credit markets. The loss of one-third of the banks
viewed the stock market boom of 1928 and 1929, dur-
reduced the amount of financial intermediation. This
ing which stock prices doubled, as excessive specula-
intensified adverse selection and moral hazard prob-
tion. To curb it, they pursued a tight monetary policy to
lems, thereby decreasing the ability of financial mar-
raise interest rates. The Fed got more than it bargained
kets to channel funds to firms with productive
for when the stock market crashed in October 1929.
investment opportunities. As our analysis predicts,
Although the 1929 crash had a great impact on the
the amount of outstanding commercial loans fell by
minds of a whole generation, most people forget that
half from 1929 to 1933, and investment spending
by the middle of 1930, more than half of the stock
collapsed, declining by 90% from its 1929 level.
market decline had been reversed. What might have
The short-circuiting of the process that kept the
been a normal recession turned into something far
economy from recovering quickly, which it does in
different, however, with adverse shocks to the agri-
most recessions, occurred because of a fall in the
cultural sector, a continuing decline in the stock mar-
price level by 25% in the 1930Ð1933 period. This
ket after the middle of 1930, and a sequence of bank
huge decline in prices triggered a debt deflation in
collapses from October 1930 until March 1933 in
which net worth fell because of the increased burden
which over one-third of the banks in the United
of indebtedness borne by firms. The decline in net
States went out of business (events described in more
worth and the resulting increase in adverse selection
detail in Chapter 18).
and moral hazard problems in the credit markets led
The continuing decline in stock prices after mid-
to a prolonged economic contraction in which unem-
1930 (by mid-1932 stocks had declined to 10% of
ployment rose to 25% of the labor force. The finan-
their value at the 1929 peak) and the increase in
cial crisis in the Great Depression was the worst ever
uncertainty from the unsettled business conditions
experienced in the United States, and it explains why
created by the economic contraction made adverse
this economic contraction was also the most severe
selection and moral hazard problems worse in the
one ever experienced by the nation.*
*See Ben Bernanke, ÒNonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,Ó American Economic Review 73 (1983): 257Ð276, for a discussion of the role of asymmetric information problems in the Great Depression period.
Application
Financial Crises in Emerging-Market Countries: Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002
In recent years, many emerging-market countries have experienced financial crises, the most dramatic of which were the Mexican crisis, which started in December 1994; the East Asian crisis, which started in July 1997; and the Argentine crisis, which started in 2001. An important puzzle is how a developing country can shift dramatically from a path of high growth before a financial crisisÑas was true for Mexico and particularly the East Asian countries of Thailand, Malaysia, Indonesia, the Philippines, and South KoreaÑto a sharp decline in economic activity. We can apply our asymmetric information
C H A P T E R 8 An Economic Analysis of Financial Structure 195
analysis of financial crises to explain this puzzle and to understand the Mexican, East Asian, and Argentine financial situations.7
Because of the different institutional features of emerging-market countriesÕ debt markets, the sequence of events in the Mexican, East Asian, and Argentine crises is different from that occurring in the United States in the nineteenth and twentieth centuries. Figure 4 diagrams the sequence of events that occurred in Mexico, East Asia, and Argentina.
An important factor leading up to the financial crises in Mexico and East Asia was the deterioration in banksÕ balance sheets because of increasing loan losses. When financial markets in these countries were deregulated in the early 1990s, a lending boom ensued in which bank credit to the private nonfinancial business sector accelerated sharply. Because of weak supervision by bank regulators and a lack of expertise in screening and monitoring borrowers at banking institutions, losses on the loans began to mount, causing an erosion of banksÕ net worth (capital). As a result of this erosion, banks had fewer resources to lend, and this lack of lending eventually led to a contraction in economic activity.
Argentina also experienced a deterioration in bank balance sheets leading up to its crisis, but the source of this deterioration was quite different. In contrast to Mexico and the East Asian crisis countries, Argentina had a wellsupervised banking system, and a lending boom did not occur before the crisis. On the other hand, in 1998 Argentina entered a recession (you can find out more on why this occurred in Chapter 20) that led to some loan losses. However, it was the fiscal problems of the Argentine government that led to severe weakening of bank balance sheets. Again in contrast to Mexico and the East Asian countries before their crises, Argentina was running substantial budget deficits that could not be financed by foreign borrowing. To solve its fiscal problems, the Argentine government coerced banks into absorbing large amounts of government debt. When investors lost confidence in the ability of the Argentine government to repay this debt, the price of this debt plummeted, leaving big holes in commercial banksÕ balance sheets. This weakening in bank balance sheets, as in Mexico and East Asia, helped lead to a contraction of economic activity.
