Prepared by Yakob Gebreegziabher 2022

Chapter 3: Financial Institutions : Deposit Type, Contractual, and Other

Financial Institutions

Financial system is made up of six components: money, financial instruments, financial markets,
financial institutions, government regulatory agencies, and the central bank. In chapter I and II we
covered the first three of these componets. In this chapter we examine financial institutions’
purpose, which is known as financial intermediation. Financial institutions intermediate between
savers and borrowers, and so their assets and liabilities are primarily financial instruments. Various
sorts of banks, brokerage firms, investment companies, insurance companies, and pension funds
all fall into this category. These are the institutions that pool funds from people and firms who
save and lend them to people and firms who need to borrow, transforming assets and providing
access to financial markets. They funnel savers’ surplus resources into home mortgages, business
loans, and investments.

financial intermediaries are involved in both direct finance—in which borrowers sell securities
directly to lenders in the financial markets—and indirect finance, in which a third party issues
claims to those who provide funds and acquires claims from those who use them. Intermediaries
investigate the financial condition of the individuals and firms who want financing to figure out
which have the best investment opportunities. As providers of indirect finance, banks want to make
loans only to the highest-quality borrowers. When they do their job correctly, financial
intermediaries increase investment and economic growth at the same time that they reduce
investment risk and economic volatility.

Ensuring that the best investment opportunities and highest-quality borrowers are funded is
extremely important. Any country that wants to grow must ensure that its financial system works.
When a country’s financial system crumbles, its economy fails with it. That is what happened in
the United States in the Great Depression of the 1930s, when a series of bank closings was followed
by an increase in the unemployment rate to more than 25 percent and a fall of nearly one-third in
the level of economic activity (measured by GDP). The Asian crisis of 1997, in which the banking
systems of Thailand and Indonesia collapsed, is a more recent example. The deep, prolonged
economic plunge of 2008–2009 highlights how a financial crisis, once started, can spread
devastation across the global economy, triggering a spiral of economic and financial decline that
is difficult to halt. And the subsequent turmoil in the euro area depressed some economies in the

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region enough to rival the traumatic 1930s experience. Without a stable, smoothly functioning
financial system, no country can prosper.

In many countries over the past 25 years, the value of stock and bond markets has come to rival or
even surpass the value of outstanding loans through financial intermediaries. But as we will see,
intermediaries, including banks and securities firms, continue to play a key role in both these types
of finance.

3.1 Deposit type institutions

Banks are the most visible financial intermediaries in the economy. Most of us use the word bank
to describe what people in the financial world call depository institutions. These are the financial
institutions that accept deposits from savers and make loans to borrowers. What distinguishes
depository institutions from non-depository institutions is their primary source of funds—that is,
the liability side of their balance sheets. Depository institutions include commercial banks, savings
and loans, and credit unions—the financial intermediaries most of us encounter in the course of
our day-to-day lives.

Banking is a business. Actually, it’s a combination of businesses designed to deliver services. One
business provides the accounting and record keeping services that track the balances in your
accounts. Another grants you access to the payments system, allowing you to convert your account
balances into cash or transfer them to someone else. Yet a third business pools the savings of many
small depositors and uses them to make large loans to trustworthy borrowers. A fourth business
offers customers diversification services, buying and selling financial instruments in the financial
markets in an effort to make a profit. Banks trade in the financial markets not just as a service to
their customers but in an effort to earn a profit for their owners as well.

The intent of banks, of course, is to profit from each of these lines of business. Our objective in
this chapter is to see how they do it. Not all banks make a profit. While some banks are extremely
large, with hundreds of billions of dollars in loans and securities on their balance sheets, their
access to funds is no guarantee of profitability. The risk that banks may fail is a problem not just
for their owners and managers but for the rest of us, too

In this section, we will examine the business of banking. We will see where depository institutions
get their funds and what they do with them. That is, we will study the sources of banks’ liabilities

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and learn how they manage their assets. And because banking is a risky business, we will examine
the sources of risk that bankers face, as well as how those risks can be managed.

The Balance Sheet of Commercial Banks

To focus our discussion of depository institutions, we will concentrate on what are called
commercial banks. These institutions were established to provide banking services to businesses,
allowing them to deposit funds safely and borrow them when necessary. Today, many commercial
banks offer accounts and loans to individuals as well. To understand the business of commercial
banking, we’ll start by examining the commercial bank’s balance sheet. Recall that a balance sheet
is a list of a household’s or firm’s assets and liabilities: the sources of its funds (liabilities) and the
uses to which those funds are put (assets). A bank’s balance sheet says that

Total bank assets = Total bank liabilities + Bank capital

Banks obtain their funds from individual depositors and businesses, as well as by borrowing from
other financial institutions and through the financial markets. They use these funds to make loans,
purchase marketable securities, and hold cash. The difference between a bank’s assets and
liabilities is the bank’s capital, or net worth—the value of the bank to its owners. The bank’s profits
come both from service fees and from the difference between what the bank pays for its liabilities
and the return it receives on its assets.

Assets: Uses of Funds

Let’s start with the asset side of the balance sheet—what banks do with the funds they raise. The
table below shows that assets are divided into four broad categories: cash, securities, loans, and all
other assets.

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Cash Items: Cash assets are of three types. The first and most important is reserves. Banks hold
reserves because regulations require it and because prudent business practice dictates it. Reserves
include the cash in the bank’s vault (and the currency in its ATM machines), called vault cash, as
well as the bank’s deposits at the Federal Reserve System. Cash is the most liquid of the bank’s
assets; the bank holds it to meet customers’ withdrawal requests. Cash items also include what are
called cash items in process of collection. When you deposit your paycheck into your checking
account, several days may pass before your bank can collect the funds from your employer’s bank.

