Industry sign banking missouri agreement myself
you what we want to do today is kind of shift gears and we're gonna we've been talking about money and credit markets and now what we want to do is start talking about banking and we don't do that directly we're not just going to say oh let's talk about banks what we're gonna do really is lead into this with the whole question of why do banks exist and you know we did that with this other issue of why does money exist there are certain functions that money performs certain functions at banks perform and so before we get into talking about the details of banking itself what assets do they hold and so forth what we want to do is talk about this sort of a unique function performed by banks that if we didn't have bankers then we'd have this problem with our economy and although it's kind of perhaps an unusual way of approaching it for many people economists have an entire discussion about this subject that's really kind of I guess generally described by the term asymmetric information and what we're really going to get down to is the question of loans that is really a key role played by banks in our economy is lending money right if you want a car loan you want a home loan you want a personal loan there's a very good chance you go to a bank and if not a bank some other institution that basically will perform these similar functions to what we're going to talk about here with respect to banking and in this whole loan market what we've got you understand with loans is we have and we'll just describe this in very general terms we have savers and we have borrowers and the nature of a loan is that the saver provides dollars to the borrower and in return receives back there's a sum loan agreement some document and that's on day one and then there's a point down the road where that loan is paid off the is given back and the interest but here's so this is the nature of a loan what happens on day one and there's a problem with that and the problem is as I say described by this term asymmetric information I guess eventually we'll look back on this discussion and we'll have an answer to this question hey why don't we savers I'm saving money for retirement you're saving for whatever your purpose is rainy day or retirement or something like that why don't I just lend my money to borrowers directly why don't I just go out and find somebody that wants to buy a car or buy a house and loan money to them and the answer is I don't do that because I want my money back here's the thing about lending money any idiot can lend money all you have to do is get a bunch of money and sit down and put a sign up it says I will loan money and people show up and take all your money now even though any idiot can lend money it takes some real skill to get it back and so the reason that savers don't just go out and lend their own money out very often is they want it back and they don't know how to get it back they don't know how to make the riot loans and they don't know how to get that money back if there's a problem that's encountered down the road and so what we do instead of savers handing their money over to borrowers usually what happens is we savers hand our money over to somebody else like a bank we make what is called a deposit in the bank and then the bank is the one that wins this money and so there is this problem or really a series of problems that have this general heading of asymmetric information and we'll talk more about it but there's a series of problems that we as individuals would encounter and don't know how to deal with those problems of asymmetric information whereas banks do and so we hand our money we savers over to the banker or a credit union or a savings and loan and so forth we hand our money over to one of these bankers and then the banker deals with asymmetric information and so this is really going to be our justification for the role banks play in the financial system so we want to talk about that today maybe a little bit tomorrow okay so anyway what do we mean by asymmetric information just the term I don't think there's any doubt about the word information and so what we have in mind here and probably you know the word symmetry symmetry means the same on either side of something a person's face is symmetrical if the right side looks just like the left side except the mirror image of it asymmetrical the a means not and so asymmetrical information means that information differs and the information we're interested in is in this lending market or in financial markets and what we would say is this is that these two characters in our story the borrower and the lender they have different information okay they simply don't possess the same information and that being the case it makes it difficult for these loan markets financial markets correctly speaking I'm gonna focus on loans I'm taking a little bit of a detour here I'm gonna focus on loans but really any issue of finance sometimes what happens is companies will finance their operations by selling stocks or shares sometimes they issue bonds and this would be whether it's a company with a bond or a governmental unit and then sometimes whether it's a company or a governmental unit or a person loans these are always financial or these are all financial types of operations and so that's asymmetric information problem it exists every single time that we get involved in these financial transactions any form of finance we encounter this our interest is loans because this is a class in money and banking banks basically are not investing in stocks we've already talked about a little bit about the bonds how that they rely on credit ratings and so forth from Moody's standard & poor's so our