Financial Intermediaries and Liquidity Creation

Trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets. These securities, which can arise endogenously, have values that do not depend on the information known only to informed agents. Bank debt (deposits) is an example of this type of liquid security which protect relatively uninformed agents, and we provide a rationale for deposit insurance in this content. High-grade corporate debt and government bonds are other examples, implying that a money market mutual fund-based payments system may be an alternative to one based on insured bank deposits. A WIDELY HELD VIEW is that the investor of modest means is a t a disadvantage relative to large investors. This popular perception, dating from at least the early 19th century, has it that the small, unsophisticated investor-"the farmer, mechanic, and the laborer"-is least equipped to acquire information and is most often victimized by having to trade with better informed agents. U.S. history is repeatedly marked by incidents of real or imagined insider shenanigans and resulting popular initiatives against the "money trusts" and the "robber barons." This view is responsible for many institutions, e.g., the SEC antitrust legislation, and various forms of taxation. This argument has also influenced bank regulation where it has been used to justify government provision of deposit insurance as a matter of public policy. The notion that informed agents can exploit uninformed agents has received some support from Kyle (1985) and Grinblatt and Ross (1985). They show that insiders can systematically benefit a t the expense of uninformed traders when prices are not fully revealing. However, in these models the uninformed traders, called noise traders, are nonoptimizing agents; they simply trade and lose money. If informed agents can, somehow, systematically take advantage of uninformed agents, then it seems clear that the uninformed agents would be motivated to respond, possibly creating alternative mechanisms. In this essay we investigate whether financial institutions and security contracts will endogenously arise as a response to problems faced by uniformed investors with a need to transact. In *Both authors from Finance Department, The Wharton School, University of Pennsylvania. A previous version of this paper was entitled "Transactions Contracts." The comments and suggestions of Mark Flannery, Jeff Lacker, Chris James, Dick Jefferis, Bruce Smith, Chester Spatt, an anonymous referee, members of the University of Pennsylvania Macro Lunch Group, especially Randy Wright and Henning Bohn, and participants in the 1988 NBER Summer Institute, the 1988 Garn Institute Conference on Federal Deposit Insurance and the Structure of Financial Markets, the 1988 Winter Econometric Society Meetings, and the Federal Reserve Bank of Richmond were greatly appreciated. The first author thanks the NSF for financial support through #SES-8618130. Errors remain the authors'. 50 The Journal of Finance particular, we ask whether there are a variety of solutions and whether government intervention might be a necessary feature of any of them. We first consider an environment that is similar in spirit to the above traditional notion that investors might need to trade in markets where better informed agents are present. The uninformed agents in our model have uncertain consumption preferences but are optimizing agents. Like the previous research, we show that the informed agents may exploit the uninformed, even though here they are optimizing. However, this result holds only when certain contractual responses by the uninformed agents are precluded. We go on to consider how the uniformed agents would respond in order to protect themselves from losses to the insiders. The central idea of the paper is that trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets. These new securities have the characteristic that they can be valued independently of the possible information known only by the informed. By using these securities for transactions purposes, the uninformed can protect themselves. While our focus is on trading contexts, Myers and Majluf (1984) have considered a related problem in corporate finance. When firm managers have inside information, the firm may face a lemons market in issuing new equity.' However, they show that, if a firm can issue default-free debt, then the firm does not have to pay a premium to outside investors. One conclusion of our paper, as discussed below, is that firms would be motivated to issue default-free debt even if there were no information assymmetries a t the new issue date. By focusing on information asymmetries within a trading context, we can develop a notion of a security's "liquidity." A liquid security has the characteristic that it can be traded by uninformed agents, without loss to insiders. We show how intermediation can create liquidity by splitting the cash flows of the underlying assets that they hold. By issuing debt and equity securities against their risky portfolios, intermediaries can attract informed agents to hold equity and uninformed agents to hold debt which they then use for trading purposes. The idea that intermediaries can alleviate the problem of trading against insiders provides a foundation for the demand for a medium of exchange such as money, which is often simply assumed in many monetary models (e.g., a cash-in-advance constraint). Thus, we provide an argument for the existence of intermediation which is distinct from the previous literature. Recent research on the existence of intermediaries can be broadly divided into two literatures. One literature focuses on efficient lending arrangements when there exist information asymmetries between borrowers and lenders. Intermediaries are seen as the unique solution to such agency problems. Examples of research in this area include Diamond (1984) and Campbell and Kracaw (1980). Unlike this literature, which focuses solely on the asset side of intermediaries, our paper is similar to a second line of research which has investigated the properties of intermediaries' liabilities. In the seminal paper by Diamond and Dybvig (1983), banks provide liquidity by acting as risksharing arrangements to insure against depositors' random consumption needs. 'Rock (1986) considers a similar problem. 51 Financial Intermediaries and Liquidity Creation The intermediary contract prevents inefficient interruptions of production. Like Diamond and Dybvig (1983), we are concerned with the idea that intermediaries provide liquidity. However, our notion of intermediaries as providers of liquidity differs in a number of important respects. As Jacklin (1987) and Cone (1983) have shown, a crucial assumption of Diamond and Dybvig (1983) is that agents cannot trade equity claims on physical assets. If a stock or equity market is open, this trading arrangement weakly dominates intermediation. Unlike Diamond and Dybvig, we do not arbitrarily rule out trading in a stock market. On the contrary, it is the presence of insiders in this market which motivates the formation of an intermediary. Second, our model differs in that the intermediaries here will explicitly issue debt and equity, serving as mechanisms that split cash flows. Finally, the existence of our intermediary does not rely on providing risk sharing or resolving inefficient interruptions of production. Our notion of liquidity as providing protection from insiders is fundamentally different. Recent independent work by Jacklin (1988) is similar to ours in that, in the context of a Diamond and Dybvig-like model, he does not rule out trading in an equity market and shows that bank liabilities can prevent losses to informed insiders. However, the intermediary modeled by Jacklin does not issue debt and equity and is partly motivated on risk-sharing grounds. Our model differs in that intermediaries explicitly issue both debt and equity securities, thereby splitting the cash flows of their asset portfolio. Thus, in our setup, intermediaries explicitly create a new, liquid security. We also consider the feasibility of this intermediary contract by considering the conditions under which the intermediary can attract insiders to become equity holders. Thus, we justify the bank from first principles on grounds different from risk sharing. Importantly, bank intermediation is not the unique solution for protecting uninformed agents. In our model, liquidity creation may be accomplished a t the firm level without the need for bank intermediation. By issuing both equity and debt, firms can split the cash flows of their asset portfolios, thereby creating a security (corporate debt) which is safer than their underlying assets. This debt can serve as the basis of a safe security that may be used by uninformed agents for transaction purposes. A key point is that private transactions contracts may not be feasible under certain conditions. This might be viewed as a "market failure" from the perspective of the uninformed agents and could justify a role for government intervention. The government can intervene on their behalf in several ways. One way of protecting the uninformed agents is by insuring the deposits of the banking system through a tax-subsidy scheme. A system of government deposit insurance can achieve the same allocation as when private bank transactions contracts are feasible. Alternatively, if it is infeasible for corporations to issue sufficient amounts of riskless debt, government intervention in the form of a Treasury bill market can improve uninformed agents' welfare by providing additional riskless securities. This form of intervention is shown to parallel that of the provision of deposit insurance since, in both cases, the government's role is to create a riskfree asset. The paper proceeds as follo