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In the meantime, the uncollected funds are considered your bank’s asset because the bank is
expecting to receive them. Finally, cash includes the balances of the accounts that banks hold at
other banks.

Securities: The second-largest component of bank assets is marketable securities. While banks in
many countries can hold stock, U.S. banks cannot, so this category of assets includes only bonds.
Banks’ bond holdings.

Loans: Loans are the primary asset of modern commercial banks, accounting for well over one-
half of assets. We can divide loans into five broad categories: business loans, called commercial
and industrial loans; real estate loans, including both home and commercial mortgages as well as
home equity loans; consumer loans, like auto loans and credit card loans; interbank loans (loans
made from one bank to another); and other types, including loans for the purchase of other
securities. These types of loans vary considerably in their liquidity. Some, like home mortgages
and auto loans, usually can be securitized and resold.

Liabilities: Sources of Funds

Deposits

To finance their operations, banks need funds. They get them from savers and from borrowing in
the financial markets. To entice individuals and businesses to place their funds in the bank,
institutions offer a range of deposit accounts that provide safekeeping and accounting services,
access to the payments system, liquidity, and diversification of risk, as well as interest payments
on the balance. There are two types of deposit accounts, transaction and non-transaction accounts.
Transaction accounts are known as checkable deposits.

Checkable Deposits “Demand deposits,” which allow a customer to withdraw funds without
notice on a first-come, first-served basis, make up the largest component of checkable deposits.
Banks also offer customers a variety of similar options that fall into the category of checking
accounts, such as insured market rate accounts. A typical bank will offer half a dozen or more of
these, each with slightly different characteristics.

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In addition to the names created by banks’ marketing departments, economists use various other
terms in speaking of checkable deposits. For example, some economists call them “sight deposits”
because a depositor can show up to withdraw them when the bank is in sight.

Non transaction Deposits: including savings and time deposits, accounted for more than half of
all commercial bank liabilities. Savings deposits, commonly known as passbook savings accounts,
were popular for many decades, though they are less so today. Time deposits are certificates of
deposit (CDs) with a fixed maturity. When you place your savings in a CD at your local bank, it
is as if you are buying a bond issued by that bank. But unlike government or corporate bonds, there
isn’t much of a resale market for your small CD. So if you want to withdraw your funds before the
CD matures, you must get them back from the bank. To discourage early withdrawals, banks
charge a significant penalty.

Borrowings

Borrowing is the second most important source of bank funds. Banks borrow in a number of ways.
First, they can borrow from the Federal Reserve or from other financial institutions. More often,
banks borrow from other intermediaries. For example, banks with excess reserves can lend their
surplus funds to banks that need them through an interbank market called the federal funds
market. Loans made in the federal funds market are unsecured— they lack collateral—so the
lending bank must trust the borrowing bank.

Finally, banks borrow using an instrument called a repurchase agreement, or repo, a short-term
collateralized loan in which a security is exchanged for cash, with the agreement that the parties
will reverse the transaction on a specific future date, typically the next day. For example, a bank
that has a U.S. Treasury bill might need cash, while a pension fund might have cash that it doesn’t
need overnight. Through a repo, the bank would give the T-bill to the pension fund in exchange
for cash, agreeing to buy it back—repurchase it—with interest the next day. In short, the bank gets
an overnight loan and the pension fund gets some extra interest, along with the protection provided
by collateral.

Bank Capital and Profitability

Net worth equals assets minus liabilities, whether we are talking about an individual’s net worth
or a bank’s. In the case of banks, however, net worth is referred to as bank capital, or equity

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capital. (Important tip: Do not confuse bank capital and cash reserves. Capital appears on the
liability side of the balance sheet, whereas reserves are an asset.) If the bank’s owners sold all its
assets (without taking a loss) and used the proceeds to repay all the liabilities, capital is what would
be left. We can think of capital as the owners’ stake in the bank.

3.2 Contractual saving institutions

Contractual savings institutions are financial intermediaries that acquire funds periodically on a
contractual basis and invest them (lend them out) in such a way that they have financial instruments
maturing when contractual obligations have to be met. In general, they can predict their liabilities
fairly accurately, and thus they (unlike depository institutions) do not have to worry as much about
losing funds.

Contractual savings institutions include national provident funds, life insurance companies, private
pension funds, and funded social pension insurance systems. They have long-term liabilities and
stable cash flows and are therefore ideal providers of term finance, not only to government and
industry, but also to municipal authorities and the housing sector. Except for Singapore, Malaysia,
and a few other countries, most developing countries have small and insignificant contractual
savings industries that have been undermined by high inflation and inhibited by oppressive
regulations and pay-as-you-go social pension insurance systems. Contractual savings institutions
play a much bigger role in the financial systems of developed countries. In some countries, such
as Switzerland, the Netherlands, and the United Kingdom, the resources mobilized by life
insurance companies and pension funds correspond to well over 100 percent of annual GDP. Since
there are many contracts, three major categories of contractual savings institutions—life insurance
companies, fire and casualty insurance companies, and pension funds and government retirement
funds—are briefly discussed below.

Life Insurance Companies.

Life insurance companies sell life insurance policies that protect the beneficiaries of a policyholder
against financial hazards that follow the death of the insured person. Life insurance companies
also sell annuities in which an insurance company contracts to make annual income payments to
the annuity buyer upon his or her retirement. These insurance companies acquire funds through
payments of premiums by individuals who pay to keep their policies in force. Life insurance

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companies can calculate liabilities with a fair degree of accuracy using mortality tables. As a result,
they use funds to buy longer term securities—primarily corporate bonds and mortgages. While
corporate stocks are also long-term securities, life insurance companies are restricted in the amount
of stocks they can hold. This government restriction is based on the perception that stocks are
risky, and they may thus jeopardize the insurance companies' ability to meet liabilities.