main focus here is loans not only because we haven't talked about it before but loans will be about sixty percent of total bank assets you know that is a big number I'm saying all the dollars coming into the bank from all sources sixty percent of those dollars end up being loans and so this is a big deal for banks this is a main function of banks more so than it is for any other financial institution okay and since this is a big deal for banks then we need to understand this whole specialization this specialty that banks have why are they such good lenders and the answer is they can come to terms with this problem of asymmetrical information now let's put a little timeline up here here's the loan is made and here's the loan is paid off and there are two different types of asymmetrical information that we're going to focus on one occurs at the time alone is made what information do we have then at that moment and what I'm saying to you again is that borrowers and lenders come together here but borrowers know more about their situation if you're borrowing money let's say you're borrowing the money to buy a car to buy a house or go on vacation you know more about your situation than I do I'm a lender maybe I don't even know you maybe we've never met before and even if we're next-door neighbors as soon as you go home and shut the door I don't know what's going on in your house I don't know what's going through your head I don't know what you're it's happening down at work I don't know what your plans are and so the borrower has a real advantage about knowing about his or her own situation and I'm talking about whether that borrower is a person or if it's maybe some corporate manager small corporation big corporation the borrower's got the real advantage here okay so there's one type of problem that occurs at that moment when the loan is made asymmetric information the borrower knows more than the saver the lender and this makes it where the lender is reluctant to go ahead with the deal then after the loan is made during this period then there's another type of problem we've got two different names for this here is adverse selection is the nature is the label given to the asymmetric information problems at the time the loan is made and then there's another asymmetric information problem that occurs after the loan is made call moral hazard and we want to talk about these and not get too much into the lending the financial markets aspect of it until we have a good understanding of what adverse selection means I'm moral hazard okay but again just to say slightly differently but same idea adverse selection is a problem where there's unequal information but at the time the loan is made when we're negotiating when we're signing the contract we know different things after the loan is made now the money is handed over here you go thank you very much and now what do you do if you're the borrower what do you do what information do you have and so forth that I don't have as the lender after the loans made and I'm still hoping to get paid back okay so anyway adverse selection this term isn't used quite as much anymore but used to be we would I heard this term used a lot I didn't even know what I meant the first time I heard it probably in grade school sometime about somebody buying a lemon and they were talking about a lousy car okay it's a car that's got problems and once you own that car you've had problem after problem after problem and it just never ends and then you just say how can I get away and really there's only one answer and that would be like run it into a river and call the police and say it's been stolen although we would never do that no but it's hard to get away from this what do I do what are these lemons come from why do we have this problem and the answer is asymmetric information let's say that you want to buy a car at Toyota or a Honda or something like this and you go online or you pick up the newspaper and you see here's a list Honda Accords and maybe you want to buy 2005 model Honda Accord and you look at it and here's 15 of them huh Honda Accord basically there's a difference in color and that's kind of it how you gonna get the best one don't know that's a problem right how you gonna avoid the one that's a problem down the road oh I like this blue and I buy the blue one you know three months later the transmission breaks and two months later there's suspension brakes and the six months later the after that I need you know valve work done on the engine and and this just goes on and on and what am I gonna do and the problem comes down to asymmetric information because here's the deal the man or woman who owns that car today who's advertising it for sale they know about that car don't they like they've been driving it they've been having problems and then they're going hold me and I gotta dump this thing now there are other people who are driving Honda Accords 2005 model and they're in great shape and they want to sell their cars - and they know it's a great car but you're the buyer and so you say huh here are all these Honda Accords which one should I buy I don't know and then what you do is we look and there's some average price average price and it doesn't make any difference with that average price is I'm just gonna say I don't know fifteen thousand dollars just to set a number here and we'll discuss that but there's some average price for these cars that average price reflects the average quality the average number of problems its X number of years old it's got so many miles on it and so forth and so there's this sort of average price and it reflects the average conditions of those cars of those 2005 model cars or whatever and so that's what we see is the buyer huh