Lecture 1

Basic issues in financial intermediation

Reading: Mishkin, Chapter 2, Chapter 8

Lecture 1: Money and Banking

Questions and problems from handouts: (see following slides)
• Mishkin, Chapter 2, problems 3, 6, 7, 9, 11, 12, 13
• Mishkin, Chapter 8, problems 1, 2, 6, 7, 15

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Lecture 1
Mishkin, Chapter 2, problems 3, 6, 7, 9, 11, 12, 13

Lecture 1: Money and Banking

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Lecture 1
Mishkin, Chapter 8, problems 1, 2, 6, 7, 15

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 Why Study Banking

• To examine how financial institutions such as banks and insurance

companies work
• To examine the role of money in the economy

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 Financial Institutions and Banking

• Financial Intermediaries: institutions that borrow funds from people

who have saved and make loans to other people:
• Banks: depository institutions that accept deposits and make loans
• Other Financial Institutions: insurance companies, finance companies,

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pension funds, mutual funds and investment banks

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 Non-depository institutions

1. Insurance companies accept premiums, which they

invest, promising compensation to policy holders under
certain events.

2. Pension funds invest individual and company contributions

in stocks, bonds and real estate to provide payments to
retired workers.

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3. Securities firms include brokers, investment
banks, underwriters, and mutual fund companies.
• Brokers and investment banks issue stocks and bonds to
corporate customers, trade them, and advise
customers.
• Mutual-fund companies pool the resources of individuals
and companies and invest them in portfolios.
• Hedge funds do the same for small groups of wealthy
investors. 6
 Non-depository institutions

4. Finance companies raise funds directly in the financial markets

in order to make loans to individuals and firms.
• Finance companies tend to specialize in particular types of
loans, such as mortgage, automobile or business equipment.

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5. Government-sponsored enterprises are US federal credit
agencies that provide loans to farmers and home
mortgagors.
• Guarantee programs that insure loans made by private lenders.
• Provides retirement income and medical care through Social
Security and Medicare.

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Types of Banks
 Commercial banks
 The major financial intermediary in any economy
 Main providers of credit
 Typically joint stock companies (listed or privately owned)
 While the main activities are deposit-taking and lending, major “universal”
banks also engage in investment banking, insurance, asset management and

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other specialized financial services.
 Retail banking also include private banking or “wealth management”.

 Savings banks
 The main difference from commercial banks relates to their ownership features
– savings are usually mutually-owned
 Saving banks are important in various countries like the US (Savings & Loans
Association – S&Ls or thrifts), Spain, Germany, etc.
 They may pursue strategic objectives other than maximising profits, relating to
the social and economic development of the region where they operate. 8
Types of Banks

 Cooperative banks
 Similar in many respects to saving banks.

 In the enlarged European Union there are 65,000 outlets and 4,000
cooperative banks, serving 176 million customers, representing about 50

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million members, they have 750,000 employees, and a total average market
share of about 20%.

 Also important in Japan (e.g., Norinchukin Bank is ranked 25th in the

world in terms of Tier 1 capital), China (the Agricultural Bank of China is
the 4th largest in the country in terms of assets), India (over 1,700 urban
cooperative banks and around 93,000 rural cooperative credit institutions) –
see Valdez and Molyneux, 2013)
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 Types of Banks
 Mortgage banks
 Some countries have a special sector dealing with mortgages.
 The UK’s building societies could be classified as mortgage banks.
Nationwide and Yorkshire Building Society are the two largest
ones.
 As discussed in Valdez and Molyneux (2013), the UK building
societies have approximately 1,652 branches, a 20% retail deposit

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market share, and around 2.5 million borrowers (around 30% market
share).
 Germany has 35 mortgage banks (Hypothekenbanken), often
subsidiaries of other banks, and a few building societies
(Bausparkassen). The largest mortgage bank is Eurohypo, owned
by Commerzbank (and merged into Commerzbank in 2021)
 The Netherlands has several mortgage banks that are subsidiaries
of other banks (e.g., Rabobank) or insurance companies.
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Types of Banks
 Islamic banks

 Over 550 institutions manage money in accordance with

Sharia (Islamic) law, that is, they are Sharia compliant.
 Paying or receiving interest (riba) is not allowed but