Fire and Casualty Insurance Companies

Fire and casualty insurance companies (also called property and casualty insurance companies)
are in the insurance business like the life insurance companies. They insure policyholders against
the risk of loss from a variety of contingencies, such as fire, flood, theft, or accidents. An individual
buys car or home insurance, for example, from a property and casualty insurance company. Like
life insurance companies, fire and casualty insurance companies acquire funds through payments
of insurance premiums from policyholders. Unlike life insurance companies, however, the
property and casualty insurance companies are subject to greater uncertainty with respect to their
liabilities—there is no way to pinpoint as to when major disasters may happen. Due to this kind of
uncertainty, these insurance companies buy more liquid assets (shorter-term securities) than life
insurance companies. Municipal bonds constitute the largest fraction of total assets. They also,
however, invest in corporate stocks and bonds, and Treasury securities.

Private Pension Funds and Government Retirement Funds

Private pension funds and government retirement funds receive periodic payments of contributions
from employers and/or employees that participate in the program. Employee contributions are
either automatically deducted from pay or made voluntarily. The pension and retirement funds'
liability is to provide retirement income, generally in the form of annuities, to individuals covered
by these pension plans. As the liabilities of private pension and government retirement funds are
fairly certain with respect to timing and are of a long-term nature, they invest resources in long-
term financial instruments, such as corporate stocks and bonds.

The federal government has encouraged growth in pension funds through legislative actions that
mandate establishment of pension plans, as well as through tax incentives to individuals that lower
their costs of contributing to the pension plans.

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3.3 Investment funds

Let us began this section by noting Information Asymmetries and Information Costs Information
plays a central role in the structure of financial markets and financial institutions. Markets require
sophisticated information to work well; when the cost of obtaining that information is too high,
markets cease to function. Information costs make the financial markets, as important as they are,
among the worst functioning of all markets. The fact is, the issuers of financial instruments—
borrowers who want to issue bonds and firms that want to issue stock—know much more about
their business prospects and their willingness to work than potential lenders or investors—those
who would buy their bonds and stocks. This asymmetric information is a serious hindrance to the
operation of financial markets. Solving this problem is one key to making our financial system
work as well as it does.

The two problems in fact, information problems are the key to understanding the structure of our
financial system and the central role of financial intermediaries. Asymmetric information poses
two important obstacles to the smooth flow of funds from savers to investors. The first, called
Adverse selection, arises before the transaction occurs, lenders need to know how to distinguish
good credit risks from bad. The second problem, called Moral hazard, occurs after the transaction,
lenders need to find a way to tell whether borrowers will use the proceeds of a loan as they claim
they will. The following sections will look at both these problems in detail to see how they affect
the structure of the financial system.

Adverse Selection Used Cars and the Market for Lemons the 2001 Nobel Prize in Economics was
awarded to George A. Akerlof, A. Michael Spence, and Joseph E. Stiglitz “for their analyses of
markets with asymmetric information.” Professor Akerlof’s contribution came first, in a paper
published in 1970 titled “The Market for ‘Lemons’.”2 Akerlof’s paper explained why the market
for used cars—some of which may be “lemons”— doesn’t function very well. Here’s the logic.

Suppose the used-car market has only two cars for sale, both 2013 model Honda Accords. One is
immaculate, having been driven and maintained by a careful elderly woman who didn’t travel
much. The second car belonged to a young man who got it from his parents, loved to drive fast,
and did not worry about the damage he might cause if he hit a pothole. The owners of these two
cars know whether their own cars are in good repair, but used-car shoppers do not.

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Let’s say that potential buyers are willing to pay $20,000 for a well-maintained car, but only
$10,000 for a “lemon”—a car with lots of mechanical problems. The elderly woman knows her
car is a “peach.” It’s in good condition and she won’t part with it for less than $20,000. The young
man, knowing the poor condition of his car, will take $8,000 for it. But if buyers can’t tell the
difference between the two cars, without more information they will pay only the average price of
$15,000. (A risk-averse buyer wouldn’t even pay that much.) That is less than the owner of the
good car will accept, so she won’t sell her car and it disappears from the market. The problem is
that if buyers are willing to pay only the average value of all the cars on the market, sellers with
cars in above-average condition won’t put their cars up for sale. Only the worst cars, the lemons,
will be left on the market. In summary, buyers’ inability to uncover the hidden attributes of the
vehicles for sale undermines the used car market as a whole.

Information asymmetries aside, people like to buy new cars, and when they do, they sell their old
cars. People who can’t afford new cars, or who would rather not pay for them, are looking to buy
good used cars. Together, these potential buyers and sellers of used cars provide a substantial
incentive for creative people to solve the problem of adverse selection in the used-car market.
Some companies try to help buyers separate the peaches from the lemons. We have found ways to
overcome the information problems pointed out by Professor Akerlof, and as a result both good
and bad used cars sell at prices much closer to their true value. So long as there exists a technology
that lets buyers determine, at a reasonable cost, the hidden attributes of used cars for sale, the
market works.

In the absence of asymmetric information, the lemons problem goes away. If buyers know as much
about the quality of used cars as sellers, so that all involved can tell a good car from a bad one,
buyers will be willing to pay full value for good used cars. Because the owners of good used cars
can now get a fair price, they will be willing to sell them in the market. The market will have many
transactions and will perform its intended job of channeling good cars to people who want them.
Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full
value of securities issued by good firms, and good firms will sell their securities in the market. The
securities market will then be able to move funds to the good firms that have the most productive
investment opportunities.

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Tools to Help Solve Adverse Selection Problems

When it comes to information costs, financial markets are not that different from the used-car
market. In the same way that the seller of a used car knows more about the car than the buyer,
potential borrowers know more about the projects they wish to finance than prospective lenders.
And in the same way that information asymmetries can drive good cars out of the used-car market,
they can drive good stocks and bonds out of the financial market.