they average price fifteen thousand dollars here's all these cars I can choose from I wonder which is a good one I wonder what's about it I don't know suppose you're on the other side of the market you get a car for sale it's a really great Honda Accord you have had the oil changed every 2,000 miles you haven't kept it in the garage every single night you have never been speeding you've never bumped into a kerb you are the perfect owner and you want to sell your car and you go huh the average Honda Accord 2005 model blah blah blah it sounded for 15,000 bucks I'm not gonna let my car go for that this is outrageous this is almost an insult no way so the people who have really nice cars not a lemon the opposite of a lemon what would be the opposite of a peach a grapefruit what is the opposite of a lemon a lime may be it may be a room anyway if you've got one of these really great cars you just go I'm not letting it go for that so what happens is this the people who have really great cars for sale they just take them off the market right they just go no I'm not gonna sell my car for this no here's what you could do somebody comes up and they look at your car and they go huh fifteen thousand bucks is about what these are going for and you go no no I want 20 mm I just car in the world who believes that I promise this is the greatest car in the world yeah okay thank you but guess what everybody else with a Honda Accord 2005 model they promised the same please take my car it's worth 20 mm no because I mean you know if that worked then everybody would say please take my car it's worth 20 mm right so the people is really nice Honda Accords I don't have any way of like sending the brainwaves ESP mind-meld was that that spot guy doesn't start wrecking or even read your mind we just don't have any way of doing this so the person who's got a really nice Honda Court just takes her car off the market and maybe out of these 15 or 20 for sale maybe five or six of them go off the market because they are just great cars and now the ones that remain on the market they're the same ones that were there before but the best ones have been taken away so average quality is really a lord than before so then people start going out and they start buying these things over time you know and then they go oh my god on average these things aren't worth $15,000 on average you're only worth $12,000 because of experience from all this and the best ones are off the market and people just keep on driving keep on driving keep on driving and the ones that are being traded those are a little bit lower quality and so over time with the experience and the word getting out and stuff like that they go you know on average these are only worth $12,000 and so we don't see this price persist it goes down here's $12,000 and then somebody who's gotten maybe a little bit imperfect Honda Accord that is worth $15,000 they just go I'm not selling my car for the average price now the average price is twelve I'm gonna take this car off the market I'm gonna keep driving it because I only get 12 for it and it's worth 15 I just keep driving it and so the ones that are worth $15,000 those are taken from the market and the owners continue driving them and the only ones that remain are really bad Honda Accords the limits and so then after the word gets out boy those Honda Accords are not very good then one out there on the used car market the price goes down to ten thousand dollars and there's somebody it's got one that's truly worth twelve thousand bucks but then they say I'm not selling my car for ten thousand dollars it's worth 12 they keep it and the only Honda Accords out there that are for sale are worth ten thousand dollars or less but once the word gets out boy did you buy one of those Honda Accords those things that wheels are falling off of it the price goes down and what's happening is this is that if there's a price that doesn't make any difference which one of these prices we start off if there's a price the only people who will sell for that price are the ones who have a below average quality car and anybody who's got a car it's above average quality they say I'm not letting my car go for fifteen thousand dollars and what's the cause of this and the cause of it is asymmetric information we can't look at that car and say this is a good one that's a bad one we can't read the minds of the owners the owners know if they've got a problem car or a really great car but we buyers don't know that and that being the case the average price is going to reflect the average experience of people who buy these and then over time the ones with the above average cars just won't sell them for that and the the average quality goes down and the price keeps going down now what do we do about this what we do about it is we try and g
t rid of this asymmetric information problem but if we don't do anything about it we just say a bunch of people go out there and buy cars or whatever the experiences they tell their neighbors and tell their friends and whatever but that's it then what happens is finally this used car market goes away because nobody will sell an above-average quality car for an average price and so what happens is the good cars are withdrawn the remaining cars are of lower quality and then the average price goes down and more of the above average cars are withdrawn and finally nobody participates in the market this market falls apart why asymmetric information what do we do about it one thing we do is this we ask for these Carfax reports give me a report on this particular car here's the VIN number I want to know if this car has been in a fire a flood a wreck I want to know if it's had major repairs I want to know how many owners