We studied financial markets in Part II, and we now turn to financial institutions (banks).  Remember some of the important functions of financial institutions:

1) Facilitate the transfer of funds from savers/investors/creditors to people who have productive investment opportunities: borrowers/debtors.

2) Minimize the problems in credit markets of a) adverse selection and b) moral hazard.

3) Minimize the overall level transaction costs in the economy of bringing savers and borrowers together, by economies of scale, etc.

We now look at a more detailed economic analysis of the financial system, to understand how/why out financial structure promotes economic efficiency and contributes to economic growth.


We start by looking at several economic "puzzles": See page 182-185.  Worldwide financial system (banks, insurance companies, mutual funds, stock and bond markets, etc.) channels billions of dollars annually from savers to borrowers, and a close look at the global financial system reveals several puzzles.  We need to solve these puzzles to understand financial structure.

See Figures 1 and 2 on pages 182 and 183, sources of external funds for corporations in U.S. and the other G-6 countries, in order of importance: Bank Loans (62%), Bonds and Commercial Paper (30%), Stocks (2%).

Puzzle #1.  Compared to bonds and bank borrowing, stocks account for very little, only about 2%, of the external funds for companies in U.S. In 1980s, companies bought back stock, stock financing was a negative source of funds. Debt (bonds and bank loans) accounts for 92% of external funds.  Even though the stock market gets most of the media attention, bank loans are 30x more important as a source of funds, and bonds are 15x more important.  Therefore, the first puzzle is:  Why is equity so much less important than debt as a source of external funding?

Puzzle #2.  Marketable securities (coporate bonds, commercial paper and stocks) provide only 32% of external funds.  Bank loans (non-marketable) account for 62% of corporate financing in U.S. and this is pretty much the same around the world.  Second puzzle is: Why are non-marketable bank loans used twice as much as marketable securities?

Puzzle #3.  Indirect finance is much more important than direct finance.  Direct finance (sale of securities directly to American households) accounts for less than 5% of the total market for new securities (bonds, stocks, etc.)  Indirect finance accounts for almost all of the securities sold to the public, 95% of newly issued securities are sold to pension funds, mutual funds and insurance companies.  Puzzle #3 is: Why are financial intermediaries and indirect finance so important in financial markets?

Puzzle #4.  Banks are the most important source of external funds used to finance business - 62% of the market vs. 32% for stocks and bonds.  25 times more funds are raised annually with bank loans than with stocks!  Puzzle 4 is: Why are banks so important in financial markets?

Puzzle #5.  Most debt contracts (bank loans) are secured with collateral (real estate, vehicles, machinery, property, etc.) vs. unsecured debt. Puzzle #5: Why is collateral so imporant in credit markets?

Puzzles #6.  Debt contracts (bank loans) are complex and contain restrictive covenants (legal restrictions that prevent or require certain actions). Puzzle #6: Why are debt contracts (bank loans and corporate bonds) so complex and restrictive?

TRANSACTION COSTS - Helps explain Puzzle #3.  Financial intermediation exists to minimize transactions costs. How?

Example: You have $5000 and you want to invest in financial markets, by buying stocks or bonds.  Problem: with only $5000 to invest, the transaction costs are very high, especially if you want a diversified portfolio of stocks, or a portfolio of stocks and bonds.  Commissions and trading fees may end up being a large percentage of your investment, making it either uneconomical to invest at all, or making it difficult to diversify (e.g. you might have to put all $5000 in one or two stocks).

1. Economies of scale of large scale banks, pension funds, mutual funds, etc. allow financial intermediaries to lower transaction costs.  Example: banks can process loans very efficiently.  They have contracts set up, legal departments, payment processing, etc. They also have a diversified portfolio of loans, can absorb losses and spread it out over thousands of loans.

Example: mutual fund.  You can easily invest $5000 in a mutual fund and have a diversified portfolio of 500 stocks in an SP500 Index fund for example.  Hard to achieve that level of diversification without a mutual fund.  Also, mutual fund is very efficient at accepting deposits and sending out distributions.  Certain amount of fixed costs (e.g. computer system) and trading costs can be spread out over thousands/millions of transactions and billions of invested dollars through financial intermediation, allowing funds to operate at a level of efficiency impossible to achieve as an individual investor using direct finance.  For example, Vanguard 500 Index fund's annual expense ratio is .18%, so the transaction costs on $5000 would only be $9 per year, $180/year for $100,000!!  And the net assets of Vanguard 500 Index fund is $100B, so fixed costs can be extremely efficiently spread out over billions of dollars.  Also, mutual funds accept subsequent deposits of amounts as little as $100, so you can efficiently make additional investments in the stock market using a mutual fund that would be impossible with direct finance.

2. Expertise - mutual funds are professionally managed, so you can take advantage of the expertise of full-time, skilled, professional fund managers.  Funds also develop expertise on the service side through computer technology, 800 service numbers, telephone transfers, etc.  Indirect finance through mutual funds increases the liquidity of your investment - easy to get into and out of mutual funds, you can get $100 or $1000 out or put $100 or $1000 in anytime you want.  Also, institutional fund managers may be better able to monitor the performance of a corporation vs. a diverse group of small shareholders all over the world, corporations may be held to a higher level of accountability when stock ownership is concentrated in the hands of professionally managed mutual funds.  May minimize the principal-agent problem, moral hazard, the issue of separation of ownership and control.