To see why, let’s start with stocks. Think about a simple case in which there are two firms, one
with good prospects and one with bad prospects. If you can’t tell the difference between the two
firms, you will be willing to pay a price based only on their average quality. The stock of the good
company will be undervalued. Because the managers know their stock is worth more than the
average price, they won’t issue it in the first place. That leaves only the firm with bad prospects in
the market. And because most investors aren’t interested in companies with poor prospects, the
market is very unlikely to get started at all. So let’s see the alternative solutions in detail:

Private Production and Sale of Information: The solution to the adverse selection problem in
financial markets is to reduce asymmetric information by furnishing the people supplying funds
with more details about the individuals or firms seeking to finance their investment activities. One
way for saver-lenders to get this information is through private companies that collect and produce
information distinguishing good firms from bad firms, and then sell it to the saver-lenders. In the
United States, companies such as Standard and Poor’s, Moody’s, and Value Line gather
information on firms’ balance sheet positions and investment activities, publish these data, and sell
them to subscribers (individuals, libraries, and financial intermediaries involved in purchasing
securities).

The system of private production and sale of information does not completely solve the adverse
selection problem in securities markets, however, because of the free-rider problem. The free-rider
problem occurs when people who do not pay for information take advantage of the information
that other people have paid for. The free-rider problem suggests that the private sale of information
is only a partial solution to the lemons problem. To see why, suppose you have just purchased
information that tells you which firms are good and which are bad. You believe that this purchase
is worthwhile because you can make up the cost of acquiring this information, and then some, by
purchasing the securities of good firms that are undervalued. However, when our savvy (free-

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riding) investor Irving sees you buying certain securities, he buys right along with you, even
though he has not paid for any information. If many other investors act as Irving does, the increased
demand for the undervalued good securities causes their low price to be bid up immediately to
reflect the securities’ true value. Because of all these free riders, you can no longer buy the
securities for less than their true value.

Now, because you will not gain any profit from purchasing the information, you realize that you
never should have paid for the information in the first place. If other investors come to the same
realization, private firms and individuals may not be able to sell enough of this information to
make it worth their while to gather and produce it. The weakened ability of private firms to profit
from selling information will mean that less information is produced in the marketplace, so adverse
selection (the lemons problem) will still interfere with the efficient functioning of securities
markets.

Government Regulation to Increase Information: The free-rider problem prevents the private
market from producing enough information to eliminate all the asymmetric information that leads
to adverse selection. Could financial markets benefit from government intervention? The
government could, for instance, produce information to help investors distinguish good from bad
firms and provide it to the public free of charge. This solution, however, would involve the
government releasing negative information about firms, a practice that might be politically
difficult. A second possibility (and one followed by the United States and most governments
throughout the world) is for the government to regulate securities markets in a way that encourages
firms to reveal honest information about themselves so that investors can determine how good or
bad the firms are. In the United States, the Securities and Exchange Commission (SEC) is the
government agency that requires firms selling their securities to undergo independent audits, in
which accounting firms certify that the firm is adhering to standard accounting principles and
disclosing accurate information about sales, assets, and earnings. Similar regulations are found in
other countries. However, disclosure requirements do not always work well, as the collapse
accounting scandals at other corporations.

The asymmetric information problem of adverse selection in financial markets helps explain why
financial markets are among the most heavily regulated sectors of the economy. Government
regulation aimed at increasing the information available to investors is necessary to reduce the

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adverse selection problem, which interferes with the efficient functioning of securities (stock and
bond) markets.

Although government regulation lessens the adverse selection problem, it does not eliminate it
entirely. Even when firms provide information to the public about their sales, assets, or earnings,
they still have more information than investors: A lot more is involved in knowing the quality of
a firm than statistics alone can provide. Furthermore, bad firms have an incentive to make
themselves look like good firms because this enables them to fetch a higher price for their
securities. Bad firms will slant the information they are required to transmit to the public, thus
making it harder for investors to sort out the good firms from the bad.

Financial Intermediation: So far we have seen that private production of information and
government regulation to encourage provision of information lessen, but do not eliminate, the
adverse selection problem in financial markets. How, then, can the financial structure help promote
the flow of funds to people with productive investment opportunities when asymmetric
information exists? A clue is provided by the structure of the used-car market.

An important feature of the used-car market is that most used cars are not sold directly by one
individual to another. An individual who considers buying a used car might pay for privately
produced information by subscribing to a magazine like Consumer

Reports to find out if a particular make of car has a good repair record. Nevertheless, reading
Consumer Reports does not solve the adverse selection problem, because even if a particular make
of car has a good reputation, the specific car someone is trying to sell could be a lemon. The
prospective buyer might also bring the used car to a mechanic for a once-over. But what if the
prospective buyer doesn’t know a mechanic who can be trusted or the mechanic charges a high fee
to evaluate the car?

Because these roadblocks make it hard for individuals to acquire enough information about used
cars, most used cars are not sold directly by one individual to another.

Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from
individuals and resells them to other individuals. Used-car dealers produce information in the
market by becoming experts in determining whether a car is a peach or a lemon. Once a dealer
knows that a car is good, the dealer can sell it with some form of a guarantee: either an explicit

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guarantee such as a warranty or an implicit guarantee in which the dealer stands by its reputation
for honesty. People are more likely to purchase a used car because of a dealer’s guarantee, and the
dealer is able to sell the used car at a higher price than the dealer paid for it. Thus the dealer profits
from the production of information about automobile quality. If dealers purchase and then resell
cars on which they have produced information, they avoid the problem of other people free-riding
on the information they produced.

Just as used-car dealers help solve adverse selection problems in the automobile market, financial
intermediaries play a similar role in financial markets. A financial intermediary, such as a bank,
becomes an expert in producing information about firms so that it can sort out good credit risks
from bad ones. It then can acquire funds from depositors and lend them to the good firms. Because
the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the
interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive
to engage in this information production activity.

