
Review Questions
23
Brokerage
Asset transformation
Savings provider
All of the above.
Only 1 and 2 above.
Theories of Financial Intermediation

24
What are the benefits of issuing financial

claims by FIs compared to those issued by
corporations
1.
2.
3.
4.
5.
No change in the nature of the claim

Lower price risk and liquidity risk
Lower transaction and monitoring costs
All of the above
Only 2 and 3 above
C1. Financing sources
D1. Information sharing coalitions
D2. Delegated monitor
E. Liquidity Insurance
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Exercise:
C. Transaction Costs
25
C. Exercise: Transaction Costs think-pairshare
26
Benson & Smith (1976)

Banks
exist because of transaction costs
Recall the transaction costs in the transfer of

funds from PBF.
Describe the transaction costs WITHOUT a
bank:
Group A: for a saver looking for investments
Group B: for a borrower looking for funding
C. Illustration
27
28
C. Transaction Costs: Borrow direct

(without FIs)
29
Each saver has $50,000 to invest

A borrower needs to borrow $500,000 for its
project
What are the 2 options of the borrower?
C. Illustration: Direct Transaction

30
Return to savers
Cost to Borrower
R TS
R + TB
where
R = interest rate
TS = cost incurred
where
R = interest rate
TB = cost incurred
Option 1
Each saver earns 6% (R) on investment but
incurs transaction cost of $1,000 (TS = 2%)
Net
Borrower
pays 6% (R) interest on loan but

incurs transaction cost of $20,000 (TB = 4%)
Net
Total
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return = R TS =
borrowing cost = R + TB =
transaction costs = TB + TS =

2013-2014
Exercise:
C. Transaction Costs: With FI

31
think-pairC. Illustration: Transact With Bank

share
32
Return to savers
Cost to Borrower
RS = R TS 1
RB = R + TB1 + C
Option 2:
Saver
invests in bank at 6% and incurs

transaction cost of only 0.1%
Net
return =
Bank
can lend at a cost of 2% (borne by

borrower)
Borrower pays bank 8% interest (including
banks cost) and incurs cost of 0.1%
Where:
C Charge raised by intermediary (banks transaction costs
borne by borrower)
T1
indicates the respective borrowers & savers costs after
the introduction of the bank
Spread = RB RS =
TB1
Net
Total
+ TS + C
1
33
borrowing cost =
transaction costs = TB1 + TS1 + C =
Exercise Questions
34
The bank lowers the cost of the transaction if:
Total cost without bank > Total cost with bank

TB + TS
>
TB1 + TS1 + C
35
Exercise:
think-pairshare
Why is it reasonable to think that FIs would

reduce transaction costs?
What advantages do banks have?
What are the sources of cost savings?
C. Questions
36
FIs reduce transaction & information costs

through:
through the capital markets?
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But why are there firms that still raise funds

How do borrowers choose among banks,
non-bank FIs and the capital market?

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C1. Transaction Costs Source of

Financing
37
C1. Illustration
38
Borrowers face a variety of financing

sources, e.g.,
How will each company raise funds?
Capital
market (equity, bonds, commercial

paper)
Banks
Venture capitalists

Financing
39

Financing
40
Capital markets
Many
large firms with established reputations,

low credit risk and good future prospects
bypass banks and find direct financing
through capital markets cheaper (lower cost
of capital by issuing securities)
Since
these borrowers are relatively new,

without well established credit reputations,
they have more to gain from bank monitoring
Banks can screen and monitor these
borrowers more effectively
Bank loans are easier to re-negotiate

