Financial Institutions Management: A Risk Management Approach 10th Edition by Anthony Saunders Solu
6. Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?
By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilized properly by the borrower. This agglomeration of funds resolves a number of problems. First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves. Second, the FI can collect information more efficiently than individual investors. The FI can utilize this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy. Thus, by acting as a delegated monitor and producing better and more timely information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.
7. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?
First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.
8. What are agency costs? How do FIs solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations?
Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from the failure to adequately monitor the activities of the borrower. If no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. That is, agency costs arise whenever economic agents enter into contracts in a world of incomplete information and thus costly information collection. The more difficult and costly it is to collect information, the more likely it is that contracts will be broken. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower because it has far more at stake than does any small individual household.
9. How do large FIs solve the problem of high information collection costs for lenders, borrowers, and financial markets?
One way financial institutions solve this problem is that they develop of secondary securities that allow for improvements in the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. When bank loan contracts are sufficiently short term, the banker becomes almost like an insider to the firm regarding informational familiarity with its operations and financial conditions. Indeed, this more frequent monitoring often replaces the need for the relatively inflexible and hard-to-enforce covenants found in bond contracts. Thus, by acting as a delegated monitor and producing better and timelier information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.
10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to buy securities issued by corporations?
FIs provide financial or secondary claims to household and other savers. Often, these claims have superior liquidity attributes compared with those of primary securities such as corporate equity and bonds. For example, depository institutions issue transaction account deposit contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn immediately on demand by household savers. Money market mutual funds issue shares to household savers that allow those savers to enjoy almost fixed principal (deposit-like) contracts while often earning interest rates higher than those on bank deposits. Even life insurance companies allow policyholders to borrow against their policies held with the company at very short notice.