CFCM 15/06: Optimal Organization of Financial Intermediaries

Abstract

In economic environments where transaction costs, informational asymmetries and incomplete markets inhibit direct relationships between borrowers and lenders, financial intermediaries bring the two parties together. To a very large extent this intermediation role is performed by banks. A defining characteristic of banks is that on their liability side they raise funds mainly by offering fix obligations to investors (depositors). However, in the last twenty years, we have seen a rapid growth of an alternative class of financial intermediaries, namely, private equity funds, that, unlike banks, raise funds by offering equity claims to their investors who are known as limited partners. Some types of private equity funds, like banks, finance a variety of new investments for firms unable to access directly the capital markets. For example, venture capital specializes in financing young, innovative firms, growth capital finances expansion activities of relatively mature firms, and mezzanine capital offers investors preferred equity to finance activities of small firms. The coexistence of two distinct organization structures for financial intermediation raises the following questions. What are the relative advantages of each structure? Taking into account the endogeneity of both structures, which types of firms are more likely to seek funding from each structure?

In this Nottingham School of Economics working paper Spiros Bougheas and Tianxi Wang consider these problem from a perspective of agency costs associated with incentivizing the intermediary to provide valuable services. Using a mechanism design approach, the authors find the optimal contractual arrangement that provides incentives to the intermediary to monitor its clients. Based on the nature of its liability side contract, the arrangement takes one of two forms, namely, Bank (liabilities are debt contracts) or Fund (liabilities are equity). The trade-off between the two structures is that it is cheaper to offer incentives using the Bank option, but the Fund alternative is more robust to the arrival of bad news about the quality of assets. This robustness is connected not with the considerations of bankruptcy or financial stress, but with agency problems of the intermediaries. In general, it is demonstrated that agency costs can be one useful perspective -- there are many others -- to investigate the organization of financial intermediaries.

The simplicity of the model triggers the question about the theory's robustness and relevance. The authors show that direct finance can never dominate financial intermediation, but the inverse holds in some cases. The results are robust to generalizing the contracting environment and to increasing the number of projects. In particular, the authors argue that in connection with greater diversification, banks may suffer a more serious internal-control problem relative to private equity funds. Lastly, the model delivers predictions consistent with empirical observations, such as relative to banks, private equity funds are more involved in the running of the firms that they finance, contribute more to the success of these firms, and provide funds to higher-risk, higher-return firms.

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CFCM Discussion Paper 15/06, Optimal Organization of Financial Intermediaries by Spiros Bougheas and Tianxi Wang

Authors

Spiros Bougheas and Tianxi Wang

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