An important element of the bank’s ability to profit from the information it produces is that it
avoids the free-rider problem by primarily making private loans, rather than by purchasing
securities that are traded in the open market. Because a private loan is not traded, other investors
cannot watch what the bank is doing and bid down the loan’s interest rate to the point that the bank
receives no compensation for the information it has produced. The bank’s role as an intermediary
that holds mostly nontraded loans is the key to its success in reducing asymmetric information in
financial markets.

Our analysis of adverse selection indicates that financial intermediaries in general— and banks in
particular, because they hold a large fraction of nontraded loans—should play a greater role in
moving funds to corporations than securities markets do.

Our analysis also explains the greater importance of banks, as opposed to securities markets, in
the financial systems of developing countries. As we have seen, better information about the
quality of firms lessens asymmetric information problems, making it easier for firms to issue
securities. Information about private firms is harder to collect in developing countries than in
industrialized countries; therefore, the smaller role played by securities markets leads to a greater
role for financial intermediaries such as banks.

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As a corollary to our analysis, as information about firms becomes easier to acquire, the role of
banks should decline. A major development in the past 30 years in the United States has been huge
improvements in information technology. Thus our analysis suggests that the lending role of
financial institutions such as banks in the United States should have declined, and this is exactly
what has occurred.

Our analysis of adverse selection also explains, which questions why large firms are more likely
to obtain funds from securities markets, a direct route, rather than from banks and financial
intermediaries, an indirect route. The better known a corporation is, the more information about
its activities is available in the marketplace. Thus it is easier for investors to evaluate the quality
of the corporation and determine whether it is a good firm or a bad one. Because investors have
fewer worries about adverse selection when dealing with well-known corporations, they are more
willing to invest directly in their securities. Thus, in accordance with adverse selection, a pecking
order for firms that can issue securities should exist. Hence we have an explanation for fact. The
larger and more established a corporation is, the more likely it will be to issue securities to raise
funds.

Collateral and Net Worth: Adverse selection interferes with the functioning of financial markets
only if a lender suffers a loss when a borrower is unable to make loan payments and thereby
defaults on the loan. Collateral, property promised to the lender if the borrower defaults, reduces
the consequences of adverse selection because it reduces the lender’s losses in the event of a
default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to
make up for the losses on the loan.

For example, if you fail to make your mortgage payments, the lender can take the title to your
house, auction it off, and use the receipts to pay off the loan. Lenders are thus more willing to
make loans secured by collateral, and borrowers are willing to supply collateral because the
reduced risk for the lender makes it more likely that the loan will be made, perhaps even at a better
loan rate. The presence of adverse selection in credit markets thus explains why collateral is an
important feature of debt contracts.

Net worth (also called equity capital), the difference between a firm’s assets (what it owns or is
owed) and its liabilities (what it owes), can perform a similar role to that of collateral. If a firm has
a high net worth, then even if it engages in investments that lead to negative profits and so defaults

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on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds
to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first
place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay
off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse
selection are less important and lenders are more willing to make loans.

Moral Hazard

The phrase moral hazard originated when economists who were studying insurance noted that an
insurance policy changes the behavior of the person who is insured. Examples are everywhere. A
fire insurance policy written for more than the value of the property might induce the owner to
arson; a generous automobile insurance policy might encourage reckless driving. Employment
arrangements suffer from moral hazard, too. How can your boss be sure you are working as hard
as you can if you’ll get your paycheck at the end of the week whether you do or not? Moral hazard
arises when we cannot observe people’s actions and so cannot judge whether a poor outcome was
intentional or just a result of bad luck. Thus, a lender’s or investor’s information problems do not
end with adverse selection. A second information asymmetry arises because the borrower knows
more than the lender about the way borrowed funds will be used and the effort that will go into a
project. Where adverse selection is about hidden attributes, moral hazard is about hidden actions.

Moral Hazard in Equity Financing If you buy a stock, how do you know the company that issued
it will use the funds you have invested in the way that is best for you? The answer is that it almost
surely will not. You have given your funds to managers, who will tend to run the company in the
way most advantageous to them. The separation of your ownership from their control creates what
is called a principal–agent problem, which can be more than a little costly to stockholders. Witness
the luxurious offices, corporate jets, limousines, and artwork that executives surround themselves
with, not to mention the millions of dollars in compensation they pay themselves. Managers gain
all these personal benefits at the expense of stockholders.

Tools to Help Solve Moral Hazard in Equity Contracts (the Principal–Agent Problem)

Solutions to the moral hazard problem in equity finance are hard to come by. Information on the
quality of management can be useful, but only if owners have the power to fire managers—and

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that can be extremely difficult. Requiring managers to own a significant stake in their own firm is
another possibility. Let’s see the alternatives.

Production of Information; Monitoring: You have seen that the principal–agent problem arises
because managers have more information about their activities and actual profits than stockholders
do. One way for stockholders to reduce this moral hazard problem is for them to engage in a
particular type of information production: monitoring the firm’s activities by auditing the firm
frequently and checking on what the management is doing. The problem is that the monitoring
process can be expensive in terms of time and money, as reflected in the name economists give it:
costly state verification. Costly state verification makes the equity contract less desirable and
explains in part why equity is not a more important element in our financial structure.

As with adverse selection, the free-rider problem decreases the amount of private information
production that would reduce the moral hazard (principal–agent) problem. In this example, the
free-rider problem decreases monitoring. If you know that other stockholders are paying to monitor
the activities of the company you hold shares in, you can take a free ride on their activities. Then
you can use the money you save by not engaging in monitoring to vacation on a Caribbean island.
If you can do this, though, so can other stockholders. Perhaps all the stockholders will go to the
islands, and no one will spend any resources on monitoring the firm. The moral hazard problem
for shares of common stock will then be severe, making it hard for firms to issue them to raise
capital.

