Slideslecture8infofrictionsandintermediationposted

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ECO 349

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Economics

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Dec 15, 2024

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Lecture 8: Information frictions, contracts &intermediationECO 349HF Money, Banking, and Financial MarketsUniversity of Toronto MississaugaasdfProfessor Mark RempelFall 20241 / 59

Intro to bankingCS Chp. 11, GLS 31, CFH 7 Appendix2 / 59

Where we left off▶Last few weeks examined various financial and monetaryinstruments▶What they are and why they are demanded▶Value of these assets depended on uncontrollable risks▶In reality1.asset payoffs depend on future actions▶Not all actions relevant to payoffs directly observable to buyerse.g. effort level or ability of employees, trustworthiness▶That is there areinformation asymmetries2.size/timeline of financing infeasible for most people3 / 59

How banks can help1.asset payoffs depend on future actions -info asymmetries▶Solutions:monitoractions &/orscreenfor desired capabilities2.size/timeline of financing infeasible for individuals, solutions:▶pooling resources, diversifying investment risks & offering liquidity▶minimizing duplication of effort in resolving info issues▶better monitoring by resolving ‘free-rider problem’▶better screening with expertise developed with experience4 / 59

Direct vs indirect financing▶Direct financing/investing:▶Publicly traded stocks & corporate bonds▶Needs public disclosures & regulatory oversight e.g. SEC, OSFI▶Standardized contracts▶Private equity & debt contracts e.g. Peer-to-peer or angel investing▶Little regulation, limited oversight, rife with info asymmetries▶Allows for more flexible terms▶Indirect (private) financing:▶Bank loans, e.g. mortgages, business loans or Venture Capital (VC)▶Mitigates info frictions without borrower public disclosures /regulation▶Financing decisions concentrated in small number of people▶Aggregate tradeoffs to intermediated vs public financing?5 / 59

Declining publicly listed equity & rising venture capitalSource: Own calculations, non-financial firms, US major stock marketsCelentano & Rempel (2023)Note: similar trends for Canada (excluding ‘Frankenstocks’)Tingle, (2021)6 / 59

Declining bank to small business lendingSource: Bank Policy Institute (BPI), 2022link7 / 59

US small business lending needs not being metSource: Reuters, March 2024link8 / 59

Canada: Bank corporate lending & mortgage share trendsOwn calculations, data source: Statistics Canada Table 36-10-0640-019 / 59

Relative financing mixMishkin & Serletis textbook10 / 59

Questions raised from these anecdotes▶Why do different firms/countries rely more on bank/non-bankfunding?▶What are the implications of these choices?▶How important is bank financing for firms?▶What could be driving the trends we’ve seen and should we beconcerned?11 / 59

Theory of credit intermediationDirect investing with moral hazard - model setupDraws on Freixas & Rochet Chp. 2.5.3, Holmstrom & Tirole (1997)12 / 59

Basic model setup (without banks)▶Two types of players: entrepreneur, and households▶E needs to investI= 1 for risky project▶yieldy= 1.5 if success▶yield is 0 with project failure▶E has cash assetsA<1 so needsI−Ain financing▶E enjoys relaxing over working hard, but lowers success probability▶E gets an extra benefitB= 0.25 from relaxing▶Probability of success by working hardphard=.9>prelax=.5▶Everyone has utility overt+ 1 consumption,u(c) =c▶Households can invest in E or government bond at rate 1+r = 1.0413 / 59

Direct investing between households and firms▶Household can invest in entrepreneurs for promised payoffx▶Entrepreneurs have limited liability so their payoff isπhard(x) = (y−x)phard+ max{0,(0−x)}(1−phard)πrelax(x) =B+ (y−x)prelax+ max{0,(0−x)}(1−prelax)▶i.e. entrepreneurs which fail default on payment to householdx▶Household expected payoff for efforte(hard / relax) isUe=E[u(c)|anticipated effort,e] =E[u(c)] =pe·x+ (1−pe)·014 / 59

When should households consider investing inentrepreneurs?▶Households net payoff takes into account outside option of fundsUNete=pe·x+ (1−pe)·0−(1 +r)IhwhereIhis the amount of money invested into the entrepreneur▶Therefore should invest for a given effort level whenUNete≥015 / 59