Financing
41
Smaller, less well known firms will use

as a source of finance (Diamond, 1991)
Research
42
Borrowers
Characteristics
Management
Skills
Future profits
Credit risk
Credit
reputation
Venture
Capital
Not
established
Not
established
Not
established
Not
established
Financing Source
Bank
Capital Market
Well
established
Poor prospects
High
Not
established
Well
established
Good
prospects
Low
Further reading: Market microstructure

theory
Why are smaller, less well known firms likely to
have high bid-ask spreads: high transaction
costs for investors, higher cost of capital?
Established
Source: Bhattacharya and Thakor, 1993
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True or False?
43
Review Question
44
New borrowers without well-established

reputations will choose banks instead of
capital markets
Large, well-established borrowers with low
credit risk and good future prospects bypass
banks
Which factor(s) determine the borrowers

choice of its financing source?
1.
2.
3.
4.
5.
C. Questions
45
Its ideas
Its credit history
Its investment opportunities
All of the above
Only 2 of the above
Theories of Financial Intermediation

46
Do you think reducing transaction costs is

the only reason banks exist?
What are the other sources of banks
advantages?
C1. Financing sources
D2. Delegated monitor
D. Exercise: Match concept with

example
D. Information Asymmetry
47
48
Recall these concepts:

Information Asymmetry
Adverse Selection
Moral Hazard
Free Rider Problem
Agency Costs
1.
2.
3.
4.
5.
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Information
Asymmetry
Adverse
Selection
a.
b.
Moral
Hazard
c.
Free Rider
Problem
d.
Agency
Costs
e.
If someone buys theft insurance for

laptop, he may be more likely to leave
laptop in his car
A sickly person may be more inclined to
buy life insurance than a healthy one
Investors observe informed traders &
buy the same security at the same time
Conflict of interest between the
shareholders who own a public
company and the managers who run it
May result in one party taking
advantage of the other partys lack of
knowledge

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D. Exercise: Match concept with

explanation
49
1.
2.
3.
4.
5.
50
Information
Asymmetry
Adverse
Selection
a.
b.
Moral
Hazard
c.
Free Rider
Problem
d.
Agency
Costs
e.
Costs relating to the risks that owners &

managers of firms that receive savers funds
will use those funds contrary to the best
interests of the savers
Borrower may engage in activities that
reduce probability of loan repayment
One party has superior information
compared to another (e.g., borrower knows
more than lender)
Lender may select wrong projects &
borrowers likely to produce a bad outcome
actively seek out loans.
People who do not pay for information take
advantage of info acquired by others.
Explains why investors are reluctant to buy
information.
51
Information is asymmetric: borrower knows

more than the investor (or lender) does
about the specific risk & returns of any
project that is being financing
Investors need to collect information about
the borrowers actions in a timely &
complete manner
Information is costly & not equally available
to every investor
Question
52
Information asymmetry raises 2 further

problems:
Moral
Hazard
Selection
How do banks help to overcome or reduce

the impact of the problems due to
information asymmetry?
Adverse
53

54
Banks help to overcome these problems by:

1.
Forming information-sharing coalitions
2.
Operating as delegated monitors of

borrowers
3.
Leyland & Pyle (1977)

Lender must collect information, since the
borrower knows more about its project risks
than the lender
Information is costly to obtain but can easily
be resold or shared (public good)
Providing a mechanism for long-term

commitment with borrowers
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Questions
55

56
Given the above,

How
do you distinguish accurate/correct
information vs poor information?

What
will be the price of information?
Original
firm may not recoup value of

information collected
Questions
57
Information quality is hard to ascertain

Thus, the price of information will reflect
quality
Firms that search for high quality information
will lose money

58
Why would investors bother to collect good

information?
How does a bank overcome these
problems?
Information
is kept private and nontransferable so bank has the incentive to

gather good information
Borrower may offer collateral security to bank
D2. Questions
59
Bank can use information to buy and hold

assets in its portfolio
Bank benefits from having many diverse

borrowers and from _____ _____ _____ _____
_____ _____ _____ _____
D2. Investors Options

60
Why do investors first lend to banks who

then lend to borrowers, instead of lending
directly?
What is the financial technology that gives
the banks the ability to serve as
middleman?
1.
Invest directly
A.
B.
2.
Monitor directly
Do not monitor
Transact with
bank
Delegate
monitoring to a
bank
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D2: Option 1: Invest directly

