Why Do Banks Exist?. Minimize Transactions Costs. Minimize Transactions Costs. While borrowers and savers might seek each other out and strike deals without going through intermediaries, traditional banking theory says this will be a groping, inefficient process .
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Why Do Banks Exist?
While borrowers and savers might seek each other out and strike deals without going through intermediaries, traditional banking theory says this will be a groping, inefficient process.
Intermediaries minimize transactions costs (search costs, negotiation costs, and enforcement costs) that serve as barriers between savers and borrowers.
Transactions services provide by intermediaries to match borrowers and savers include:
Holders of marketable securities have little incentive to monitor.
Managerial incentive schemes and bond covenants reduce but do not eliminate agency problems.
Why? Bond contracts are inflexible.
Bond contracts are inflexible (cont.):
Worst case scenario: bankruptcy due to severe but temporary shock. Everybody loses from failure to negotiate. Bank lending has the flexibility to avoid this outcome!
Banks act as delegated monitors.
And banks also have agency problems…
Solutions to bank agency problems:
Solution – Diversification!
Banks have a comparative advantage in monitoring (uncollateralized loans) because:
Informational economies of scope between checking and loan monitoring are greatest for small firms doing business exclusively in local markets.
Bank “Seals of Approval”:
The stock price of firm X rises when news a bank has loaned money to firm X hits the market.
Liquidity Insurance (cont.):