THE IMPACT OF THE CAPITAL MARKET
CHAPTER 3 BANKS AND FINANCIAL INTERMEDIATION
3.5 ASYMMETRY OF INFORMATION
The basic rationale underlying the asymmetry of information argument is that the borrower is likely to have more information about the project that is the subject of a loan than the lender. The borrower should therefore be more aware of the pitfalls of any project and, in particular, the degree of risk attached to the project than the lender. Asymmetry of information between borrower and lender raises two further problems: i.e., moral hazard and adverse selection. In the context of ¢nance, moral hazard is the risk that the borrower may engage in activities that reduce the probabil- ity of the loan being repaid. Moral hazard may arise both before and after the loan is made. Prior to the loan being granted, the borrower may well have in£ated the probable pro¢tability of the project either by exaggerating the pro¢t if the venture is successful or minimizing the chance of failure. It is di⁄cult for the lender to assess the true situation. After the loan is negotiated, moral hazard may occur because the borrower acts in a way detrimental to the repayment of the loan; for example, engaging in other more risky activities. Adverse selection may occur because the lender is not sure of the precise circumstances surrounding the loan and associated project. Given this lack of information, the lender may select projects which are wrong in the sense that they o¡er a lower chance of meeting the outcomes speci¢ed by the borrower than loans for other more viable projects which are rejected.
The results of the existence of asymmetric information between a borrower and lender and the associated problems of moral hazard and adverse selection reduce the e⁄ciency of the transfer of funds from surplus to de¢cit units. In which ways can the introduction of a bank help to overcome these problems? Three answers are given in the literature, namely: (i) the banks are subject to scale economies in the borrowing/lending activity so that they can be considered information-sharing coalitions; (ii) banks monitoring the ¢rms that they ¢nance, i.e. delegated monitor- ing of borrowers; and (iii) banks’ provision of a commitment to a long-term
ASYMMETRY OF INFORMATION 41
relationship. In all these cases a bank may be able to overcome the twin problems of moral hazard and adverse selection.
3.5.1 INFORMATION-SHARING COALITIONS
The seminal contribution to this literature is Leyland and Pyle (1977). As we have discussed above, the assumption is made that the borrower knows more about the risk of a project than the lender. Hence, it is necessary to collect information to try to redress the balance. One problem is that information is costly to obtain and that it is in the nature of a ‘public good’. Any purchaser of information can easily resell or share that information with other individuals so that the original ¢rm may not be able to recoup the value of the information obtained. A second aspect is that the quality of the information is di⁄cult to ascertain so that the distinction between good and bad information is not readily apparent. Leyland and Pyle argue that because of this di⁄culty the price of information will re£ect its average quality so that ¢rms which search out high-quality information will lose money.
They further argue that these problems can be resolved through an intermediary which uses information to buy and hold assets in its portfolio. Thus, information becomes a private good because it is embodied in its portfolio and, hence, is not transferable. This provides an incentive for the gathering of information.
Furthermore, Leyland and Pyle argue that one way a ¢rm can provide informa- tion about its project is by way of o¡ering collateral security, and so a ‘coalition of borrowers’ (i.e., the bank) can do better than any individual borrower. This can easily be demonstrated. Assume N individual borrowers each with an identical project yielding the same expected return, sayR. The variance of each individual return is given by2. The ‘coalition’ does not alter the expected return per project, but the variance is now2=Nbecause of diversi¢cation.
Leyland and Pyle also put forward the view that their analysis o¡ers an explana- tion for the liability structure of a bank’s balance sheet. They propose that the optimal capital structure for ¢rms with riskier returns will be one with lower debt levels. Provided a bank has reduced the level of risk, then the structure of liabilities observed with high debt in the form of deposits is quite logical.
3.5.2 BANKS’ ROLES IN DELEGATED MONITORING
De¢ned broadly, ‘monitoring’ refers to the collection of information about a ¢rm, its investment projects and its behaviour before and after the loan application is made. Examples of monitoring include:
1. Screening application of loans so as to sort out the good from the bad, thus reducing the chance of ¢nancing excessively risky loans.
2. Examining the ¢rm’s creditworthiness.
3. Seeing that the borrower adheres to the terms of the contract.
A bank has a special advantage in the monitoring process since it will often be operating the client’s current account and will therefore have private information concerning the client’s £ows of income and expenditure.
This factor is very important in the case of small- and medium-sized companies and arises from the fact that banks are the main operators in the payments mechanism.
A bank will require a ¢rm to produce a business plan before granting a loan.
