2 Intermediary-Based Transformation Approaches
3 Transaction Costs
4 The Liquidity Insurer Model
5 Delegated Monitoring
6 Information Sharing Coalitions
Having a deposit account and thus using a bank as an intermediary to take care for one’s savings seems usual and obvious for nearly everyone in the developed world. But in recent years, the public was confronted with several unpleasant events regarding the financial industry as a whole. There was the financial crisis in 2008 which can be defined as a caesura of the modern banking system: The worldwide financial landscape could only be rescued by multiple tremendous efforts of governments who bailed out shuttered banks and gave deposit insurance - sponsored by taxpayers, while the risk-takers were ‘rewarded’ with extraordinary bonus payments. Subsequently, the whole industry lost reputation and trust, which is actually the foundation of most of its business models. That situation has been followed seamless by the virulent “Euro-crisis” evolving in 2010 and finding its previous highlight in limited cash withdrawals for Greek citizens in 2015. Accompanied by the current low-interest environment where savers find no more positive riskless returns, the question ‘why do banks exist?’ is now more relevant than ever. The growing fintech industry which offers interesting alternatives to classic bank deposits enforces the questioning of the legitimacy of the existence of banks.
In the following, the models which explain banks’ presence will be presented and critically evaluated in order to give a thorough understanding of their role as intermediaries in the modern financial environment.
An important aspect of banks’ existence lies in the principle of financial intermediation, which was invented by the Fuggers in Germany during the 16th century (Kindleberger 1993, p. 47). As a basic concept we have the size transformation: Investment projects are typically too large for individual lenders, so they have to be divided and matched by an intermediary like a classic bank, or a syndicate of banks in special cases (Unit 2, p. 6). Freixas and Rochet (1997, p. 4) define that process as ‘convenience of denomination’ in the sense of a convenient banking customer. They see that kind of transformation as one of the principal explanations of intermediation (Ibid.).
The second level of transformation refers to maturity issues. Typical bank loans are medium or long term, while deposits are usually payable on demand (Unit 2, p. 6). That kind of transformation is therefore really helpful, because savers aren’t willing to renounce the benefit of liquid accounts. On the other hand, borrowers traditionally have a need for long repayment periods (Kindleberger 1993, p. 47). The risks which banks are bearing during maturity matching can be hedged via derivatives (Freixas & Rochet 1997, p. 5), which is difficult to imagine as a transaction done by unsophisticated savers themselves.
Thirdly, we have risk transformation as the capability of intermediaries to diversify risks such as default risks of bank loans or interest risks of bonds bought by the bank. Through intelligent risk diversification banks can reduce the risks of their assets as a sum compared to the single asset risks, which makes the deposits less risky to the same extent. (Unit 2, p. 7). The risk transformation works better if the loans of the bank are diversified across industries and regions, i.e. their correlation is low (Unit 2, p. 8). That means, that the returns of an agricultural loan in France may be independent of a mortgage in Italy. ‘This appraisal of risk and correlative estimation of the risk return on a bank loan is one of the main functions of modern banking.’ (Freixas & Rochet 1997, p. 6).
In practice, the three described functions appear in a miscellaneous form: Modern banks coordinate the sizes of loans and deposits, they match the maturities and finally they reduce the loan risk through diversification (Kindleberger 1993, p. 47). At this point, we can conclude that the transformation approaches give us good arguments for the existence of banks. But on the other hand, depositors could theoretically perform all the mentioned actions by themselves, if there were no transaction costs and a perfect information situation (Unit 2, p. 9). That thought could be expanded by the fact, that intermediators are costly by nature and therefore disadvantageous. The transformation approaches are hence useful for our main question, but it explains not completely the presence of banks.
The concept of transaction costs refers to the aspect that the relevant information needed to conduct financial market operations is distributed unequal. To overcome this situation, some kind of financial intermediation, which bears various types of costs, is needed (Unit 2, p. 9).
First there are searching costs. Nowadays, financial markets are very complex and it needs a lot of time and exertion to find the right contractor for each specific purpose (Unit 2, p. 10). For example, it could be challenging for a saver to find a counterparty which wants to borrow the amount he is looking for and has furthermore a risk-return profile that fits into his expectation.
Verification costs contain the investigation effort concerning the true quality of investment opportunities (Ibid.). It is nearly impossible for a private market participant to evaluate the true condition of a global operating conglomerate issuing financial securities. If we further assume that the saver uses the in 2 described diversification approach, he has to conduct this rating process for a great number of companies.
After entering into a financial contract, the investor typically bears monitoring costs. These arise from the fact that once the loan is paid under the agreed conditions, the borrower could decide to take higher risks than previously appointed to generate higher returns on his own equity (Ibid.) In the worst case such action would lead to bankruptcy and the lender would lose his complete deposit.
The last part of transaction costs are enforcement costs. If monitoring is successful and shows that the counterparty doesn’t behave like agreed, consequences have to follow (Ibid.). Here we can consider extrajudicial steps or legal action. Both can be very costly and consume more than the expected return of the loan.