it's had in the past has this changed hands over and over and over okay another thing we do sometimes we say I want to test drive the car and then we go down the street we've got maybe some trusted mechanic and this we say hey would you look at this car over and tell me if you see any problems with it I mean we're trying to come to terms with these problems because otherwise we're not gonna be able to buy a good car okay so sometimes what happens is we say I'm not gonna buy a used car whether it's a Honda or anything else I'm not gonna buy a used car from a person I'm only gonna buy one if I can get it from a dealer and that dealer will give me a warranty and so that way if in the first 90 days or whatever the warranty would cover if during that period I have any significant prompts I can go back to that dealer and they will fix the problem but without these other steps the CARFAX or they have a you know a mechanic look at it or get a warranty or something without that this used car market will disappear and it's because of asymmetric information sellers know more about their cars than buyers do let's talk about moral hazard by the way I'll bring this come back and relate this problem.this adverse selection by the way what do we mean by this adverse selection we are selecting through this process of not having enough information we are selecting out only the worst cars that will trade in the marketplace an adverse is negative so we're selecting the worst cars and we end up with a market dominated by limits unless we take some corrective steps okay so anyway let's talk about moral hazard and I'll come back I was talking about cars here a moment ago I'll talk about cars again let's say car insurance this term moral hazard was developed in the insurance industry a long time ago and basically what this is about what the insurance industry had to come to terms with is this as they said you know once we insure something for people like their cars some people act kind of irresponsibly because like if you have no insurance and you're driving down the road and you run your car into a curb or into a post or something like that then one of two things happens one of three things happens one is you run it into something and now it won't drive anymore and you are afoot and a second thing that happens is you run it into something now you've got to get it paid or you've got to get a paid you've got to get it fixed and you pay for that out of your pocket and that hurts you so in the first case you were a foot and in the second case you're spending a lot of money on your own pocket right and so there's just no way of avoiding the responsibility for being a lousy driver if you have no insurance but if you do have insurance and you're driving down the road and maybe text messaging sound familiar or on the cell phone or swatting the kids in the backseat acting like you're solanum or speeding a little bit maybe you're not speeding going fast like 80 miles an hour maybe what you're doing is driving 50 miles an hour on snow and ice but that's kind of speeding you start acting a little bit irresponsible and you bump into something a post or a curb or another car and you get out of your car and look the situation over and say that's too bad and then you get out your phone and you call the insurance agent all right have the car towed in have it fixed and send the bill to the insurance agent and so now the insurance agent not just the agent but the company is going oh my gosh you know here's this person it would be totally responsible if they had to pay the bill out of their own pocket and now that we're paying the bill for them their text messaging they're making phone calls they're driving too fast they're driving recklessly having conversations this is terrible we just can't afford to insure these people and there's a whole raft of things like and we hear about some of this with health insurance oh we've got somebody else to pay our bills so if you bring a fingernail maybe you can go to the doctor and see you know how them look that over I've exaggerated but that's the idea ask for a pill for every little thing that goes wrong don't exercise don't stop smoking if you get sick somebody else will pay the bill or oh I love candles I'll burn candles throughout my house well what if one of those candles kind of gets a little bit too close to a curtain or to the wall or something like that before you know what the house burn is done what do I do do I just go oh I just lost one hundred and fifty thousand dollars there boy I was stupid that'll take me years the make up for that do it is that what we do or do we go oh I'll just live outside on the ground no what we say is well shucks that fire got out of control I'll call the insurance agent say hey we I need to get my house rebuilt I'll send you the bill we behaved more recklessly after somebody else's paying the bill and that's what moral hazard is about that's what insurance companies are how they described is the moral hazard problem is once you take over responsibility for somebody else then that somebody else has new incentives and the incentive is to behave more recklessly to behave less responsibly you with me on this deal now what do car come insurance companies do a car insurance company will say something like this oh you had a fender bender we're gonna raise your premiums or they may say oh you had a fender bender you're cancelled what they are trying to do is protect themselves against this irresponsible behavior by again putting some of the consequences back on you from behaving irresponsibly right and they may say something like this if you get a certain number of tickets speeding tickets then we will raise your premium or cancel you or if you