Consistent with the U.S. experience in the nineteenth and early twentieth centuries, another precipitating factor in the Mexican and Argentine (but not East Asian) financial crises was a rise in interest rates abroad. Before the Mexican crisis, in February 1994, and before the Argentine crisis, in mid1999, the Federal Reserve began a cycle of raising the federal funds rate to head off inflationary pressures. Although the monetary policy moves by the Fed were quite successful in keeping inflation in check in the United States, they put upward pressure on interest rates in both Mexico and Argentina.
7This chapter does not examine two other recent crises, those in Brazil and Russia. RussiaÕs financial crisis in August 1998 can also be explained with the asymmetric information story here, but it is more appropriate to view it as a symptom of a wider breakdown in the economyÑand this is why we do not focus on it here. The Brazilian crisis in January 1999 has features of a more traditional balance-of-payments crisis (see Chapter 20), rather than a financial crisis.
196 P A R T I I I
Financial Institutions
Deterioration in
Increase in
Stock Market
Increase in
Banks’ Balance Sheets
Interest Rates
Decline
Uncertainty
Adverse Selection and Moral
Hazard Problems Worsen
Fiscal
Foreign Exchange
Imbalances
Crisis
Adverse Selection and Moral
Hazard Problems Worsen
Economic Activity
Declines
Banking
Crisis
Adverse Selection and Moral
Hazard Problems Worsen
Economic Activity
Declines
Factors Causing Financial Crises
Consequences of Changes in Factors
F I G U R E 4 Sequence of Events in the Mexican, East Asian, and Argentine Financial Crises
The arrows trace the sequence of events during the financial crisis.
The rise in interest rates in Mexico and Argentina directly added to increased adverse selection in their financial markets because, as discussed earlier, it was more likely that the parties willing to take on the most risk would seek loans.
Also consistent with the U.S. experience in the nineteenth and early twentieth centuries, stock market declines and increases in uncertainty occurred prior to and contributed to full-blown crises in Mexico, Thailand,
C H A P T E R 8 An Economic Analysis of Financial Structure 197
South Korea, and Argentina. (The stock market declines in Malaysia, Indonesia, and the Philippines, on the other hand, occurred simultaneously with the onset of the crisis.) The Mexican economy was hit by political shocks in 1994 (specifically, the assassination of the ruling partyÕs presidential candidate and an uprising in the southern state of Chiapas) that created uncertainty, while the ongoing recession increased uncertainty in Argentina. Right before their crises, Thailand and Korea experienced major failures of financial and nonfinancial firms that increased general uncertainty in financial markets
As we have seen, an increase in uncertainty and a decrease in net worth as a result of a stock market decline increase asymmetric information problems. It becomes harder to screen out good from bad borrowers, and the decline in net worth decreases the value of firmsÕ collateral and increases their incentives to make risky investments because there is less equity to lose if the investments are unsuccessful. The increase in uncertainty and stock market declines that occurred before the crisis, along with the deterioration in banksÕ balance sheets, worsened adverse selection and moral hazard problems (shown at the top of the diagram in Figure 4) and made the economies ripe for a serious financial crisis.
At this point, full-blown speculative attacks developed in the foreign exchange market, plunging these countries into a full-scale crisis. With the Colosio assassination, the Chiapas uprising, and the growing weakness in the banking sector, the Mexican peso came under attack. Even though the Mexican central bank intervened in the foreign exchange market and raised interest rates sharply, it was unable to stem the attack and was forced to devalue the peso on December 20, 1994. In the case of Thailand, concerns about the large current account deficit and weakness in the Thai financial system, culminating with the failure of a major finance company, Finance One, led to a successful speculative attack that forced the Thai central bank to allow the baht to float downward in July 1997. Soon thereafter, speculative attacks developed against the other countries in the region, leading to the collapse of the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, and the South Korean won. In Argentina, a full-scale banking panic began in OctoberÐNovember 2001. This, along with realization that the government was going to default on its debt, also led to a speculative attack on the Argentine peso, resulting in its collapse on January 6, 2002.