Financial intermediaries 1) achieve incredible levels of operational efficiency through economies of scale and thereby significantly lower transaction costs and 2) achieve additional efficiencies by developing cost-saving expertise and 3) increase the liquidity of financial securities (you can write checks against a money market mutual fund).  These efficiencies of financial intermediaries explain Puzzle #3, why 95% of securities are sold through indirect finance, i.e. transaction costs are prohibitively high for individual investors engaging in direct finance.


ASYMMETRIC INFORMATION - incomplete information and knowledge about the other party in a transaction. Leads to problems of adverse selection and moral hazard.

Moral hazard: the problem or risk that one party in a transaction/contract will take advantage of another party.

Could be either illegal or unethical behavior. Could be a result of incompatibility of incentives, an incentive incompatible contract.

Example: People filing bogus insurance claims, or making frivolous claims. How to prevent? ___________________________

Rental contracts? ________________________________

Moral Hazard in Equity Contracts: "Principal-Agent Problem"

In a corporation, you usually have a potential P-A problem because of the separation of ownership and control.  See example, page 193.  You invest $9000 to be a silent partner and own 90% of your friend Steve's ice cream business, he puts up $1000 and owns 10%.  Steve gets a salary, and you and he will split the profits every year, 90% for you and 10% for him.  Potential problems?  

Principals - owners - own the company
Agents - managers - run the company

Goal of the Firm?: ______________________________________

Managers may not always have the same incentive to maximize value as the shareholders - potential conflict of interest. Risk of moral hazard due to asymmetric information between managers and owners. Owners cannot perfectly monitor the actions/behavior of managers.

Ways that managers can take advantage of owners:

1) Shirking - not working hard enough.
2) Giving themselves raises/bonuses
3) Spending money on corporate jets, boats, expense accounts, expensive art
4) Giving business, awarding contracts to friends
5) Pursuing corporate strategies that don't create value, but increase personal power.
Example: acquiring other firms - horizontal diversification.

How to minimize P-A problem for equity?





Moral Hazard for Debt

Interests of lender and borrower may not always be perfectly aligned. Could be the shareholders and bondholders, or managers and bondholders.

1) you have a mortgage and you don't take out homeowners insurance and the house burns down.
2) RJR Nabisco takeover - management team wanted to do an LBO, issue lot of debt, buy all publicly held stock, take the company private. Debt Ratio would go from 40 to 95%. Outstanding bonds had been rated A+, went to junk status in two days. Prices fell by 20%. Led to putable bonds.
3) Bondholders/bank get paid a fixed amount of interest, regardless of the profitability of the firm. There could be an incentive to borrow money, and invest it in very risky projects. If the project pays off, the owners get all of the benefit/profits, pay out a fixed int payment. Owners participate in the profits, bondholders don't. Could be an incentive to agree to a safe project, then go risky.

Solutions to Moral Hazard in Debt Contracts:

Restrictive Covenants for bonds, bank loans or mortgages can minimize or eliminate moral hazard:

1. Restrictions in loan to prevent borrower from engaging in risky activity. Restrictions on what the money can be used for - only certain investments are allowed. Restrictions on dividends. Restrictions on altering real estate.

2. Encourage desirable behavior. Require insurance and taxes to be paid to the mortgage company. Require high net worth - example 20% down for house. Requirement to maintain certain asset base for businesses. Require a sinking fund.

3. For secured loan, Requirement to keep collateral in good condition. Property or equipment. Example: collision insurance is required for car loans. Home: keep house in saleable condition, maintain insurance.

4. Requirement to provide information to bondholders or bank on a regular basis so they can be monitored. Example: small company has to provide quarterly income statements to bank, company may have to provide quarterly financial statements to bondholders.

Point: restrictive covenants can reduce moral hazard problem.

Analysis partially explains Puzzles #1, 2, 4-6.  Due to the problems of asymmetric information, moral hazard and potential conflicts of interest, debt can be more effectively used than equity to minimize these problems, and the easiest way to deal with many of these potential problems is to use private loans through banks, with collateral and restrictive covenants.

Free rider problem - Another potential problem in the credit markets.  Everybody benefits from obtaining information about a firm's stock or bonds. When shareholders or bondholders are a diverse group spread all over the world, everybody would benefit from information about the financial condition of the firm, either before or after you buy a security.  But suppose a large insurance company owns a company's stocks/bonds and pays for information about the financial position of the company and then makes trades.  You could just watch what they do and follow.  Or the diverse group of bondholders is supposed to monitor whether the corporation is following the restrictive covenants or not.  Bondholders will all benefit from active monitoring of a coporation, but will have little incentive to spend time and money themselves to monitor, they will have an incentive to "free-ride" on other bondholder's monitoring.  In equilibrium, the "free-rider" problem will lead to less than optimal monitoring of marketable securities, and the problem of moral hazard may not be effectively solved.  Private non-marketable bank loans more effectively deal with this potential problem than marketable securities.

With bank borrowing, no one can free-ride on the private information that the bank gets through the bank's monitoring and enforcing of the restrictive covenants.


1.  External financing is critical for businesses/firms to undertake productive investment opportunities.
2.  Asymmetric information and moral hazard present potential problems in the market for external financing for businesses in the economy.
3.  In general, debt is more effective than equity at addressing and minimizing the potential moral hazard problems of external financing.
4.  Collateral and restrictive covenants can be used in debt contracts (bonds and bank loans) effectively to minimize the moral hazard problem.
5.  Banks have an incentive to monitor and enforce restrictive loan covenants, and nobody can free-ride because private loans are not traded.  This help explains why there are twice as many bank loans as bonds (marketable debt securities) in the credit market.
6.  Conclusion: Bank loans are the most important source of external financing (62%) because they most effectively minimize the moral hazard problem.