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depositors are paid a share of profit on a range of
permitted investments in companies–excluding those
involved with gambling, liquor or tobacco.
 The first Islamic bank is thought to be Mitshamr in Egypt
in 1963.
 The Islamic Bank of Britain (Al Rayan Bank) was formed in
2004 aiming to provide services to the UK’s 3.4 million+
Muslims (as of September 2021, 5.2% of the population)
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Types of Banks
 Credit unions
 Another type of mutual deposit institutions
 Worldwide there are more than 86,000 credit unions
(declining through mergers and consolidations) in 118
countries serving over 375 million people (2020)
 Non-profit institutions owned by members
 Some facts from Valdez and Molyneux (2013):

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 The first credit union goes back to 1849 in Germany when a local
mayor formed a union to help people cope with debt and poverty
 By the early 1900s, the idea had spread to Australia, Canada, New
Zealand, Ireland, the UK and the US
 In the US, credit unions don’t pay federal income tax. There are
5,000+ credit unions with 125 million members (as of 09/2021)
 In the UK, there are 246 credit unions with 1.4 million members (as
of 09/2022)
 In Ireland, the 212 credit unions have 3.6 million members (as of 12
12/2021)
Types of Banks
 Investment banks (non-depository)
 They mainly deal with companies and other large institutions and
they typically do not deal with retail customers (except from
some services offered under the umbrella of private banking).
 They do not hold retail deposits and their liabilities are
mainly securities and short-term wholesale financing

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 Their main business relates to issuing new debt and equity on behalf
of clients as well as providing corporate advisory services on
M&As and other types of corporate restructuring. As discussed in
Casu et al. (2006) their activities cover the following areas:
• Financial Advisory (M&A) advice
• Underwriting of securities issues
• Trading & investing in securities on behalf of the bank (“proprietary
trading”) or for clients (“secondary market making”)
• Asset management
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• Other securities services (e.g., brokerage, financing services, etc.)
Why do we need financial intermediaries?

In their role as financial intermediaries, banks perform 5 functions:

1. Pooling the resources of savers
2. Providing safekeeping and accounting services, as well as
access to payment systems

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3. Supplying liquidity by converting savers’ balances directly
into a means of payment whenever needed
4. Providing ways to diversify risk
5. Collecting and processing information in ways that reduce
information costs

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1. Pooling Savings

• The most straightforward economic function of a

financial intermediary is to pool the resources of many
small savers.

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• In order to do this, the intermediary:
• Must attract substantial numbers of savers, and
• Must convince potential depositors of the
institution’s soundness.

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2. Safekeeping, Payment Systems
Access & Accounting
• Banks:

• Are a place for safekeeping.

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• Provide access to payment systems -- the network that transfers
funds from the account of one person or business to the account
of another.

• Specialize in handing payment transactions, allowing them

to offer these services relatively cheaply.

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2. Safekeeping, Payment Systems
Access & Accounting (cont.)

• By giving us a way to pay for things, financial

intermediaries facilitate the exchange of goods and services.

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• This principle of comparative advantage leads to
specialization so that each of us ends up doing their own job
and not being distracted.

• Financial intermediaries help our economy to function more

efficiently by providing us with a reliable and inexpensive
payment systems
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2. Safekeeping, Payments System
Access & Accounting (cont.)
• Financial intermediaries also help us manage our finances

• They provide us with bookkeeping and accounting services, noting all

our transactions for us and making our lives easier in the process

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• These force financial intermediaries to write legal contracts - but
one contract can be written and used over and over again - reducing
the cost of each.

• Much of what financial intermediaries do takes advantage of economies

of scale, in which the average cost of producing a good or service falls
as the quantity produced increases. 18
 3. Providing Liquidity
• Liquidity is a measure of the ease and cost with which an asset can be
turned into a means of payment

• Financial intermediaries offer us the ability to transform assets into

money at relatively low cost – e.g. ATM’s (automated teller
machine)

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• Banks can structure their assets accordingly, keeping enough funds
in short-term, liquid financial instruments to satisfy the few people
who will need them and lending out the rest.