61
D2: Option 1: Invest directly

62
Lender 2
Lender
Lender 1
Lender m
Borrower
Question
63
When investors make direct investments in

corporations, they must monitor the
corporation effectively otherwise they
would be exposed to _____ _____ costs.
(Diamond (1984))
However, there is a high cost of information
collection for investors and a lack of
expertise
So, often investors leave it to each other to
collect information and monitor firms (_____
_____ problem)
D2: Option 2: Delegate to bank

64
Why not place funds with a bank and

appoint the bank to act on their behalf in
collecting information and investing funds?
Savers delegate authority to FIs to invest in

financial assets. FIs pool the funds of investors
and invest directly in the corporations.
Saver
2
Saver
1
D2. Delegated Monitoring
Saver
m
BANK
Borrower

66
FIs will have a higher stake than each

investor and therefore will have greater
incentive to collect information.
FIs reduce information costs when acting as
Delegated Monitor (Diamond, 1984)
The
average cost of information is lower as FIs

enjoy economies of scale in information
production & collection
FI likely to have informational advantage,

monitoring power and control
Development
of private, short term loans give

banks more incentive to monitor and an
advantage in collecting information
Shorter
term debt contracts easier to monitor

than bonds
Source: Saunders & Cornett, Financial Institutions Management, 2008
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Questions
68
FIs can have a well diversified portfolio with

more predictable returns
Lower
When does delegated monitoring pay off?

What
are the costs of external financing (per

borrower) under imperfect information?
What are the costs when monitoring is
delegated to a bank?
variance of returns
Thus, banks transform loans that need costly

monitoring and enforcement into bank
deposits that do not (need monitoring)
through _____ _____ _____ _____
D. Questions
69
Delegated monitoring pays off when its

costs are less than direct financing:
K + D min [S, m x K]
How do investors know that the information

provided by the monitor is reliable?
Who monitors the monitor?
Why would banks monitor? 4Rs
R
R
where
K is the cost of monitoring
D is the delegation cost per borrower
S is the contracting cost without monitoring
m x K is the cost of direct monitoring by m lenders
R
R
Questions
71

72
How do you ensure that the borrower will

not run off with the money?
Can you put all conditions in a contract?
It
is impossible to draw up complete, binding

contracts
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No contract can specify all possible

outcomes and commit borrowers to their
bank over the _____ _____
Banks close relationship with their borrowers

may provide an alternative means of longterm commitment (Mayer (1990))
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73

74
Banks close relationship with its borrowers

enables it to:
Have
good information about borrowers

future prospects
Take remedial actions other than foreclosure
Ameliorate moral hazard and adverse
selection problems
Main
bank has an _____ _____ ___ advantage

over other financiers
Banks provide _____ _____, i.e., develop
secondary securities, that result in more
effective monitoring
D. True or False?
75
Borrowers are committed to their main

bank
D. Review Question
76
Information asymmetries bring about which of

the following issues:
If not done by FIs, the process of monitoring the

actions of borrowers would reduce the
attractiveness and increase the risk of investing in
corporate debt and equity by individuals.
a)
b)
Failure to monitor the actions of firms in a timely

and complete fashion after purchasing securities in
that firm exposes the investor to agency costs.
c)
Because bank loans have a shorter maturity than

most debt contracts, FIs typically exercise less
monitoring power and control over the borrower.
d)
e)
D. Review Question
77
Moral hazard and adverse selection

It may not be profitable for investors to
search for high quality, costly information
Investors dont have time, inclination or
expertise to monitor borrowers
It is impossible to write contracts that specify
all possible outcomes
All of the above
D. Review Question
78
In its role as a delegated monitor, the FI

a. keeps track of required interest and principal
payments.
b. works with financially distressed borrowers in
danger of defaulting on their loans.
c. holds portfolios of loans.
d. maintains contact with borrowers so as to
ensure that loan proceeds are utilized for
intended purposes.
e. All of the above.
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Why do households prefer to use FIs as