When should households consider investing inentrepreneurs?▶Will assume:▶Positive total surplus from investing in hardworking entrep.phardy+ (1−phard)·0−(1 +r)>0(1)▶Negative total surplus for investing in lazy entrep.prelaxy+B−(1 +r)<0(2)▶∴financing only for entrep. who will work hard16 / 59

Designing contracts to illicit E’s hardwork▶A feasible contract will:1.incentivize E to work hard, which requiresπhard(x)≥πrelax(x)(3)this is anincentive compatibility constraintwhich explicitly is(y−x)(phard−prelax)≥B▶this constraint ensures E expects to be better off working hard thanrelaxing▶i.e. pay (more) for-performance (aka success)2.make both contracting parties at least weakly better off▶it is in the household’s interest (‘individually rational’) to investUNethard(x)≥0▶it is in E’s interest to accept contractπhard(x)≥017 / 59

Household optimal contract design problem▶Household wants to maximize their expected payoffs withinfeasible contracts incentiving hard workmaxx,IhUNethard(x) =phardx−(1 +r)Ihsubject to(4)πhard(x)≥πrelax(x)(5)πhard(x)≥0(6)UNethard(x)≥0(7)Ih+A≥I(8)18 / 59

Theory of credit intermediationDirect investing with moral hazard - solutionDraws on Freixas & Rochet Chp. 2.5.3, Holmstrom & Tirole (1997)19 / 59

A caution on solving for the optimal contract▶In earlier models, we just substituted in equality contraints & tookFOCS..▶Claim: here we can’t do that1.unlike with budget constraints which will always bind (prefer moreto less), here imposing binding (equality) constraints is not possible▶Supposeπhard(x) = 0, thenπrelax(x) =Bwhich violates IC▶This is a contradiction!! Not a feasible contract.2.taking FOCs and solving for an interior solution won’t work here▶Recall using FOCs in maximization problems require concavity,u′(c)>0>u′′(c)▶here:u(c) =c, sou′(c) = 1 is constant,u′′(c) = 0▶thus, within the feasible contract space, household always prefershigherx20 / 59

Finding an upper-bound on household success payoutx▶How to solve then? find binding constraint(s) limiting paymentx,i.e.x≤¯x1.Since already seen thatπhard(x)>0, can ignore this constraint2.Obviously, sinceUNethard(x) is in the objective, andx= 0.001 isfeasible,UNethard= 0 can’t bind either3.Thus, only possible bound onxmust come from the IC constraint▶Solving for investor success payoffxyields upper bound ¯xx≤¯x=y−Bphard−prelaxThus, entrepreneurs need sufficient stake (‘skin-in-the-game’) towork hard21 / 59

Pinning down optimal amount of invested capitalIh▶Households prefer investingIhover saving ifUNethard(x)≥0(1 +r)Ih≤phardxsolving forIh, and using the upper-bound onx,¯x:Ih≤phard1 +rx≤phard1 +r¯x(9)▶Since entrepreneur needs a minimum ofI−Ato be directlyfinanced, and household payoffs strictly decreasing inIhIh=I−A≤phard1 +r¯x▶Solving forAyields capital lower bound for financing (A≥¯A):¯A=phard1 +r¯x−I22 / 59

Putting it all together to characterize feasible/optimalcontracts▶For a given entrepreneur and household, a feasible contract has:1.Upper bound payout constraint for household (lower bound forentreprenuer):x≤¯x=y−Bphard−prelax2.Minimal skin-in-the-game entrepreneur investment hurdle met:I−A≤phard1 +r¯xorA≥A23 / 59

Characterizing equilibrium (optimal) contracts varyingcompetition▶If household has the bargaining power, optimal contract is:1.Household gets the upper bound payout,x= ¯x2.Household minimizes the amount of funds investedIh=I−A▶Could instead have households competing to finance so optimally:1.Household gets minimal payout needed to make them investx=x=(1 +r)phardIh2.Household pays in the minimal investment necessary (sinceIh>I−Ayields cost1+rph>1 = marginal benefit to entrepreneur)▶Thus, depending on competition, equilibrium contract has (x,Ih):1.x≤x≤¯x2.Ih=I−AwithA≥A24 / 59