Government Regulation to Increase Information: As with adverse selection, the government

has an incentive to try to reduce the moral hazard problem created by asymmetric information,
which provides another reason why the financial system is so heavily regulated. Governments
everywhere have laws to force firms to adhere to standard accounting principles that make profit
verification easier. They also pass laws to impose stiff criminal penalties on people who commit
the fraud of hiding and stealing profits. However, these measures can be only partly effective.
Catching this kind of fraud is not easy; fraudulent managers have the incentive to make it very
hard for government agencies to find or prove fraud.

Financial Intermediation: Financial intermediaries have the ability to avoid the free-rider
problem in the face of moral hazard, and this is another reason why indirect finance is so important.
One financial intermediary that helps reduce the moral hazard arising from the principal–agent

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problem is the venture capital firm. Venture capital firms pool the resources of their partners and
use the funds to help budding entrepreneurs start new businesses. In exchange for supplying the
venture capital, the firm receives an equity share in the new business. Because verification of
earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist
on having several of their own people participate as members of the managing body— the board
of directors—of the new business so that they can keep a close watch on the new firm’s activities.
When a venture capital firm supplies start-up funds, the equity in the new firm is private—that is,
not marketable to anyone except the venture capital firm. Thus other investors are unable to take a
free ride on the venture capital firm’s verification activities. As a result of this arrangement, the
venture capital firm is able to garner the full benefits of its verification activities and is given the
appropriate incentives to reduce the moral hazard problem. Venture capital firms have been
important in the development of the high-tech sector in the United States, which has resulted in
job creation, economic growth, and increased international competitiveness.

Debt Contracts: Moral hazard arises with an equity contract, which is a claim on profits in all
situations, whether the firm is making or losing money. If a contract could be structured so that
moral hazard would exist only in certain situations, the need to monitor managers would be
reduced, and the contract would be more attractive than the equity contract. The debt contract has
exactly these attributes because it is a contractual agreement by the borrower to pay the lender
fixed dollar amounts at periodic intervals. When a firm has high profits, the lender receives the
contractual payments and does not need to know the exact profits of the firm. If the managers are
hiding profits or pursuing activities that are personally beneficial but don’t increase the firm’s
profitability, the lender doesn’t care, as long as these activities do not interfere with the ability of
the firm to make its debt payments on time. Only when the firm cannot meet its debt payments,
thereby putting itself in a state of default, does the lender need to verify the state of the firm’s
profits. Only in this situation do lenders involved in debt contracts need to act more like equity
holders; to get their fair share, they now must know how much income the firm has.

The less frequent need to monitor the firm, and thus the lower cost of state verification, helps
explain why debt contracts are used more frequently than equity contracts to raise capital. The
concept of moral hazard therefore helps explain, which states that stocks are not the most important
source of financing for businesses.

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Tools to Help Solve Moral Hazard in Equity Contracts (the Principal–Agent Problem)

Moral Hazard in Debt Finance When the managers of a company are the owners, the problem of
moral hazard in equity financing disappears. This suggests that investors should prefer debt
financing to equity financing. Debt does go a long way toward eliminating the moral hazard
problem inherent in equity finance, but it doesn’t finish the job. Because debt contracts allow
owners to keep all the profits in excess of the loan payments, they encourage risk taking.

Solving the Moral Hazard Problem in Debt Finance to some degree, as follows.

Production of Information; Monitoring: You have seen that the principal–agent problem arises
because managers have more information about their activities and actual profits than stockholders
do. One way for stockholders to reduce this moral hazard problem is for them to engage in a
particular type of information production: monitoring the firm’s activities by auditing the firm
frequently and checking on what the management is doing. The problem is that the monitoring
process can be expensive in terms of time and money, as reflected in the name economists give it:
costly state verification. Costly state verification makes the equity contract less desirable and
explains in part why equity is not a more important element in our financial structure.

As with adverse selection, the free-rider problem decreases the amount of private information
production that would reduce the moral hazard (principal–agent) problem. In this example, the
free-rider problem decreases monitoring. If you know that other stockholders are paying to monitor
the activities of the company you hold shares in, you can take a free ride on their activities. Then
you can use the money you save by not engaging in monitoring to vacation on a Caribbean island.
If you can do this, though, so can other stockholders. Perhaps all the stockholders will go to the
islands, and no one will spend any resources on monitoring the firm. The moral hazard problem
for shares of common stock will then be severe, making it hard for firms to issue them to raise
capital.

Government Regulation to Increase Information: As with adverse selection, the government

has an incentive to try to reduce the moral hazard problem created by asymmetric information,
which provides another reason why the financial system is so heavily regulated. Governments
everywhere have laws to force firms to adhere to standard accounting principles that make profit
verification easier. They also pass laws to impose stiff criminal penalties on people who commit

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the fraud of hiding and stealing profits. However, these measures can be only partly effective.
Catching this kind of fraud is not easy; fraudulent managers have the incentive to make it very
hard for government agencies to find or prove fraud.

Financial Intermediation: Financial intermediaries have the ability to avoid the free-rider
problem in the face of moral hazard, and this is another reason why indirect finance is so important.
One financial intermediary that helps reduce the moral hazard arising from the principal–agent
problem is the venture capital firm. Venture capital firms pool the resources of their partners and
use the funds to help budding entrepreneurs start new businesses. In exchange for supplying the
venture capital, the firm receives an equity share in the new business. Because verification of
earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist
on having several of their own people participate as members of the managing body— the board
of directors—of the new business so that they can keep a close watch on the new firm’s activities.
When a venture capital firm supplies start-up funds, the equity in the new firm is private—that is,
not marketable to anyone except the venture capital firm. Thus other investors are unable to take a
free ride on the venture capital firm’s verification activities. As a result of this arrangement, the
venture capital firm is able to garner the full benefits of its verification activities and is given the
appropriate incentives to reduce the moral hazard problem. Venture capital firms have been
important in the development of the high-tech sector in the United States, which has resulted in
job creation, economic growth, and increased international competitiveness.

