Banks as Delegated Monitors Flashcards
What are the key questions concerning banks as delegated monitors ?
- Why do bank deposits sometimes offer better risk-return characteristics than direct investment ?
- How can financial intermediation and direct investment coexist ?
What is Diamond basic idea ?
4 points
- Entrepreneurs = better informed than investors about project’s success + have incentive to misreport to avoid full repayment of loans
- For investors, monitoring success of project = costly
- Bank as financial intermediaries can economize on monitoring costs through diversification
→ Financial intermediation may dominate direct lending under certain conditions.
What is Diamond’s model structure ?
- Two periods (0,1)
- Each of n entrepreneurs need 1 unit of capital to finance project
- Large number (> n ∙ m) of small and risk neutral investors, each endowed with 1/m units of capital
- Investors can either invest in an entrepreneur’s project or alternative investment yielding CF I in T=1
→ Investors invest only in project if expected repayment in T=1 is at least I
→ Excess supply of capital = investors’ expected repayment from project = I
What is the production technology ?
Entrepreneur’s project = risky + yields random CF y ̃ ≥ 0 in T=1
- Funding project = efficient : E(y ̃ ) > I
- CF y ̃ = private information to the entrepreneur
- CF across projects = independently distributed
What are the asymmetric information features ?
Asymmetric information limits set of available contracts
- Entrepreneurs always report y ̃ = 0 to avoid repayment
- Investors anticipate entrepreneurs’ misbehaviour and chose alternative investment
→ Entrepreneurs cannot fund projects by promising repayment proportional to y ̃
→ Entrepreneurs’ interest to engage in contract limiting room for misbehavior
What are the two solutions for asymmetric information ?
- Incentive compatible loan contract with punishment
2. Monitoring
What is exactly monitoring ?
Monitoring = alternative to standard loan contract
• Fixed monitoring costs c per contract
• Total monitoring costs under direct lending are
nm ∙ c as each of nm investors monitors loan contract individually
When does monitoring outperform standard loan contract ?
Monitoring outperforms standard loan contract if :
m ∙ c < E[φ* (z(y))]
- Monitoring costly if large number m of investors needed to finance project
- Standard loan contract costly if project failure likely
→ Monitoring = superior to standard loan contract if investors = large and projects = risky
What is the main idea behind delegated monitoring ?
Bank finances each loan completely → aggregate monitoring costs fall from nm ∙ c to n ∙ c
How prevent bank from misbehaving ?
• Each investor monitoring bank individually cannot be optimal as would add delegation costs of nm ∙ c
• Total monitoring costs would increase to
nm ∙ c + n ∙ c
→ Instead bank offers fixed repayment R in standard debt/deposit contract with punishment
→ Total costs under delegated monitoring :
n ∙ c + E[φ*(z(y))]
When does delegated monitoring outperform individual monitoring ?
When n ∙ c + E[φ*(z(y))] < nm ∙ c
How can banks economize on delegation costs trhrough diversification ?
By law of large numbers :
mean of y→ E[y] ⇒ Pr(bank failure) ↓ ⇒ E[φ*(z(y))]↓
- Probability of bank failure and thus expected punishment costs, E[φ*(z(y))] decrease in n
- If number of financed projects n → ∞ expected punishment costs E[φ*(z(y))] → 0
→ Total costs of delegated monitoring → n ∙ c < nm ∙ c
→ Result critically depends on success rate not being (perfectly) correlated across projects
What does the model imply regarding predictions ?
4 points
- Delegated monitoring and financial intermediation play important role if asymmetric information is highly pronounced
- Banks mainly financed by fragmented debt rather than equity
- Diversification renders deposits relatively safe even if individual loans are risky
- Banking is natural monopoly characterized by globally increasing economies of scale
What are the empirical caveats ?
- Financial intermediaries often less than perfectly diversified + hold lots of highly correlated assets
- Small banks can compete against large and complex banks → enjoy subsidy of implicit government guarantees
- Equity increases bank loss absorbing capacity + renders deposits even safer
How can financial intermediaries reduce the overall monitoring costs through diversification even though they create another layer of asymmetric information ?
- Information asymmetries between entrepreneurs and investors are pronounced
- Investors = small relative to required investments
- Risk across investments = only partly correlated