The institutional structure of debt markets in Mexico and East Asia now interacted with the currency devaluations to propel the economies into fullfledged financial crises. Because so many firms in these countries had debt denominated in foreign currencies like the dollar and the yen, depreciation of their currencies resulted in increases in their indebtedness in domestic currency terms, even though the value of their assets remained unchanged. When the peso lost half its value by March 1995 and the Thai, Philippine, Malaysian, and South Korean currencies lost between a third and half of their value by the beginning of 1998, firmsÕ balance sheets took a big negative hit, causing a dramatic increase in adverse selection and moral hazard problems. This negative shock was especially severe for Indonesia and Argentina, which saw the value of their currencies fall by over 70%, resulting in insolvency for firms with substantial amounts of debt denominated in foreign currencies.
198 P A R T I I I
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The collapse of currencies also led to a rise in actual and expected inflation in these countries, and market interest rates rose sky-high (to around 100% in Mexico and Argentina). The resulting increase in interest payments caused reductions in householdsÕ and firmsÕ cash flow, which led to further deterioration in their balance sheets. A feature of debt markets in emerging-market countries, like those in Mexico, East Asia, and Argentina is that debt contracts have very short durations, typically less than one month. Thus the rise in short-term interest rates in these countries meant that the effect on cash flow and hence on balance sheets was substantial. As our asymmetric information analysis suggests, this deterioration in householdsÕ and firmsÕ balance sheets increased adverse selection and moral hazard problems in the credit markets, making domestic and foreign lenders even less willing to lend.
Consistent with the theory of financial crises outlined in this chapter, the sharp decline in lending helped lead to a collapse of economic activity, with real GDP growth falling sharply.
As shown in Figure 4, further deterioration in the economy occurred because the collapse in economic activity and the deterioration in the cash flow and balance sheets of both firms and households led to worsening banking crises. The problems of firms and households meant that many of them were no longer able to pay off their debts, resulting in substantial losses for the banks. Even more problematic for the banks was that they had many short-term liabilities denominated in foreign currencies, and the sharp increase in the value of these liabilities after the devaluation lead to a further deterioration in the banksÕ balance sheets. Under these circumstances, the banking system would have collapsed in the absence of a government safety netÑas it did in the United States during the Great DepressionÑbut with the assistance of the International Monetary Fund, these countries were in some cases able to protect depositors and avoid a bank panic. However, given the loss of bank capital and the need for the government to intervene to prop up the banks, the banksÕ ability to lend was nevertheless sharply curtailed. As we have seen, a banking crisis of this type hinders the ability of the banks to lend and also makes adverse selection and moral hazard problems worse in financial markets, because banks are less capable of playing their traditional financial intermediation role. The banking crisis, along with other factors that increased adverse selection and moral hazard problems in the credit markets of Mexico, East Asia, and Argentina, explains the collapse of lending and hence economic activity in the aftermath of the crisis.
In the aftermath of their crises, Mexico began to recover in 1996, while the crisis countries in East Asia saw the glimmer of recovery in 1999. Argentina was still in a severe depression in 2003. In all these countries, the economic hardship caused by the financial crises was tremendous. Unemployment rose sharply, poverty increased substantially, and even the social fabric of the society was stretched thin. For example, Mexico City and Buenos Aires have become crime-ridden, while Indonesia has experienced waves of ethnic violence.
C H A P T E R 8 An Economic Analysis of Financial Structure 199
Summary
1.There are eight basic puzzles about our financial structure. The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; the fifth recognizes that financial markets are among the most heavily regulated sectors of the economy; the sixth states that only large, well-established corporations have access to securities markets; the seventh indicates that collateral is an important feature of debt contracts; and the eighth presents debt contracts as complicated legal documents that place substantial restrictions on the behavior of the borrower.
2.Transaction costs freeze many small savers and borrowers out of direct involvement with financial markets. Financial intermediaries can take advantage of economies of scale and are better able to develop expertise to lower transaction costs, thus enabling their savers and borrowers to benefit from the existence of financial markets.
3.Asymmetric information results in two problems: adverse selection, which occurs before the transaction, and moral hazard, which occurs after the transaction. Adverse selection refers to the fact that bad credit risks are the ones most likely to seek loans, and moral hazard refers to the risk of the borrowerÕs engaging in activities that are undesirable from the lenderÕs point of view.