Taking stock▶Solved for optimal contract between a given entrepreneur andhousehold▶Here no direct costs of mitigating the info friction▶with households having all the market power, limits their returns▶here payoffs to E have to be riskier than would otherwise... not abig deal for E since risk-neutral, but this prediction would still gothrough if E risk-averse∴optimal contract punishes entrepreneurwith higher risk than fundamentally there▶Main issue: not any entrepreneur can be financed!!▶Entrepreneurs withA≥Acan be financed, those without can’t▶If there is a distribution of entrepreneurs overA∈[0,∞) given byG(A)▶Without information frictions, measure of entrepreneurs invested =G(∞) = 1▶With information frictions, onlyG(A) of entrepreneurs financed25 / 59

In-class game reduxPrivate info market game26 / 59

Class exercise: market game with private info▶Seven teams:▶Three seller teams▶Four buyer teams▶Game will be played up to 6 times (periods). Each period:1.Sellers posts a price and quality “grade” to sell on board2.Randomly ordered buyers choose seller price/quality if any▶Each buyer can purchase at most 1 good3.Seller chooses to accept or reject each buy offer▶Each seller can sell up to 2 goods, but cost of 2nd good +1▶2nd good must be same price and quality grade4.Payoffs for a given sale (otherwise zero)▶Buyer profits= value of grade - price paid▶Seller profits = sale price - cost of grade made27 / 59

Seller costs and buyer valuesLow gradeMedium gradeHigh gradeSeller cost of 1st unit$1.40$4.60$11.00Seller cost of 2nd unit$2.40$5.60$12.00Buyer value per unit$4.00$8.80$13.60Link to spreadsheet on quercus28 / 59

Game versions - banking redux▶Version F: As above▶Version A: Only price will be posted by seller (quality still fixedupfront)▶Version M: Only price will be posted by seller (seller can switchquality after buyer commits to purchase for$1)▶Version B: Version A, but buyers can pay 50 cents to see all sellerqualities & can’t see other buyer choices▶Version C: Version A, but buyers can pay 50 cents to see all sellerqualities &cansee other buyer choices▶Version P: Version M, but buyers can pool resources and delegatea single buyer to purchase for them29 / 59

New surveyLink to survey30 / 59

Debrief version F31 / 59

Theory of credit intermediationAdding in banks as monitorsDraws on Freixas & Rochet Chp. 2.5.3, Holmstrom & Tirole (1997)32 / 59

Adding banks (indirect) financing to the model▶Three players in the economy: entrepreneurs, households, banks▶Banks = same as households but with ability to monitor▶Monitoring effort comes at a fixed disutilityM= 0.01▶Monitoring reduces the time entrepreneurs can slack off,b= 0.1<B▶Can always choose not to monitor, even after contracting▶Are significantly rationed in aggregate fundsKbank, i.e.Kbank<G(A)<1▶Assume now that households/banks are in excess supply (so arecompeting to finance)33 / 59

Financing with banks and households▶Projects financed by any mix of households and banks▶Total financing must be at least amount requiredIIh+Ibank+A≥I(10)▶If banks choose to monitor, the entrepreneur’s incentivecompatibility constraint isπhard(xbank,xh)≥πrelax(xbank,xh,b)(11)whereπe(xbank+xh,b) =phard(y−xbank−xh) +bfore∈ {hard,relax}▶If banks choose not to monitor or finance then similar IC as beforeπhard(xbank+xh,0)≥πrelax(xbank+xh,B)(12)▶Entrepreneurs differ by their initial wealthA, distributedG(A)34 / 59

Bank monitoring choice for projects withA≥ABank(s) need to choose which projects to provide funds/monitor▶Already know projects withA≥Ahouseholds can finance alone▶Denote from hereonAhas the cutoff for households financing alone▶If bank monitors such a project and is receivingxbank, thenexpected payoffphardxbank−M▶If bank doesn’t monitor but still finances, they getphardxbank−0⇒any bank will default on monitoring such a project35 / 59

Bank monitoring choice forA<Ah▶Projects withA<Ahcan’t be financed by households alone▶With monitoring, new cutoffAbank<AhwhereA≥Abankfinanced▶If bank monitors such a project and is receivingxbankthenphardxbank−M▶If bank doesn’t monitor such a project, entrepreneur can relax:prelaxxbank▶Thus, bank monitoring incentive compatibility constraint is:phardxbank−M≥prelaxxbank(13)▶This yields minimal contracted payment for bank monitoringxbankxbank≥xbank=Mphard−prelax36 / 59