middle persons to invest their surplus
funds?
a. Since FIs are very efficient, the middle
person's transaction costs are quite low.
b. To achieve the benefits of diversification.
c. The FI can obtain information in a less costly
way than individual households.
d. All of the above.
e. Answers b and c.
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E. Illustration
E. Questions
79
80
How long do savers want to commit their

savings?
How long do borrowers need the funds
theyve borrowed?
Why do banks offer deposits that are
cashable on demand?
What is liquidity?
What is insurance?
Savers
E. Savers Options
81
want access to cash

anytime at a fixed
price
Borrowers
want borrowed funds

to be committed until
maturity
E. Banks Solution
82
If savers invest directly and they need funds

before maturity,
Sell
the investment (claim) at secondary

market price
Alter their consumption
Maintain a pool of liquidity
can
be withdrawn anytime at a _____ price,

with low risk
has a smaller loss from early liquidation than is
available holding the illiquid assets directly
E. Bank Solution
83
Banks create demand deposits to provide

savers with liquid investment assets
Deposits
E. Bank Solution
84
Bank accepts deposits from various sources

Bank expects only a small fraction of
withdrawals in the short term (i.e., individual
expenditure needs are largely
uncorrelated)
Bank does not need to hold the full cash
amount for deposits given
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Bank can make loans over a long horizon,

while keeping only relatively small amounts
of cash on hand for withdrawals
Banks provide better risk sharing among
people who need to consume at different
random times by issuing deposits (Diamond
& Dybvig (1983)
14

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E. Illustration
85
86
Bank Balance Sheet
E. Questions
87
In pooling together investors funds, FIs offer

low monitoring, highly liquid & low price-risk
contracts (e.g., deposits) to savers & invest
in relatively illiquid securities (e.g., loans)
The service of improving liquidity through
offering of secondary securities which have
superior liquidity attributes compared to
primary securities is called _____ _____ _____
_____ _____ _____ _____.
E. True or False?
88
How do banks fund illiquid assets with liquid

liabilities?
F. Research: Other Special Services

89
The ability of diversification to eliminate much

of the risk from the asset side of the balance
sheet of an FI is caused by the choice of assets
that are less than perfectly positively
correlated.
FIs typically provide secondary claims to
household savers that have inferior liquidity
attributes than the primary securities of
corporations such as equity and bonds.
Maturity Transformation
90
Maturity intermediation
Transmission of monetary policy.
Credit allocation (Areas of special need
such as home mortgages).
Intergenerational transfers or time
intermediation.
Payment services
Denomination intermediation.
May arise as a consequence of the banks

provision of liquidity
Bank assets are financed with liabilities of a
shorter maturity
Thus,
banks need to refinance & reprice

liabilities more frequently
Demand deposits can be withdrawn
immediately
Source: Saunders & Cornett, Financial Institutions Management, 2011
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2013-2014
Recap
Recap: theories
91
92
Banks fulfill savers need for:

information and monitoring costs
Low price risk
High liquidity
Small transaction size
Banks lower transaction & information costs
Banks overcome information asymmetry by:
Low
Having the incentive to collect high quality,

private information
Monitoring borrowers on behalf of investors given
banks informational advantages, monitoring
power and control and portfolio diversification
Having long term relationships with borrowers
Banks have 2 main functions:

Brokerage
Asset
transformation
Research
93
Banks can finance smaller, less reputable firms
Banks offer highly liquid, low risk deposit

contracts to savers
Review Question
94
Advantages of depositing funds into a typical

bank account instead of directly buying
corporate securities include all of the following
EXCEPT
a. monitoring done by the bank on your
behalf.
b. increased liquidity if funds are needed
quickly.
c. increased transactions costs.
d. less price risk when funds are needed.
e. better diversification of deposited funds.
What are the trends in banking?