4.Adverse selection interferes with the efficient functioning of financial markets. Tools to help reduce the adverse selection problem include private production and sale of information, government
regulation to increase information, financial intermediation, and collateral and net worth. The freerider problem occurs when people who do not pay for information take advantage of information that other people have paid for. This problem explains why financial intermediaries, particularly banks, play a more important role in financing the activities of businesses than securities markets do.
5.Moral hazard in equity contracts is known as the principalÐagent problem, because managers (the agents) have less incentive to maximize profits than stockholders (the principals). The principalÐagent problem explains why debt contracts are so much more prevalent in financial markets than equity contracts. Tools to help reduce the principalÐagent problem include monitoring, government regulation to increase information, and financial intermediation.
6.Tools to reduce the moral hazard problem in debt contracts include net worth, monitoring and enforcement of restrictive covenants, and financial intermediaries.
7.Financial crises are major disruptions in financial markets. They are caused by increases in adverse selection and moral hazard problems that prevent financial markets from channeling funds to people with productive investment opportunities, leading to a sharp contraction in economic activity. The five types of factors that lead to financial crises are increases in interest rates, increases in uncertainty, asset market effects on balance sheets, problems in the banking sector, and government fiscal imbalances.
Key Terms
agency theory, p. 175, 189
debt deflation, p. 192
pecking order hypothesis, p. 180
bank panic, p. 191
financial crisis, p. 189
principalÐagent problem, p. 181
cash flow, p. 190
free-rider problem, p. 176
restrictive covenants, p. 172
collateral, p. 172
incentive-compatible, p. 185
secured debt, p. 172
costly state verification, p. 182
insolvent, p. 192
unsecured debt, p. 172
creditor, p. 188
net worth (equity capital), p. 180
venture capital firm, p. 182
200 P A R T I I I Financial Institutions
QUIZ Questions and Problems
Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó
1.How can economies of scale help explain the existence of financial intermediaries?
*2. Describe two ways in which financial intermediaries help lower transaction costs in the economy.
3.Would moral hazard and adverse selection still arise in financial markets if information were not asymmetric? Explain.
*4. How do standard accounting principles required by the government help financial markets work more efficiently?
5.Do you think the lemons problem would be more severe for stocks traded on the New York Stock Exchange or those traded over-the-counter? Explain.
*6. Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their activities? Why?
7.How can the existence of asymmetric information provide a rationale for government regulation of financial markets?
*8. Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? Why?
9.Rich people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection?
*10. The more collateral there is backing a loan, the less the lender has to worry about adverse selection. Is this statement true, false, or uncertain? Explain your answer.
11.How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?
*12. Explain how the separation of ownership and control in American corporations might lead to poor management.
13.Is a financial crisis more likely to occur when the economy is experiencing deflation or inflation? Explain.
*14. How can a stock market crash provoke a financial crisis?
15.How can a sharp rise in interest rates provoke a financial crisis?
Web Exercises
1. In this chapter we discuss the lemons problem and its
2. This chapter discusses how an understanding of
effect on the efficient functioning of a market. This
adverse selection and moral hazard can help us better
theory was initially developed by George Akerlof. Go to
understand financial crises. The greatest financial crisis
faced by the U.S. has been the Great Depression from
This site reports that Akerlof, Spence, and Stiglitz
1929Ð1933. Go to www.amatecon.com/greatdepression
were awarded the Nobel prize in economics in 2001
.html. This site contains a brief discussion of the fac-
for their work. Read this report down through the sec-
tors that led to the Depression. Write a one-page sum-
tion on George Akerlof. Summarize his research ideas
mary explaining how adverse selection and moral
in one page.
hazard contributed to the Depression.
C h a p t e r
9 Banking and the Management of
Financial Institutions
PREVIEW
Because banking plays such a major role in channeling funds to borrowers with productive investment opportunities, this financial activity is important in ensuring that the financial system and the economy run smoothly and efficiently. In the United States, banks (depository institutions) supply more than $5 trillion in credit annually. They provide loans to businesses, help us finance our college educations or the purchase of a new car or home, and provide us with services such as checking and savings accounts.
In this chapter, we examine how banking is conducted to earn the highest profits possible: how and why banks make loans, how they acquire funds and manage their assets and liabilities (debts), and how they earn income. Although we focus on commercial banking, because this is the most important financial intermediary activity, many of the same principles are applicable to other types of financial intermediation.