To put this together, we can say that the saver would decide to use the bank deposit rather than the direct transaction, if the deposit return is higher than original return less transaction costs (Unit 2, p. 11). This creating of value is caused by two concepts explained in the following: Economies of scale describes the benefits of producing something in a large number and profiting from the decreasing fixed costs per produced unit (Ibid.). A classic example is the oil drilling industry: If a well is established, the fixed cost portion of every additional drilled barrel is declining. Translated to financial markets, we have a block of costs belonging to each transaction which can now be divided to many small contracts (Unit 2, p. 12).
Furthermore we have the cost-reducing concept of economies of scope. That refers to the cost reduction in cases of different product lines at the same company and is not dependent on the size (Ibid.). In relation to our previous described transaction costs an example is, that the bank can use a given infrastructure (e.g. website, branches) to offer different services more cheaply to borrowers and lenders (Koch n.d.).
If we come back to our main question, we can clearly assume that banks are useful if their own intermediary costs are lower than the previous mentioned single transaction costs (Unit 2, p. 11). On the other hand, this is not enough for a complete understanding of the role of banks. Up to that point it is unclear, where the differentiation between banks and other intermediaries lies. On top of that, it is not transparent where the mentioned transaction costs originally result from (Unit 2, p. 13).
Another way of understanding banks is the liquidity insurer model which in contrast to the previous showed approaches gives a clearer focus on banks within the groups of financial intermediaries. Diamond and Dybvig (1983) address with the help of their model a completely new perspective: They show how a bank adds value through investing in long-term illiquid assets while at the same time it is ensured that depositors can withdraw their money whenever they want or they are forced to liquidate - without negative consequences (Unit 2, p. 13).
That works in the following way: There exist three deposit periods (0,1,2) accompanied by probabilities and concerning consumer behaviour (early or late), the amount of investment I (≦1), the gross rate of return L (<1) for liquidation in period 1 and the gross rate of return R (>1) for the long-term investment. Basically savers are risk-averse and prefer steady consumption levels after depositing in period 0. Investors learn in period 1, whether they continue or consume (Unit 2, p.14-15). Now the output of investment in form of consumption is investigated in three different circumstances:
First we consider financial autarky, where no transactions with others are conducted. The lower the invested amount I, the higher the absolute result in period 1 (early liquidation because of a consumption shock) compared to period 2.That is because a higher amount 1-I is stored at the beginning. The other way round, the higher I, the higher the result in period 2 compared to period 1 (Ibid.). That is logical, because if the maximum (I=1) is invested and not interrupted, there will be the maximum output.
The next step contains the addition of a bond market. In the case of forced earlier consumption in period 1 the saver issues a bond of one year duration with price p and uses the proceeds to consume. The advantage is that the long-term investment I has not to be interrupted and can unfold its whole return R in period 2, which is discounted (multiplied by p) and exchanged to period 1 with the term pIR. Defining p=1/R we get 1 as a result for all values of I. In case of late consuming there is the particularity that the stored amount 1-I from period 0 is invested at period 1 in bonds yielding (1-I)/p. It arises R for every value of I. Thus, for every risk profile the bond market provides superior results than financial autarky (Unit 2, p. 15-17).
In the last step the financial intermediary is introduced, who offers liquid deposits, so that every saver can consume when he needs to. That is made possible through the large number of depositors and the use of the probability of early consuming . There has to be stored only that fraction 1-I that fulfills the expected withdrawals. In the meantime the rest can be invested long-term to get RI. The result is the best possible allocation guaranteed by the intermediary, because from the beginning in period 0 every unit of deposit is used efficiently through the usage of probabilities and the law of large numbers (Unit 2, p. 18-19).
The model shows that we have superior outcomes regarding the liquidity situation of consumers if intermediaries are involved, but the existence of banks is still not fully explained by that.
The next two models are focussing rather on the asset side of banks’ balance sheets and try to explain their existence in the presence of asymmetric information. To overcome this problem monitoring is needed. Therefore the savings generated in observing the borrower S have to be greater than the cost of monitoring K (Unit 3, p. 3-4). The lenders are counted with m. They could conduct the monitoring all by themselves with total cost mK or delegate it with delegation cost D (Diamond 1996, p. 53).
If we try to avoid the monitoring costs we could consider an equity contract. The borrower wouldn’t reveal the true value V of his project and report an official return Z in order to keep the difference. Consequently, no one would lend under such conditions, as long as there is a safe asset with a warranted yield (1+r). On the other hand there is a debt contract with a liquidation option, if a minimum repayment level f is not accomplished. Because liquidation is the worst scenario for both, the borrower would avoid paying less than f - making this unmonitored debt contract a viable alternative (Diamond 1996, p. 55-57).
One advantage of monitoring in this context is that liquidation can be avoided, if the borrower cannot pay f but instead a minimum and plausibilized value of L, what is superior to zero in the liquidation case. However, it is likely that this value of monitoring S will be overlapped by mK. At that point the delegated monitor offers its benefits, because K is only paid once. It could be further questionable, if the delegated monitor has to be monitored either. That thought can be rejected, because with a large sum of independent loans the probability of an intermediary default goes to zero (Unit 3, p. 8-9). So with that concept the moral hazard problem can be overbeared.
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