Debt Contracts: Moral hazard arises with an equity contract, which is a claim on profits in all
situations, whether the firm is making or losing money. If a contract could be structured so that
moral hazard would exist only in certain situations, the need to monitor managers would be
reduced, and the contract would be more attractive than the equity contract. The debt contract has
exactly these attributes because it is a contractual agreement by the borrower to pay the lender
fixed dollar amounts at periodic intervals. When a firm has high profits, the lender receives the
contractual payments and does not need to know the exact profits of the firm. If the managers are
hiding profits or pursuing activities that are personally beneficial but don’t increase the firm’s
profitability, the lender doesn’t care, as long as these activities do not interfere with the ability of
the firm to make its debt payments on time. Only when the firm cannot meet its debt payments,
thereby putting itself in a state of default, does the lender need to verify the state of the firm’s

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profits. Only in this situation do lenders involved in debt contracts need to act more like equity
holders; to get their fair share, they now must know how much income the firm has.

The less frequent need to monitor the firm, and thus the lower cost of state verification, helps
explain why debt contracts are used more frequently than equity contracts to raise capital. The
concept of moral hazard therefore helps explain, which states that stocks are not the most important
source of financing for businesses.

Tools to Help Solve Moral Hazard in Debt Contracts

Net Worth and Collateral: When borrowers have more at stake because their net worth (the
difference between their assets and their liabilities) is high or the collateral they have pledged to
the lender is valuable, the risk of moral hazard—the temptation to act in a manner that lenders find
objectionable—is greatly reduced because the borrowers themselves have a lot to lose. In other
words, if borrowers have more “skin in the game” because they have higher net worth or pledge
collateral, they are likely to take less risk at the lender’s expense. Let’s return to Steve and his ice-
cream business. Suppose that the cost of setting up either the ice-cream store or the research
equipment is $100,000 instead of $10,000. Now Steve needs to invest $91,000 (instead of $1,000)
of his own money in the business, in addition to the $9,000 supplied by your loan. If Steve is
unsuccessful in inventing the no-calorie, nonfat ice cream, he has a lot to lose—the $91,000 of net
worth (the $100,000 in assets minus the $9,000 loan from you). He will think twice about
undertaking the riskier investment and is more likely to invest in the ice-cream store, which is
more of a sure thing. Thus, when Steve has more of his own money (net worth) invested in the
business, and hence more skin in the game, you are more likely to make him the loan. Similarly,
if you have pledged your house as collateral, you are less likely to go to Las Vegas and gamble
away your earnings that month, because you might not be able to make your mortgage payments
and therefore might lose your house.

One way of describing the solution that high net worth and collateral provide to the moral hazard
problem is to say that it makes the debt contract incentive-compatible; that is, it aligns the
incentives of the borrower with those of the lender. The greater the borrower’s net worth and
collateral pledged, then the greater the borrower’s incentive to behave in the way that the lender
expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is

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for the firm or household to borrow. Conversely, when the borrower’s net worth and collateral are
lower, the moral hazard problem is greater, making it harder to borrow.

Monitoring and Enforcement of Restrictive Covenants: As the example of Steve and his ice-
cream store shows, if you could make sure that Steve doesn’t invest in anything riskier than the
ice-cream store, it would be worth your while to make him the loan. You can ensure that Steve
uses your money for the purpose you expect by writing provisions (restrictive covenants) into the
debt contract that restrict his firm’s activities. By monitoring Steve’s activities to check whether
he is complying with the restrictive covenants and by enforcing the covenants if he is not, you can
make sure that he will not take on risks at your expense. Restrictive covenants are directed at
reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable
behavior. There are four types of restrictive covenants that achieve this objective:

1. Covenants to discourage undesirable behavior. Covenants can be designed to lower moral

hazard by keeping the borrower from engaging in the undesirable behavior of undertaking risky
investment projects. Some covenants mandate that a loan be used only to finance specific
activities, such as the purchase of particular equipment or inventories. Others restrict the borrowing
firm from engaging in certain risky business activities, such as purchasing other businesses.

2. Covenants to encourage desirable behavior. Restrictive covenants can encourage the borrower
to engage in desirable activities that make it more likely that the loan will be paid off. One such
restrictive covenant requires the breadwinner in a household to carry life insurance that will pay
off the mortgage upon that person’s death. For businesses, restrictive covenants of this type focus
on encouraging the borrowing firm to keep its net worth high because higher borrower net worth
reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive
covenants typically specify that the borrowing firm must maintain minimum holdings of certain
assets relative to the firm’s size.

3. Covenants to keep collateral valuable. Because collateral is an important protection for the
lender, restrictive covenants can encourage the borrower to keep the collateral in good condition
and make sure that it stays in the possession of the borrower.

This is the type of covenant ordinary people encounter most often. Automobile loan contracts, for
example, require the car owner to maintain a minimum amount of collision and theft insurance

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and prevent the sale of the car unless the loan is paid off. Similarly, the recipient of a home
mortgage must have adequate insurance on the home and must pay off the mortgage when the
property is sold.

4. Covenants to provide information. Restrictive covenants also require a borrowing firm to

provide information about its activities periodically, in the form of quarterly accounting and
income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard.
This type of covenant may also stipulate that the lender has the right to audit and inspect the firm’s
books at any time.

