BANKING I

LECTURE 1

WHAT IS SPECIAL ABOUT BANKS ?

Robert Suban
Department of Banking & Finance
University of Malta
 Lecture Outline
• Introduction & Definitions
• The nature of financial intermediation
• The Role of Banks
• Information economies
• Why do banks exist ? Theories of financial
intermediation
• The benefits of financial intermediation
• Chapter 1 CGM Book

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 Introduction
• What do banks do ?
• What makes banks so special ?
• Why are banks different than any other
business ?
• What functions do banks fulfill in the
economy ?
• We will try to answer all these questions

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 Definitions
• Surplus Unit: an economic unit (company, government,
household) whose income exceeds its expenditure. Therefore
they have a surplus of funds which can be lent (lenders)
• Deficit Units: an economic unit (company, government,
household) whose expenditure exceeds its income. Therefore
they have a deficit of funds and need to borrow to make up for
the deficit (borrowers)
• Financial Claim: A financial claim is generated whenever an act of
borrowing takes place
• Financial claims can take several forms, such as money, bank
deposit account, bonds, shares, loans, etc.
• The lender holds a financial asset
• The borrower holds a financial liability

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 Definitions (cont.)
• Direct Finance: A situation in which
borrowers (deficit units) obtain funds directly
from lenders (surplus units) without the need
of intermediation
• Ex: A Bond issue
• Indirect Finance: A situation in which
borrowers obtain funds from a financial
intermediary, such as a bank, and lenders
deposit money into a financial intermediary

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 Direct and Indirect Finance
• Indirect Finance
Savers/Depositors Financial Borrowers
Intermediaries

• Direct Finance
Financial Markets Borrowers
Savers/Depositors

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 Lenders’/Borrowers’ Requirements
• Lenders’ Requirements
– Minimisation of risk
– Minimisation of costs
– Liquidity
• Borrowers’ Requirements
– Funds to be available at a specific date
– Funds to be available for a specific period (usually
long-term)
– Funds to be available at the lowest possible cost
• Conclusion, there is a mismatch between
borrowers and lenders requirements
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 The nature of financial intermediation
• Financial intermediaries can bridge the gap between
borrowers and lenders by satisfying the often incompatible
needs and preferences of these two groups
• Financial intermediaries help to lower transaction costs
– Search costs
– Costs of obtaining information about them
– Costs of negotiating the contract
– Costs of monitoring the borrowers
– Enforcement costs (in case of default)
• Financial intermediaries also help to overcome information
asymmetries
• Why one to choose ? direct or indirect finance ?
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 The role of banks
• To understand why indirect finance has advantages over
direct finance we have to understand the role that banks
fulfill
• Banks fulfill three main functions
• Size transformation
– By pooling small depositors funds into large loans
• Maturity transformation
– By transforming short-term deposits into long-term loans
• Risk transformation
– By minimising risks through diversification, screening,
monitoring, and holding capital and reserves in case of
losses

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 Information Economies
• Transaction costs
– Banks differ from other FI as
• their liabilities are accepted as a means of exchange
• Example: Certificate of Deposits (CDs)
• Can create and destroy credit How ?
• Economies of Scale
– FI reduce transaction, information, and search costs by exploiting
economies of scale (as volume of transactions increases, the cost per
unit of transaction decreases)
– How ? Standardisation of contracts, trained staff, monitoring of
customers, etc.
• Economies of scope
– When the costs of combining two outputs is less than aggregating the
individual costs of the two outputs produced separately
– Example: banking and insurance services

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 Asymmetric Information
• Asymmetric information occurs when one party has
more information than the other party to the
transaction
• Example: seller/buyer of a second hand car
• Information is at the heart of all financial
transactions
• But… information is not a free good and acquiring
information is not a costless activity
• Because of asymmetric information FI have to deal
with various problems

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 Adverse selection
• Occurs when one party has more information than the other party
and will tend to exploit it
• Adverse selection is a problem at the search verification stage of
the transaction (ex ante)
• “lemon” problem (Akerlof 1970)
• Example: Second-hand car market
• Applied to banking: how does the bank know whether you will pay
back loan ?
• How do you overcome adverse selection problems ?
• Signalling (by the more informed party) for example willing to
provide security for loan
• Screening (action undertaken by the less informed party) for
example asking client for a loan to provide pay slips, bank
statements, and other information
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 Moral Hazard
• Occurs when a contract or financial arrangement creates
incentives for the parties involved to behave against the
interests of the others
• Example: buy car insurance and drive dangerously, etc.
• Applied to banking: apply for a loan for a safe project and
then do a risky project
• How do we overcome moral hazard ?
• Monitoring
– Loan officers request information from borrowers
– Credit rating agencies
• Can consumers/investors monitor performance of FI ?
• No This is why we need regulation

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 Principal-Agent Problem
• A principal-agent relationship exists when a principal (owner)
engages an agent (employee) to perform duties on his behalf
• A principal-agent problem arises as a result of the fact that
the principal can never be sure that the agent is acting solely
in the interests of his principal rather than his own interests
(conflict of interests) (Jensen and Meckling 1976)
• We saw that monitoring costs money so whenever we have
potential conflicts of interests it is best to solve them by
creating incentives to align the interests of the agent with
those of the principal
• We have similar situations in financial contracts so this is why
there is a need for monitoring

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Why do banks exist ? Theories of financial
intermediation
• Banks as delegated monitors (Diamond 1984)
– The monitoring of loan contracts is delegated to
banks by small depositors
• Banks as producers and processers of
information (comparative advantage)
• Banks as transformers of liquidity
• Banks as enabling consumption smoothing

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 Benefits of financial intermediation
• To ultimate lenders (surplus units)
– Greater liquidity
– Less risk
– Marketable securities
– Lower transaction costs
– Simplified lending decision
• To ultimate borrowers (deficit units)
– Can borrow for a longer time period
– Can borrow larger amounts
– Lower transaction costs
– Interest rate is lower
– Available when required
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 Benefits of financial intermediation
• To society as a whole
– More efficient allocation/use of funds
– Higher level of borrowing and lending to be
undertaken
– More funds available to higher-risk ventures

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 Things to Remember
• Difference between direct and indirect finance
• What is financial intermediation ?
• Different characteristics between lenders and
borrowers
• The special role of banks in financial intermediation
• Problems of information asymmetries in financial
intermediation
• Main theories that explain the existence of financial
intermediaries
• Benefits of financial intermediation

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