To understand how banking works, first we need to examine the bank balance sheet, a list of the bankÕs assets and liabilities. As the name implies, this list balances; that is, it has the characteristic that:
total assets total liabilities capital
Furthermore, a bankÕs balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by charging an interest rate on their holdings of securities and loans that is higher than the expenses on their liabilities. The balance sheet of all commercial banks as of January 2003 appears in Table 1.
A bank acquires funds by issuing (selling) liabilities, which are consequently also referred to as sources of funds. The funds obtained from issuing liabilities are used to purchase income-earning assets.
Checkable Deposits. Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties. Checkable deposits include all accounts
201
202 P A R T I I I
Financial Institutions
Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, January 2003)
on which checks can be drawn: non-interest-bearing checking accounts (demand deposits), interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts (MMDAs). Introduced with the Depository Institutions Act in 1982, MMDAs have features similar to those of money market mutual funds and are included in the checkable deposits category. However, MMDAs differ from checkable deposits in that they are not subject to reserve requirements (discussed later in the chapter) as checkable deposits are and are not included in the M1 definition of money. Table 1 shows that the category of checkable deposits is an important source of bank funds, making up 9% of bank liabilities. Once checkable deposits were the most important source of bank funds (over 60% of bank liabilities in 1960), but with the appearance of new, more attractive financial instruments, such as money market mutual funds, the share of checkable deposits in total bank liabilities has shrunk over time.
Checkable deposits and money market deposit accounts are payable on demand; that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately. Similarly, if a person who receives a check written on an account from a bank, presents that check at the bank, it must pay the funds out immediately (or credit them to that personÕs account).
A checkable deposit is an asset for the depositor because it is part of his or her wealth. Conversely, because the depositor can withdraw from an account funds that
A bank’s borrowings from the Federal Reserve System; also known as advances.
C H A P T E R 9 Banking and the Management of Financial Institutions 203
the bank is obligated to pay, checkable deposits are a liability for the bank. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to a liquid asset that can be used to make purchases. The bankÕs costs of maintaining checkable deposits include interest payments and the costs incurred in servicing these accountsÑprocessing and storing canceled checks, preparing and sending out monthly statements, providing efficient tellers (human or otherwise), maintaining an impressive building and conveniently located branches, and advertising and marketing to entice customers to deposit their funds with a given bank. In recent years, interest paid on deposits (checkable and time) has accounted for around 25% of total bank operating expenses, while the costs involved in servicing accounts (employee salaries, building rent, and so on) have been approximately 50% of operating expenses.
Nontransaction Deposits. Nontransaction deposits are the primary source of bank funds (56% of bank liabilities in Table 1). Owners cannot write checks on nontransaction deposits, but the interest rates are usually higher than those on checkable deposits. There are two basic types of nontransaction deposits: savings accounts and time deposits (also called certificates of deposit, or CDs).
Savings accounts were once the most common type of nontransaction deposit. In these accounts, to which funds can be added or from which funds can be withdrawn at any time, transactions and interest payments are recorded in a monthly statement or in a small book (the passbook) held by the owner of the account.
Time deposits have a fixed maturity length, ranging from several months to over five years, and have substantial penalties for early withdrawal (the forfeiture of several monthsÕ interest). Small-denomination time deposits (deposits of less than $100,000) are less liquid for the depositor than passbook savings, earn higher interest rates, and are a more costly source of funds for the banks.
Large-denomination time deposits (CDs) are available in denominations of $100,000 or over and are typically bought by corporations or other banks. Largedenomination CDs are negotiable; like bonds, they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds, and other financial institutions as alternative assets to Treasury bills and other short-term bonds. Since 1961, when they first appeared, negotiable CDs have become an important source of bank funds (14%).
Borrowings. Banks obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are called discount loans (also known as advances). Banks also borrow reserves overnight in the federal (fed) funds market from other U.S. banks and financial institutions. Banks borrow funds overnight in order to have enough deposits at the Federal Reserve to meet the amount required by the Fed. (The federal funds designation is somewhat confusing, because these loans are not made by the federal government or by the Federal Reserve, but rather by banks to other banks.) Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks). Borrowings have become a more important source of bank funds over time: In 1960, they made up only 2% of bank liabilities; currently, they are 28% of bank liabilities.