get a DWI we will raise your premium or cancel you so what they're trying to do is place a penalty on you so that you don't engage in these irresponsible actions same kind of deal now so we've got asymmetric information here's where it comes into play after somebody gives you insurance then at that point you're covered and you can kind of do what you want and somebody else pays the bill and now we have to have a solution for that otherwise nobody would issue issue insurance right if if you could just go out and let's say do DWIs and speed and have wrecks and your premium is I don't know five hundred dollars every six months no matter what who would have that insurance you would yeah you crazy maniac okay but the point is we'd all say yeah give me that insurance I'll just do whatever I want to do I'm gonna light a bonfire right in the middle of my living room I'm never gonna exercise smoke smoke smoke whatever goes wrong somebody else will pay the bill demand the best I need a new part put it in new lungs I mean whatever you can do fix it up I want something nice give me a handsome face no there's no insurance but anyway so we had this problem insurance companies then tried to protect themselves against this moral hazard problem what about financial markets in the financial markets we want to come back to these two problems adverse selection and moral hazard and by the way let me go back for the most part large companies when they need financing large companies issue stocks and bonds to get that financing for the most part large companies don't get loans people cannot issue stocks and bonds except in rare cases people when they need money get loans and so I mainly now going to be talking about since its loans that concern banks or mainly talking about smaller companies and mainly talking about people so anyway let's say you're running a bank and you say I've got money to lend quite a bit I got several million dollars doing it and then you just have a whole bunch of people lined up to take out loans and we don't know one from another right these are just people and they're just lined up saying I want ten thousand twenty thousand 50 thousand dollars what interest rate do we charge them and the answer is I don't know these are people they're borrow money for houses I'll charge them I don't know seven percent or just set some average rate which reflects average risk and there are some people that say to themselves gosh I am a really good borrower I have a great job I've had it for years I've been getting raises I've never been laid off I'm totally responsible with my spending I've got assets I've got maybe you know a couple of houses rental houses or some other assets that if I didn't make payments on this loan the banker could come and take those away from me and that banker wants to charge me 7% and maybe this is the really good borrower and he or she knows this I'm a really good borrower I promise I'll pay you word of honour and there's somebody else over here and maybe what happens is they go through periods of unemployment and they don't have their expenditures under control and maybe what's happened is they're not always good about paying their payments on time utility bills car payments and things like that but if there's just this asymmetric information and we don't know anymore and that's where we're starting this process off is the asymmetric information each person knows about themselves but the lender doesn't know and for sure if you were the lender you wouldn't know these things about people they just come up to you and say I want to borrow money so here's this average rate 7% and this guy goes I'm insulted there's no way I'm gonna pay 7% you're charging everybody 7% there's no risk in lending me the money and so people who are a really good credit risk they just say I'm not interested and then the people who are really kind of deadbeats they go 7% reasonable I would pay that always promised a pad and so what happens is this is like the good cars are taken off the market the good borrowers remove themselves from the market and all that remains are the not-so-good borrowers and so bankers would go ahead and say we'll make these loans and they make a series of an angle you know defaults are higher than we expected I don't think seven percents right anymore let's charge eight percent there's a higher default rate than we expect it so they charge eight percent and there's somebody else that goes well you know I'm a pretty good borrower now I'm not perfect I've been unemployed a couple times in the last five years my kids are in college it's costing me quite a bit of money put them through school and you know there's a chance that I'd have trouble making these payments but I sure think I could I'm really committed to it this guy goes eight percent that's too much so he goes I just don't think I'm interested and this guy goes I'll take that up a percent and because this guy knows yeah I'll promise to pay a percent if I can and I will but if I can't run and hide this person knows about his situation there's asymmetric information there's no look on the face you can't say that's persons handsome they're gonna make their payments on time this person's not handsome they won't that's not how we do it this person's got facial hair this one doesn't this one's tall this wasn't short no that doesn't do it big muscles small muscles how do we tell and if we go back we as individuals before the bank's entered the scene and what I'm really gonna tell you is banks are the specialists at dealing with this but before banks entered the scene it was just people making loans that was hard for people to know and so what happened over time is the good borrowers said I'm not willing to pay