Basic raison d'être for banks: information costs and liquidity

Introduction

The question needs to be asked: "why cannot borrowers and lenders come together without the intermediation of a profit-maximising company offering this function?" The answer is that they do, but this happens on a limited scale. Examples are:

• A father lending to his son, enabling his son to repay his bond. If we assume the bank home loan rate bond is 12% and the deposit rate is 8%, they will probably do the deal at 10%. Both score on the deal and they cut out the banking sector (called bank disintermediation).

• A member of the household sector holding a portfolio of shares (here we regard share finance as "infinite borrowing" where the lender gets a share of the profits).

• A corporate entity holding a treasury bill for LCC 5 million.

It will be recalled that these are examples of direct financing. However, we need to look at the likely facts:

• The lenders are probably wealthy.

• In the first example the mortgage bond is probably an "access bond", i.e. a bond where the outstanding amount can be flexible (up to a maximum), i.e. the son can access the bond when the father needs the money. This means that the term to maturity of the bond is flexible. If the term of the bond was 20 years and the outstanding amount was not flexible, the father would probably not have done the deal.

• The father is fully aware of the creditworthiness of his son.

• In the case of the corporate entity and the wealthy member of the household sector, the securities are marketable, meaning that they lenders have access to their funds - by selling the securities in the secondary markets.

What are we saying? We are saying that there are two critical considerations that make banks useful intermediaries:

• Information costs. The dad lends money to his son because he has the knowledge that his son will repay the loan. Banks lend funds to borrowers that are not known to the depositors, and they incur costs in gathering in information on the borrowers. Here we have one reason for the existence of banks - information costs.

• Asymmetry in liquidity preference. Only few dads lend to their sons, because most dads do not have the surplus funds to do so. In general, the many dads, moms, companies, etc find it convenient to get interest from the bank while the money is available, which is probably for only a portion of the month. The banks lend to borrowers for long periods, for example 25 years in the case of government bonds. Here we have the second reason for the existence of banks: lenders and borrowers have different liquidity preferences. It is true that securities markets do provide liquidity for the lender; however, these markets are only accessible to high net worth

Following is a discussion on these two main reasons for the existence of banks.

Information costs

Four main types of information costs can be identified:

• Search costs.

• Verification costs.

• Monitoring costs.

• Enforcement costs.

Search costs are incurred whenever a transaction between two parties is done. The borrower is not concerned with the quality of the lender, but the lender is concerned with the quality of the borrower. Search costs include negotiation and the gathering of information, which take place during meetings that usually take some time.

Verification costs are incurred because the bank is obliged to verify the information gathered. Banks are concerned with the well-known problem of asymmetric information (a gap in knowledge between lender and borrower), which can give rise to the problems of adverse selection (poor selection prior to the loan) and moral hazard (financially-immoral behaviour by the borrower after the loan is made).

It is interesting to note that a higher rate charged to compensate for a risky client can be negatively self-fulfilling, i.e. it can make the project for which the money is borrowed unviable. A high rate is of course perfectly acceptable to the borrower who knows s/he is going to default.

Monitoring costs are incurred by the bank because once the money is lent the bank has an incentive to monitor the client (this will be discussed in more detail later under the risks of banks).

Enforcement costs are incurred when borrowers do not adhere to the terms of the contract, i.e. the terms of the loan. When conditions are breached, the bank (the injured party) has to take action, and "action" could mean expensive "legal action".

The individual lender (surplus economic unit) does not have the time or the inclination or the skill to gather information, verify the information, monitor client behaviour or enforce legal contracts, and delegates this function to the bank - which is skilled in this area. It may be said that banks have "informational economies of scope"; they focus on this function and consequently the cost per transaction is lower than in the case where an individual lender assesses a few borrowers.

Asymmetry in liquidity preference

Lenders and borrowers have different requirements in terms of liquidity, which essentially means term to maturity of the loan or deposit. Borrowers usually borrow for projects that have long lives and consequently long-term repayment schedules, whereas lenders usually require deposits that are liquid, i.e. deposits that are available immediately or in the short-term. Banks satisfy both parties; they essentially transmute illiquid assets into liquid liabilities.

Depositors earn a rate of interest and have liquidity, and they accept a low rate of interest compared with the loan rate for this convenience. The large banks have little risk of losing funds (liquidity risk) because withdrawals of liquid deposits do not deplete the system of funds; these funds remain in the system and flow back to the deficit banks via the interbank market.

The borrowers are prepared to pay a higher rate of interest than that available to the lenders because of the convenience, i.e. availability of the funds for the required period, which would most likely not be the case if the ultimate lender loaned the funds.

OTC versus securities markets

It should be evident that banks mainly operate in the informal (over-the-counter - OTC) financial market: taking of deposits from and making loans to individuals and smaller companies in the main. The alternative to the informal market is the formalised market, i.e. the financial (share and bond) exchange/s, where informational and liquidity problems are overcome by:

• The borrowers (issuers of securities) being the large creditworthy borrowers (which are usually rated by credit rating agencies).

• The existence of standardised contracts.

• The ability to dispose of investments when the need arises.