Financial intermediaries are recognized to promote the efficiency of resource allocation
by mitigating problems of incentives, asymmetric information and contract incompleteness.
The role played by financial intermediaries is perceived so crucial that these institutions have
received all over the world the greatest attention of regulators. Differences in regulatory regimes as well as in the real economies have produced a large
variety in the characteristics of financial sectors and of individual intermediaries. In particular, in different places and times it is possible to observe banking sectors more or less competitive, populated by credit intermediaries of different sizes and with different levels of specialization. This variety of institutions raises interesting questions about the features of a well functioning financial intermediation sector. These questions have inspired an important body of economic literature which, however, is still inconclusive in many aspects. This dissertation includes three studies all intending to contribute in this direction.
Chapter 2
Recent empirical works have found evidence consistent with larger banks having lower
incentives to collect soft information and, in particular, to lend to small firms which are
typically regarded as relatively opaque borrowers. Another market segment affected by
relatively high levels of opaqueness is that of long-term loans and the reason is that, as
emphasized in the corporate finance literature, short-term maturities are useful for the purpose
of screening and monitoring investment projects. It is therefore interesting to assess whether
large and small banks differ in their propensity to issue long-term loans, a type of investigation
which has not been conducted yet.
The reason why small and large banks might be expected to have a different propensity
to issue long-term loans has to do with two notions. First, the effectiveness of a short-term
maturity as a screening and monitoring device is preserved only if parties anticipate that,
when payments are due, the lender will not be willing to extend the maturity, otherwise the
initial short-term loan is de facto a long-term one. The problem may rise if the liquidation
of insolvent firms produces lower payoffs than their refinancing: under these circumstances,
as suggested by theories on renegotiation, liquidation is not implemented no matter what
is written on the contract (parties can easily avoid the inefficiency that would result from liquidation, for example by simply granting a new loan). Second, at a more specific level
theories on renegotiation suggest that the ability to commit to not extend thematurity decreases with bank size.1 Small banks are therefore predicted to issue shorter-term loans and to make a better selection of projects.
The results are consistent with this prediction. Controlling for other characteristics of
both the demand- and the supply-side as well as for the type of guarantee supplied, small
banks have lower proportions of long-term loans to total loans and lower proportions of non
performing loans to total loans.
It should be pointed out that this does not imply that small banks are necessarily more
efficient since short-term maturities also have costs; in particular, short-term maturities can
interfere with the incentives of good types by inducing short-termism (the inflation of shortterm
results at the expenses of total profitability). Moreover, beyond the ability to commit
other supply-side features are shown to be relevant in the determination of the maturity, at
least with specific classes borrowers. In particular, the findings are also consistent with the presence of economies of scale in lending at long maturities to firms in more technical and
innovative industries. Since providing the right incentives to high quality entrepreneurs and to firms in innovative sectors is more likely to be a priority in more advanced countries, a policy
implication is that these economies need more the presence of large credit institutions and
the more so if venture capital and stock market are of limited size.
Chapter 3
As already emphasized, theories on renegotiation suggest that the ability of banks to
commit to a given course of action is an important factor for efficiency and that such ability depends on observable characteristics, like bank size. An important aspect which has not been analyzed in the theoretical literature is the effect that competition among banks exert on their ability to commit. The theoretical model presented in chapter 3 tries to provide an answer to this question. More specifically, the model studies the effects of competition among banks when these are subject to dynamic commitment problems which may result in excess refinancing
of insolvent borrowers (soft budget constraint) as well as in excess termination of profitable
ones (ratchet effect and short-termism). The building assumption is that, because of priority
schemes and relationship lending, competition is harsher for new lending than for lending to
ongoing projects.
The main conclusion is that there exists a trade-off between the benefits that competition
brings by disciplining low quality borrowers and the costs implied by worsening the incentives
of good ones. The model also allows to look at the effects of competition on stability.
This is done in two ways by looking at the extent to which competition interferes with the
procyclicality of the banking sector and by studying if competition may eliminate or add
inefficient equilibria. The main policy implication is that the optimal level of competition of a banking system is positively related to the quality of the underlying economy.