Contract requirements with bank monitoring▶With the monitoring incentive compatibility constraint (11)xbank≤¯xbank=y−bphard−prelax▶From the above, we know bank financing with monitoring is onlyfeasible if information rent reduction from monitoring exceeds thecostsxbank≤xbank≤¯xbank⇐⇒y−bphard−prelax≥Mphard−prelax▶Thus without making assumptions on bank competition / marketstructure, anyxbankwithin the above is a feasible financingcontract with a firm to ensure monitoring and hardwork37 / 59

Theory of credit intermediationSolving bank financing as monitorsDraws on Freixas & Rochet Chp. 2.5.3, Holmstrom & Tirole (1997)38 / 59

Bank and household returns under the contract(s)▶Define bank and household per-dollar returns,Rbank,Rh▶Bank per-dollar returns under a contract withARbank=phardxbank(A)Ibank(A)▶Household per-dollar returns under a contract withARh=phardxh(A)Ih(A)▶Since banks can always choose not to monitorRbank≥Rh▶Since households can always choose to invest in government bondsRh≥1 +r▶Competition between households per dollar⇒Rh= 1 +r39 / 59

Household and bank financing decisions▶IfKbank<G(Ah), banks can’t finance all projects withA≤Ah▶Banks investing inA≥Ahwill earnRh= 1 +rper dollar▶Banks investing inA<Ahwill earnRbank>Rhper dollar⇒banks will invest all funds inA<Ah▶As banks must earnxbank≥xbank(A) to monitorRbank≥phardxbank(A)Ibankbank competition⇒above holds with equality for allA<Ah▶Re-arranging yields minimal bank investment with monitoringIbank(A)≥Ibank=phardxbank(A)Rbank(14)▶Since projects requireIbank+Ih+A≥I, ifIbank<I−Athenhouseholds offer remaining funds forRh<RbanksoIbank=Ibank40 / 59

Pinning down the equilibrium cutoffAbank▶It remains to pin downAbank▶Returning to entrepreneur’s IC constraint forA<Ahπhard(xbank+xh,0)≥πrelax(xbank+xh,b)orxbank+xh≤y−bphard−prelax▶Sincexbank=xbankandRh=phardxhIh= 1 +r,Ih≤¯Ih(xbank) =phard1 +ry−bphard−prelax−xbank▶Finally, for project to get off the ground,Ih+Ibank+A≥I▶combining above and solving forA≥Abank:Abank=I−¯Ih(xbank)−Ibank(15)This is the new entrepreneur skin-in-the-game constraint41 / 59

Determining the equilibrium bank returnRbank▶RecallingIbankdepends onRbank, remains to pin this down▶aggregate bank fund supply isKSbank=Kbank▶aggregate funds demanded atRbankisKDbank(Rbank)KDbank(Rbank) = [G(Ah)−G(Abank(Rbank))]Ibank(Rbank)▶market clearing of bank funds (implicitly) pins downRbankKS=KDbank(Rbank)▶Not testable, but note...can verifyIbank(Rbank) is↓inRbank, whileAbank↑inRbank⇒KDbankis↓inRbankso a unique clearing rate42 / 59

Equilibrium financing with banks and householdsA(rB) = 1−Ibank(Rbank)−Ih▶Firms withA<A(Rbank) cannot be financed even with monitoring▶Firms withA(Rbank)≤A<Ahneed bank financing to be financed▶Firms withA≥Ahdon’t need bank financing43 / 59

Equilibrium financing over assetsSource: Freixas & Rochet Sec. 2.5.3Assuming distributionG(A) is Normally distributedIn graph, notation isAbank=A(β,r),Ah=¯A(r)44 / 59

Takeaways from model▶Firm financing is challenged due to borrowers hidden actions▶Firms with more skin in the game (invested assets) have lessfinancing difficulties▶Good contract design▶can mitigate issues with performance-based pay & skin-in-the-game▶cannot help for borrowers that can’t commit enough ’skin’ upfront▶Bank intermediation (monitoring effort) reduces moral hazardseverity▶helps poorer/smaller firms be financed for a price▶comes at the cost of monitoring effort & still imperfect solution45 / 59

Comparative statics to think about▶How does increasing the moral hazardBimpact theA?▶How does increasing the yield impact amount of financing▶How does the difference in the probability of success/failure impact▶How does the government bond yields impact entrepreneurfinancing?46 / 59