• By collecting funds from a large number of small investors, the

bank can reduce the cost of their combined investment, offering
each individual investor both liquidity and some rates of return.
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4. Diversifying Risk

• Financial institutions enable us to diversify our investments and

reduce risk

• Banks take deposits from thousands of individuals and make

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thousands of loans with them

• All financial intermediaries provide a low-cost way for

individuals to diversify their investments

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5. Coll ecting and Processing Information

• The fact that the borrower knows whether he/she is

trustworthy, while the lender faces substantial costs to obtain
that information, results in an information asymmetry

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Borrowers have information that lenders do not

• By collecting and processing standardized information,

financial intermediaries reduce the problems that
information asymmetries create and lower related costs.
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Function of Financial Intermediaries

• Conclusion:
• Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of financial
markets.

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Flows of Funds Through the Financial System

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Primary Assets and Liabilities of Financial
Intermediaries

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Principal Financial Intermediaries and Value of Their
Assets (USA)

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Regulation of the Financial System
• To increase information available to investors:
• Reduce adverse selection and moral hazard problems
• Reduce insider trading (SEC, Securities & Exchange
Commission)

• To ensure the soundness of financial intermediaries:

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• Barriers / Restrictions on entry (chartering process)
• Disclosure of information
• Restrictions on Assets and Activities (control holding of risky
assets)
• Deposit Insurance (avoid bank runs)
• Limits on Competition (mostly in the past, 1980s-1990s):
• Branching
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• Restrictions on Interest Rates
Sources of External Funds for Nonfinancial Businesses: A Comparison
of the United States with Germany, Japan, and Canada

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Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical
Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 28
and are gross flows as percentage of the total, not including trade and other credit data, which are not available.
 8 Basic Facts
1. Stocks are not the most important sources of external
financing for businesses
2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their operations
3. Indirect finance is many times more important than direct
finance

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4. Financial intermediaries, particularly banks, are the most
important source of external funds used to finance businesses
5. The financial system is among the most heavily regulated
sectors of the economy
6. Only large, well-established corporations have easy access to
securities markets to finance their activities
7. Collateral is a prevalent feature of debt contracts for both
households and businesses
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8. Debt contracts are complicated legal documents that place
substantial restrictive covenants on borrowers
Asymmetric Information
• Asymmetric information arises when insufficient information
of one party involved in a transaction makes it impossible to
make accurate decisions when conducting the transaction
• Adverse selection occurs before the transaction: bad

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borrowers are the ones most likely seeking to borrow
• Moral hazard arises after the transaction: the lender runs the
risk that the borrower will engage in riskier activities after the
loan has been agreed, making its repayment riskier
• Agency theory analyses how asymmetric information
problems affect economic behavior
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Adverse Selection: The Lemons Problem

• If quality cannot be assessed, the buyer is willing to pay

at most a price that reflects the average quality
• Sellers of good quality items will not want to sell at the
price for average quality

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• The buyer will decide not to buy at all because what is
left in the market is poor quality items
• This Lemons problem explains fact 2 and partially
explains fact 1 (see slide 29 “8 basic facts”)

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 Adverse Selection: Solutions

• Private production and sale of information

• Free-rider problem
• Government regulation to increase information
• Not always works to solve the adverse selection

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problem, explains fact 5
• Financial intermediation
• Explains facts 3, 4 & 6
• Collateral and net worth
• Explains fact 7

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Moral Hazard in Equity Contracts

• Called the Principal-Agent Problem

• Principal: less information (stockholder)
• Agent: more information (manager)

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• Separation of ownership and control of the firm
• Managers pursue personal benefits and power
rather than the profitability of the firm for the
benefits of stockholder

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 Principal-Agent Problem:
Solutions

• Monitoring (Costly State Verification)

• Free-rider problem
• Fact 1

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• Government regulation to increase information
• Fact 5
• Financial Intermediation
• Fact 3
• Debt Contracts
• Fact 1 34
Moral Hazard in Debt Markets

• Borrowers have incentives to take on projects that

are riskier than the lenders (OPM, Other People’s
Money) would like.
• This prevents the borrower from paying back the

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loan.