If taken together, the results of chapters 2 and 3 also provide a theory about local or
regional banks which is not based on any aprioristic assumption about the technology of these type of intermediaries. As long as these institutions can be seen as banks with a relatively high market power and a relatively small size (they are often important players at a local level although of limited size), both chapters 2 and 3 suggest that these intermediaries can more easily commit to a tough stance at the refinancing stage, with positive effects on their ability to screen out bad projects but with negative effects on their ability to incentivize good types and
to fund more technical and innovative firms. In other words, these institutions might promote
growth at earlier stages of development, although they are not sufficient to address the incentive
issues of more advanced economies. Interestingly, this interpretation of the role of local banks
is totally distinct from the traditional one which is based on the aprioristic assumption that
these banks are good in doing relationship lending.
Chapter 4
Conflicts of interest of economic institutions carrying out a variety of functions are considered a widespread phenomenon severely limiting the efficiency that can be achieved. These worries are often taken as justification for regulations imposing transparency requirements or tougher measures like separation of functions. At the same time, contract
theory suggests that the effects of opportunistic behavior can be limited by adopting
appropriate incentive schemes. The third study, chapter 4, tries to understand from a theoretical
point of view to what extent the use of incentive schemes can address the distortions posed by
the presence of conflicts of interest.
The universal bank is regarded as a (common) agent serving different clients with
potentially conflicting interests: for example, it may buy assets on behalf of investors and
sell assets on behalf of issuing firms. The clients offer incentive schemes to the bank and they behave non-cooperatively. The bank decides a level of effort and, when firewalls are absent,
a level of collusion, modelled as a costly and unproductive redistribution of wealth among
the clients (for example, the banks can at no cost sell the securities it is underwriting to the
funds it manages and can do so at the price it likes). Firewalls are defined as all legal or
economic devices imposing a real separation of functions and therefore preventing the bank
from colluding as specified above.
The main conclusion is that in the absence of firewalls the equilibrium incentive schemes
are steeper. This means that the equilibrium level of effort is higher and may compensate the
(ex post) inefficiency of collusion. In other words, not only appropriate incentive schemes
can eliminate the distortions posed by conflicts of interest but, at least in principle, their
presence may even be necessary for efficiency (this happens if effort is a public good for
the two principals so that the allocation without firewalls is characterized by under-provision
of effort). At the same time, the allocation without firewalls is shown to be the least efficient in the presence of one naive player who does not recognize the existence of the conflict of interest. As long as transparency requirements can be considered tools to improve market
participants’ sophistication, these results suggest why and how this type of regulation can
work. Moreover, the model allows to draw conclusions about the desirability of tougher
regulation prescribing a more or less neat separation of functions. With sophisticated economic agents, who can address the distortions posed by conflicts of interest by choosing appropriate incentive schemes, separation of functions is unnecessary or even detrimental for efficiency. On the other hand, more or less powerful firewalls are desirable if market participants are not considered sufficiently sophisticated to be able to react to the presence of conflicts of interest and if transparency requirements cannot increase their sophistication.
In few words, the optimal regulation of conflicts of interest is softer in situations involving professionals who are more likely to realize and to react by choosing an appropriate incentive scheme or, more generally, for institutions operating in advanced economies where
the average level of market participants sophistication is higher.
| Identifer | oai:union.ndltd.org:BICfB/oai:ulb.ac.be:ETDULB:ULBetd-01232008-180256 |
| Date | 31 October 2008 |
| Creators | Albertazzi, Ugo |
| Contributors | Mathias Dewatripont |
| Publisher | Universite Libre de Bruxelles |
| Source Sets | Bibliothèque interuniversitaire de la Communauté française de Belgique |
| Language | English |
| Detected Language | English |
| Type | text |
| Format | application/pdf |
| Source | http://theses.ulb.ac.be/ETD-db/collection/available/ULBetd-01232008-180256/ |
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