Financial Intermediation: Although restrictive covenants help reduce the moral hazard problem,
they do not eliminate it completely. It is almost impossible to write covenants that rule out every
risky activity. Furthermore, borrowers may be clever enough to find loopholes in restrictive
covenants that make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A
restrictive covenant is meaningless if the borrower can violate it knowing that the lender won’t
checkup or is unwilling to pay for legal recourse. Because monitoring and enforcement of
restrictive covenants are costly, the free-rider problem arises in the debt securities (bond) market
just as it does in the stock market. If you know that other bondholders are monitoring and enforcing
the restrictive covenants, you can free-ride on their monitoring and enforcement. But other
bondholders can do the same thing, so the likely outcome is that not enough resources will be
devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues
to be a severe problem for marketable debt.

As we have seen before, financial intermediaries—particularly banks—can avoid the free-rider

problem by primarily making private loans. Private loans are not traded, so no one else can free-
ride on the intermediary’s monitoring and enforcement of the restrictive covenants. The
intermediary making private loans thus receives the full benefits of monitoring and enforcement,
and will work to shrink the moral hazard problem inherent in debt contracts. The concept of moral
hazard has provided us with additional reasons why financial intermediaries play a more important
role in channeling funds from savers to borrowers than marketable securities do.

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Now we can conclude this section by noting two things: (1) Wealthy countries have high levels of
financial development, and (2) intermediaries play key roles both in lending and securities finance.
The first is explained by the fact that the financial system improves the efficient operation of the
economy, helping to channel resources to their most productive uses. Our discussion suggests that
information problems are the primary explanation for the second. But a corporation that wants to
undertake an investment project can obtain financing not only directly from financial markets,
through the issuance of stocks or bonds; or indirectly from a financial intermediary, in the form of
a loan; it can also use its own profits. That is, instead of distributing profits to shareholders in the
form of dividends, the firm can retain the earnings and use them as a source of investment
financing. You may be surprised to learn that the vast majority of investment financing comes
from internal sources. In both the United States and the United Kingdom, for example, more than
80 percent of business investment comes from internal sources. The only possible explanation for
this fact is that information problems make external financing—obtained either by issuing into
markets or by borrowing from financial institutions—prohibitively expensive and difficult to get.
It’s not just individuals that have to finance their activities without any help—businesses do, too.
The fact that managers have superior information about the way in which their firms are and should
be run makes internal finance the rational choice.

3.4 Other types of financial institutions

1. Central Banks

Central banks are the financial institutions responsible for the oversight and management of all
other banks. In the United States, the central bank is the Federal Reserve Bank and in our country
it is National bank, which is responsible for conducting monetary policy and supervision and
regulation of financial institutions. Individual consumers do not have direct contact with a central
bank; instead, large financial institutions work directly with the Federal Reserve Bank or National
bank to provide products and services to the general public.

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2. Retail and Commercial Banks

Traditionally, retail banks offered products to individual consumers while commercial banks
worked directly with businesses. Currently, the majority of large banks offer deposit accounts,
lending, and limited financial advice to both demographics.

Products offered at retail and commercial banks include checking and savings accounts,
certificates of deposit (CDs), personal and mortgage loans, credit cards, and business banking
accounts.

3. Internet Banks

A newer entrant to the financial institution market is internet banks, which work similarly to retail
banks. Internet banks offer the same products and services as conventional banks, but they do so
through online platforms instead of brick-and-mortar locations.

Under internet banks, there are two categories: digital banks and neo-banks. Digital banks are
online-only platforms affiliated with traditional banks. However, neobanks are pure digital native
banks with no affiliation to any bank but themselves.

4. Credit Unions

A credit union is a type of financial institution providing traditional banking services and is created,
owned, and operated by its members. In the recent past credit unions used to serve a specific
demographic per their field of membership, such as teachers or members of the military. You can
see this with Hawassa university staffs owning a credit union that collects and provide fund from
its members.

Credit unions are not publicly traded and only need to make enough money to continue daily
operations. That's why they can afford to provide better rates to their customers than commercial
banks.

5. Savings and Loan Associations

Financial institutions that are mutually owned by their customers and provide no more than 20%
of total lending to businesses fall under the category of savings and loan associations. They provide
individual consumers with checking and accounts, personal loans, and home mortgages.

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Unlike commercial banks, most of these institutions are community-based and privately owned,
although some may also be publicly traded. The members pay dues that are pooled together, which
allows better rates on banking products.

6. Investment Banks

Investment banks are financial institutions that provide services and act as an intermediary in
complex transactions, for instance, when a startup is preparing for an initial public offering (IPO),
or in merges. They can also act as a broker or financial adviser for large institutional clients such
as pension funds.

Investment banks do not take deposits; instead, they help individuals, businesses and governments
raise capital through the issuance of securities. Investment companies, traditionally known as
mutual fund companies, pool funds from individuals and institutional investors to provide them
access to the broader securities market.

Global investment banks include JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup,
Bank of America, Credit Suisse, and Deutsche Bank. Robo-advisors are the new breed of such
companies, enabled by mobile technology to support investment services more cost-effectively
and provide broader access to investing by the public.

7. Brokerage Firms

Brokerage firms assist individuals and institutions in buying and selling securities among available
investors. Customers of brokerage firms can place trades of stocks, bonds, mutual funds, exchange-
traded funds (ETFs), and some alternative investments.

8. Insurance Companies

Financial institutions that help individuals transfer the risk of loss are known as insurance
companies. Individuals and businesses use insurance companies to protect against financial loss
due to death, disability, accidents, property damage, and other misfortunes.

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9. Mortgage Companies

Financial institutions specialized in originating or funding mortgage loans are mortgage

companies. While most mortgage companies serve the individual consumer market, some
specialize in lending options for commercial real estate only.

Mortgage companies focus exclusively on originating loans and seek funding from financial
institutions that provide the capital for the mortgages. Many mortgage companies today operate
online or have limited branch locations, which allows for lower mortgage costs and fees.

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