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Moral Hazard in Debt: Solutions

• Net worth and collateral

• Incentive compatible
• Monitoring and Enforcement of Restrictive Covenants
• Discourage undesirable behavior

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• Encourage desirable behavior
• Keep collateral valuable
• Provide information
• Financial Intermediation
• Facts 3 & 4

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Summary Table 1 Asymmetric Information Problems and
Tools to Solve Them

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Asymmetric Information in Transition
and Developing Countries
• “Financial repression” created by an institutional
environment characterized by:
• Poor system of property rights (unable to use
collateral efficiently)

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• Poor legal system (difficult for lenders to enforce
restrictive covenants)
• Weak accounting standards (less access to good information)
• Government intervention through directed credit
programs and state-owned banks (less incentive to proper
channel funds to its most productive use).

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Conflicts of Interest
• Type of moral hazard problem caused by economies
of scope (applying one information resource to
many different services)
• Arise when an institution has multiple objectives

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and, as a result, has conflicts between those
objectives
• A reduction in the quality of information in financial
markets increases asymmetric information
problems
• Financial markets do not channel funds into
productive investment opportunities 39
Why Do Conflicts of Interest Arise?
• Underwriting and Research in Investment Banking
• Information produced by researching companies is used to
underwrite the securities issued by the same companies: the
bank is attempting to simultaneously serve two client groups
(issuers and investors) whose information needs differ
• Spinning occurs when an investment bank allocates hot, but
underpriced, IPOs to executives of other companies in return

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for their companies’ future business.

• Auditing and Consulting in Accounting Firms

• Auditors may be willing to skew their judgments and opinions
to win consulting business
• Auditors may be auditing information systems or tax and
financial plans put in place by their non-audit colleagues within
the firm
• Auditors may provide an overly favorable audit to solicit or retain 40
audit business
Why Do Conflicts of Interest Arise? (cont’d)
• Auditing and Consulting in Credit-Rating Firms
 Conflicts of interest can generally arise when:
• Multiple users with divergent interests depend on the
credit ratings (investors and regulators vs. security
issuers)

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• Credit-rating agencies also provide ancillary consulting
services (e.g. advise on debt structure to improve
rating)
 The potential decline in the quality of information
negatively affects the performance of financial markets

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Conflicts of Interest: Remedies
• Sarbanes-Oxley Act of 2002 (Public Accounting
Return and Investor Protection Act) increased
supervisory oversight to monitor and prevent
conflicts of interest in the US
• Established a Public Company Accounting Oversight Board
• Increased the SEC’s budget

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• Made it illegal for a registered public accounting firm
to provide any non-audit service to a client
contemporaneously with an impermissible audit
• Beefed up criminal charges for white-collar crime
and obstruction of official investigations
• Required the CEO and CFO to certify that financial
statements and disclosures are accurate
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• Required members of the audit committee to be
independent
Conflicts of Interest: Remedies (cont’d)
• Global Legal Settlement of 2002
• Required investment banks to sever the link between
research and securities underwriting
• Banned spinning
• Imposed $1.4 billion in fines on accused investment

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banks (Citibank, Morgan Stanley, etc.)
• Required investment banks to make their analysts’
recommendations public
• Over a 5-year period, investment banks were required
to contract with at least 3 independent research firms
that would provide research to their brokerage
customers.
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Financial Crises

• Financial crises are major disruptions in financial

markets that are characterized by sharp declines
in asset prices and the failures of many financial
and nonfinancial firms

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• In 2007, a major financial crisis hit the global
economy, its impact being the greatest since the
Great Depression of 1929

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Money and Business Cycles

• Evidence suggests that money plays an important

role in generating business cycles
• Recessions (unemployment) and expansions affect
all of us

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• Monetary Theory links changes in the money
supply to changes in aggregate economic activity
and the price level (inflation, see since 2022!)

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Aggregate Price Level and the Money Supply
in the United States, 1960–2020

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Money and Inflation

• The aggregate price level is the average price of

goods and services in an economy
• A continual rise in the price level (inflation) affects all
economic players

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• Data shows a connection between the money supply
and the price level

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Money Growth (M2 Annual Rate) and Interest Rates
(Long- Term U.S. Treasury Bonds), 1950–2020

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Money and Interest Rates
• Interest rates are the price of money
• Prior to 1980, the rate of money growth and the
interest rate on long-term Treasury bonds were
closely tied

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• Since then, the relationship is less clear but the
rate of money growth is still an important
determinant of interest rates

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Money Growth (M2 Annual Rate) and the Business Cycle in
the United States, 1950–2020

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