Given the number of such plans examined, a bank will have developed special expertise in assessing such plans and will therefore be more competent in judging the validity of the plan and separate the viable from the nonviable projects. A similar process will be required for domestic loans and the bank will scrutinize the purpose of domestic loans. Further controls exist in the form of ‘credit-scoring’
whereby a client’s creditworthiness is assessed by certain rules. A very simple example of this is in respect of house purchase where the maximum amount of a loan is set with reference to the applicant’s income. It should be admitted that other more public information is available in respect of ¢rms. Speci¢c rating agencies exist who provide credit ratings for ¢rms and also sovereign debt. The most well- known examples are Standard & Poor and Moody. This information becomes available to the general public because of reports in the media. Nevertheless, the existence of rating agencies augments rather than detracts from the role of banks in the assessment of creditworthiness of prospective borrowers. The ¢nal example concerns monitoring after the loan has been granted. Banks will set conditions in the loan contract which can be veri¢ed over time. For a ¢rm these typically will include the adhering to certain accounting ratios and a restraint over further borrow- ing while the loan is outstanding. The bank is able to check that such conditions are being adhered to. In addition, collateral security will often be required. Failure to adhere to the terms of the agreement will cause the loan to be cancelled and the collateral forfeited.12
The information obtained from borrowers is also con¢dential, which is not the case when funds are obtained from the capital market. In the latter situation, the
¢rm raising funds must provide a not inconsiderable amount of detail to all prospec- tive investors. There is a second advantage to ¢rms raising bank loans. The fact that a ¢rm has been able to borrow from a bank and meet its obligations regarding repayment provides a seal of approval as far as the capital market is concerned. It shows that the ¢rm has been satisfactorily screened and absolves the capital market from repeating the process. The role of banks, in particular, provides a means for the problems associated with asymmetric information to be ameliorated. For monitoring to be bene¢cial it is necessary to show that the bene¢ts of monitoring outweigh the costs involved in gathering the information. As noted in Section 3.3, banks have a comparative advantage in the process of monitoring the behaviour of
ASYMMETRY OF INFORMATION 43
12This argument abstracts from the dilemma facing banks in the case of loans at risk. Should they lend more and hope to regain the outstanding amount of the loan at some time in the future or should they cancel the loan now? The ¢rst option entails the risk of a larger loss in the future and the second a loss now.
borrowers both before and after the loan is granted. This gives the lenders an incentive to delegate the monitoring to a third party, thus avoiding duplication of e¡ort. Any bankruptcy cost will be spread over a large number of depositors, making the average cost per depositor quite small. This contrasts with the situation if each lender is concerned with few loans. In such cases the failure of one borrower to service the loan according to the agreement would have a major impact on the lender.
Diamond (1984, 1996) presents a more formal model of intermediation reducing the costs of outside ¢nance under conditions of imperfect information.
Diamond considers three types of contracting arrangements between lenders and borrowers: (a) no monitoring, (b) direct monitoring by investors and (c) delegated monitoring via an intermediary. In the case of no monitoring, the only recourse to the lender in the case of a failure by the borrower to honour his obligations is through some form of bankruptcy proceedings. This is an ‘all or nothing’ approach and is clearly expensive and ine⁄cient. Direct monitoring can be extremely costly.
The example given by Diamond (1996) assumes there aremlenders per borrower and a single borrower. IfK is the cost of monitoring, then the total cost of moni- toring without a bank is mK. The introduction of a bank changes the situation.
Assume a delegation cost ofDper borrower, then the cost after delegation will be ðKþDÞ as against ðmKÞ without a bank.13 It is readily apparent that ðKþDÞ will be less thanmK so that the introduction of a bank has lowered the cost of intermediation. This process is illustrated in Figure 3.3.
The analysis so far assumes that the monitoring cost per loan remains the same, but, as noted earlier, the monitoring cost per transaction would be expected to fall because of the existence of economies of scale and scope. There is still the problem for the lenders/depositors to monitor the behaviour of the bank since the depositors will not be able to observe the information gleaned by the bank about the borrowers. They can however observe the behaviour of the bank so that it could be argued that the process has merely led to a transfer of monitoring of the behaviour of the lender to that of the bank. The second prop to the analysis is that it is assumed that the bank maintains a well-diversi¢ed portfolio so that the return to the investors in the bank ^ i.e., the ultimate lenders ^ is almost riskless (but not completely so given the facts that banks do fail, e.g. BCCI) and, therefore, not subject to the problems associated with asymmetric information. The depositors also have the sanction of withdrawing deposits as a means of disciplining the bank.
Furthermore, in addition to the diversi¢cation of its portfolio, depositors receive further protection because of the supervision of banks carried out either by a regulative authority, the precise nature of which depends on the institutions of the country concerned. Consequently, the bank is able to issue ¢xed-interest debt and make loans to customers with conditions signi¢cantly di¡erent from those o¡ered to the depositors.
13If there wereNrather than a single borrower then the two costs without and with a bank would benmKandðKþnDÞ, respectively. This leaves the analysis intact.
ASYMMETRY OF INFORMATION 45
FIGURE 3.3
Financial intermediation as delegated monitoring (a) Monitoring without a bank
(b) Monitoring with a bank Borrower
Lender 1
Lender 2
Lender m
Borrower Bank
Lender 1
Lender 2
Lender m
3.5.3 A MECHANISM FOR COMMITMENT
The third reason given for the existence of banks given asymmetric information is they provide a mechanism for commitment. If contracts could be written in a form which speci¢es all possible outcomes, then commitment would not be a problem.
However, it is quite clear that enforceable contracts cannot be drawn up in a manner which does specify all the possible outcomes; in other words, there is an absence of complete contracts. Mayer (1990) suggests that if banks have a close relationship with their borrowers then this relationship may provide an alternative means of commitment. It is argued that, in particular, Japanese and German banks do have a close relationship with their clients and in many cases are represented on the ¢rms’ governing bodies. This enables the bank to have good information about investment prospects and the future outlook for the ¢rm and to take remedial actions other than foreclosure in the event of the ¢rm experiencing problems. This close relationship may help, then, to ameliorate the twin problems of moral hazard and adverse selection. Hoshiet al. (1991) provide supportive evidence that ¢rms with close banking ties appear to invest more and perform more e⁄ciently than
¢rms without such ties. On the other hand, there is the danger of ‘crony’ capitalism and the close ties may inhibit banks’ actions.