that average rate and they went away and the ones that remain were the lemons the bad borrowers and we had high default rates and over time what's happening this this markets going away the people who are the savers you or I that are saving for retirement and we're lending money over time we just go man this is a losing proposition I'll own my money on I don't get it back and if I'm not careful there will be no money for retirement no and guess what when people start doing that and say there will be no money for retirement I keep pointing then at that point there are no loans and by the way a similar problem exists in these other markets we're just not talking about them but the stock market the bond market it is I don't want to participate and as soon as we savers just start pulling back saying I don't want to participate there aren't loans and then what happens is huh all these activities that cause our economies be strong those activities don't get undertaken there aren't people buying houses there aren't people starting companies and it's because and I just was given the example of an individual but it's the same thing for companies small companies also there are different small companies some of them are really likely to pay off their loans that some of them are really not likely and the ones and if we just set some rate on average this is about average for default risk among small companies then the ones that are the very best companies just say I'm not paying that rate they pulled themselves out of the market and only the lemons remain and then after a while there's no savers that wanted to extend money to them so it's the lemon problem all over again the financial market here the used car market was falling apart in the lemon market and here we've got the financial market falling apart let's go back to moral hazard suppose that I loan you money and you say to me oh I'm gonna start a company or oh I'm gonna use this money to go to schools take some classes and become an accountant or whatever and then I'll have these skills and my income will go up and I can easily pay you off and I say oh ok you know you've made a good case here I'm gonna lend you I don't know fifty thousand bucks you go to school you become an accountant you earn an extra twenty thousand dollars a year you pay me off in a few years I'll get my money back and you'll be in a better position you say okay so I give you your $50,000 you go to school and you train to be I don't know an artist a sociologist whatever you feel like moral hazard is after the transaction occurs then the hazard is from my point of view the lenders point of view that you may be doing something at that point irresponsible with my money and I don't mean to say it's your response will be come an artist or irresponsibly become a sociology major I mean I gave you my money because I thought hey here's this activity it's gonna be financed with my money and that activity will generate enough revenue to pay me off and then what you made you I lend you the money and maybe you go on vacation say oh I'm gonna you know take spring break that goes from this spring until next spring a one-year spring break want a spring break and then you come back and go I'm sorry you know I'm just not gonna be able to pay that loan off so moral hazard is the problem that wants somebody else is basically your financial backer that you'll do something with that you're responsible and make it impossible for them to collect their money and so if I'm saving for retirement and you come to me and say you know I want to borrow some money I don't know I may be dumb enough to do this a time or two with people but after a while you go you know I loaned that money to people and as soon as I do they just go do something you're responsible and by the way let me just say as an aside I have over the years
ad friends who borrow money from me and it's never paid back like it's promised now that's it's not an overgeneralization for my case I'm not going to tell you that everybody in the world goes out and make loans to friends and you'll never get it back maybe you will I don't friends relatives and I don't lend to strangers but I'm just saying to you that if you want to retire someday and you're saving money and people still come and borrow money from you it's going to be hard to make a choice of the who to lend it to in the first place and if you say boy I think I got this one right it's hard at that point to make sure that they do something responsible with that money and so what do we do we just say no I'm not gonna make that loan and when we say no I'm gonna not make that loan then what happens is there aren't loans and then there aren't people going to college or are people starting businesses those things that are essential for the function of our economy and that falls apart the credit markets go away and so what I'm saying to is this process of us just trying to deal with adverse selection and moral hazard on our own it doesn't work very we have that choice there is nobody in the world that says you may not loan your savings directly to people there's not a lot that says you can't do it and yet when we go out there in the world and look around what we find out is people do not lend their savings out directly to other people and small companies as a rule rarely they do it but as a rule they don't now why not and the answer is these problems are something they cannot come to terms with they cannot solve it on their own and so what we do is we say we've got to find a solution to these problems and the solution we find is banks banks have found a way to come to terms with adverse selection and moral hazard problems and we'll talk about that a little bit next time so long