What are the changing dynamics of bank
specialness?
Review Question
95

96
Which of the following statements is FALSE?

a. A financial intermediary specializes in the
production of information.
b. A financial intermediary reduces its risk
exposure by pooling its assets.
c. A financial intermediary benefits society by
providing a mechanism for payments.
d. A financial intermediary may act as a broker to
bring together funds deficit and
funds surplus
units.
e. A financial intermediary acts as a lender of last
resort.
Lillibeth Ortiz
Explain the functions of banks as financial

intermediaries, and analyse the theory of
delegated monitoring.(2011, Zone A)
Critically analyse how (i) transaction costs
and (ii) delegated monitoring could lead to
a preference for intermediation over direct
financing. (2011, Zone B)
Explain how transaction costs and
information asymmetry provide reasons for
the existence of financial intermediation.
(2010, Zone A)
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2013-2014

97
G. Group Discussion
98
Discuss the primary functions of financial

intermediaries, and critically analyse the
theory of delegated monitoring. (2010, Zone
B)
Explain how the presence of imperfect
information and asymmetric information
provides theoretical reasons for financial
intermediaries to exist. (2009, Zone A)
Critically analyse how (i) transaction costs
and (ii) delegated monitoring could lead to a
preference for intermediation over direct
financing. (2009, Zone B)
G. Group Work:
Exam Solution Outline
99
Explain the functions of financial

intermediaries, and analyse the theory of
delegated monitoring. (2008, Zone B)
H.
Essential Reading
100
Introduction
Main Body
Conclusion
Sources:
Books
Matthews & Thompson, The Economics of Banking
(2008). Chapter 3.
Saunders & Cornett Financial Institutions Management
(2008). Chapter 1, pp.210,1521.
Journal articles
Bhattacharya, S. and A.V. Thakor Contemporary
banking theory, Journal of Financial Intermediation,
3(1) 1993, pp. 250; Sections 1, 2, and 7.
Diamond, D.W. Financial intermediation as
delegated monitoring: A simple example, Federal
Reserve Bank of Richmond Economic Quarterly, 82(3)
1996, pp.5166.
Next Week:
101
Read Chapter 2 (subject guide): Bank Runs
Chapter 1 & 2: Sample Exam Question
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Financial Intermediation - Theories of

Information sharing coalitions

2013 Lillibeth Ortiz

Critically analyse key elements of the theory

B. Two Types of Economic Entities

Why are Financial Intermediaries (FIs)

Financial Intermediation - Theories of

Imagine a world without FIs

Equity & Debt

Diagram from: Saunders & Cornett, Financial Institutions Management

B. Issues without FIs

Without FI, fund flows are low due to the

cost (less liquidity, longer maturity)

FIs act as intermediaries between surplus &

B. Two Functions of FIs

B. Two Functions of FIs

act as an agent for investors:

Provide information and

Reduce information and transaction costs through

not change the nature of the claim being

Source: Bhattacharya & Thakor,

Financial Intermediation - Theories of

B. Two Functions of FIs

B. Two Functions of FIs

Asset transformation (or Quantitative

funds from surplus units and lends to

purchase primary securities (debt &

claims that are more attractive to savers

Alter the nature of the claims

and sells financial assets

Types of financial intermediaries

insurance companies, pension funds, trusts

In this course, we refer to

B. Transformation: Balance Sheets

How do FIs fulfill investors requirements in

B. Banks Liability Characteristics

B. Two Functions of FIs

Liquid can be withdrawn on demand

Mostly not transferable

In asset transformation, FIs hold the long-term,

Financial Intermediation - Theories of

B. Two Functions of FIs

Asset transformation includes 2 subfunctions:

Financial institutions intermediate between

The asset transformation function of an FI is

What is/are the main reason(s) for the low

Financial intermediaries fulfill which of the

High monitoring costs

Theories of Financial Intermediation

What are the benefits of issuing financial

No change in the nature of the claim

Financial Intermediation - Theories of

C. Exercise: Transaction Costs think-pairshare

Benson & Smith (1976)

exist because of transaction costs

Recall the transaction costs in the transfer of

Group B: for a borrower looking for funding

C. Transaction Costs: Borrow direct

Each saver has $50,000 to invest

C. Illustration: Direct Transaction

pays 6% (R) interest on loan but

Financial Intermediation - Theories of

C. Transaction Costs: With FI