Theory of credit intermediationEvaluating and testing the theory47 / 59

Evaluating the theory▶What does the theory imply about the data patterns seen at startof class?▶Trend of declining bank lending?▶Cross-country differences in bank lending vs direct (equity/bond)financing▶Rise in CEO average pay levels & performance pay?▶Do these rationalizations make sense to you?▶What other aspects are missing about firm financing decisions?48 / 59

Testable implications of the theory1.More wealthy entrepreneurs will be financed, poor won’t▶Firms with more earnings (e.g. older/mature firms) publiclyfinanced, younger (less)assuming positive correlation between age and earnings2.Entrepreneurs/managers compensation is performance-based▶Compensation varies with project performancecov(xentrepreneur,project payoff) =phardy(y−Bphard−prelax)+prelax·0·0▶Compensation volatility can be higher than project riskwhen?3.Banks earn higher returns from lending than public markets49 / 59

Information frictions and incentive pay▶Compensation for executives & many financial professionals notpurely salary▶See SEC 10-K and /or Proxy Statement SEC Schedule 14A forCEO compensation structurehttps://www.sec.gov/Archives/edgar/data/320193/000119312521001987/d767770ddef14a.htm▶Various forms of performance/incentive pay:▶Salary - not incentive based▶Bonus - based on observable individual / team performance▶Stock - not directly tied to individual performance, but firm▶Stock options - tie to particular changes in stock price50 / 59

Trends in CEO pay levels & performance-paySource: own calculations, data from Execucomp (US S&P 1500CEOs)Takeaway: Typical US CEO pay up 9 x, tied to↑performance payComp share = performance based share of total pay51 / 59

Financial options & other derivativesBasic details & contextCS 952 / 59

Financial derivative contracts▶Common derivative contracts based on underlying financialinstruments▶futures∼fixed price to buy asset at dateT(e.g.Ft=e−rTSTifSTknown)▶options∼agreement to buy at fixed price & under some conditions▶Utility of options / derivative contracts for investors▶Risk management / hedging▶Profit off changes in distribution of returns▶Futures and options traded on exchanges▶e.g. Chicago Mercantile Exchange (CME)CME Group website”Thebiggest financial exchange you have never heard of” The Economist(2013)▶Typically expire on Fridays53 / 59

Definining standard option contracts▶Option contract = maturity dateT, strike priceK, option type,maturity type▶Quantity is standardized for stocks = 100 shares▶Option type = call or put▶Call option = option to buy▶Put option = option to sell▶maturity type = european or american▶european = only trade at maturity▶american = trade anytime before maturity▶Q: which one should price higher? european option value =intrinsic value<intrinsic value + time value = american▶In practice:▶American option standard for individual stocks / most ETFs▶European option standard for S&P 500 index54 / 59

Option hockey stick payoff diagrams55 / 59

Option portfolios useful for insurance / completing marketsStraddle = buy a call and put at the same timePayoff = max{ST−K,0) + max{K−ST,0) =|ST−K|56 / 59

Value of derivative assets▶Can be used to minimize risk or gamble with exotic strategies▶i.e. is a tool to ‘complete’ markets (precludes arbitrage)▶Values are highly subjective, depend on beliefs of entiredistribution of underlying asset price movements▶Options markets are subject to abuse by sophisticated participants▶ex1. Madoff fraud▶ex2. incentives & evidence of market manipulation, seeCommodity Future Trading Commission Paper on manipulation - Danger, Flage, & Outen (2020)▶Can search for market participants who have had complaints raisedagainst them:NFA57 / 59

Madoff’s ‘never-lose’ option strategy▶Chairman of Nasdaq stock exchange▶Parlayed his good reputation into a boutique hedge fund with$12bassets under management (AUM) by pension funds/high net worthclients▶Claimed used a ‘never-lose’ option strategy & order flowinformation to outperform market▶In reality operated a ponzi scheme: held money in bank account &just paid out implied returns for those withdrawingSource:source58 / 59

What was the option strategy that tricked “smart” money?Current price =$100strategy = long out of money call (105 strike), short an out of the money put(95 strike)≈0 cost strategy while avoiding holding actual assetpayoffs∼“synthetic” stock with less volatility59 / 59