Presentation on theme: "Agency theory: how asymmetric information affects economic behavior"— Presentation transcript:
1Agency theory: how asymmetric information affects economic behavior Asymmetric Information in Finance Financial StructureAdverse selection: Before a transactionLemons ProblemMoral hazard: After the transactionPrincipal – Agent ProblemDebtor & RiskConflicts of InterestTBTF: No Bank Left Behind
2The Trouble With Lending: The Mantra:...A healthy, vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities…The Trouble With Lending:Worst risks line up firstBorrowers won’t do what they “promised”The Trouble With Buying a Share:If it’s such a good deal, why offer it to me?Management might ripoff, not share with shareholdersSo how can a financial system “move funds” from savers to entrepreneurs?
4Financing business: Eight Facts Stocks are not most important source of external financingIssuing marketable securities (debt and equity) not the main way businesses finance operationsIndirect finance is much more important than direct financeFinancial intermediaries the most important source of external fundsThe financial system is (supposed to be) heavily regulatedOnly large, well-established corporations have (had) easy access to securities markets to finance their activities need reputation and net worthDebt contracts: trust … but collateralDebt contracts: trust … but restrictive covenants
5Why Intermediaries? … Transaction Costs Economies of scaleExpertise: information specialists to handle adverse selection and moral hazard problemsWhat went wrong? … Perverse incentivesAsymmetric Information ProblemsAdverse selection before a transaction“Lemons problem”Moral hazard after the transactionDebt & risky behavior…insurance & risky behaviorManagers and principal - agent problemConflicts of interest
6Countering Adverse Selection Private production and sale of information...but there are problemsFree-rider problemPerverse incentives: who pays Moody’s?Gov’t regulation to increase information...but there are problemsRegulatory capture…the revolving doorFinancial intermediation: information specialists?!?Collateral and net worth…skin in the gameRomney on regulation & Dodd-FrankCountering Moral Hazard: Principal – Agent ProblemAlign manager incentives with owners’Stock/stock options/bonuses/bonus claw-backsMonitor venture capital firmsAvoid ownership debt not equity
7Moral Hazard in Debt Markets Borrowers have incentives to take on riskHeads they win/Tails you loseCountering Moral Hazard in Debt ContractsNet worth and collateral…skin in the gameIncentive compatible…loss is borrower’s, not lendersEnforce Restrictive CovenantsKeep collateral valuable/Provide informationBut there are costs...Cost of credit intermediation/state verificationDid borrower really lose...or is he ripping off?When economy tanks, don’t bother to lend credit crunch
8Incentives leading to the subprime-triggered crisis The PlayersHomebuyer…live free…or defaultAppraiser…feeMortgage broker…commissionOriginate and sellSecuritizer: Investment banks/commercial banksFees, bonusesMoving, not storageRatings agency…fee“Investors”/GSEs…returnGovernment roleRegulation/supervisionDeposit insuranceLender of last resortTBTF…Too Interconnected to Fail
9Denizens of the Pre-Crisis Financial System Depository institutionsFederal loan programs (SBA,FHA)GovtSponsoredEnterprises (Fannie Mae, Freddie Mac, FHLB)Insurance CompaniesPension FundsDiversified Broker-Dealers (Investment Bank Holding Cos.)Mortgage InsurersMonoline InsurersShadow Banks (Standalone and captive finance cos., conduits—single-seller, multi-seller, hybrid, repo, security arbitrage conduits—StructuredInvestmentVehicles, Limited Purpose Finance Cos., Credit Hedge Funds)Money Market Intermediaries (MMMFs, overnight sweeps, cash “plus” funds, enhanced cash funds, ultra-short bond funds, local gov’t investment pools, securities lenders)European banks
10The Shadow Banking System: A Daisy Chain From origination to wholesale fundingLoan origination: Finance cos. funded by CommercialPaperLoan warehousing: Conduits funded by AssetBackedCommercialPaper (the loans are the assets)Pooling and structuring loans into AssetBackedSecurities: Broker-dealer ABS syndicate desksABS warehousing: Trading books funded by reposPooling ABS into CollaterizedDebtObligations: Broker-dealer syndicate desksABS intermediation: LimitedPurposeFinanceCos., Structured InvestmentVehicles, etc., funded by ABCP, bonds, notesWholesale funding of all of the above by MoneyMarketMutual Funds, money market investors. Also fixed income mutual funds, pension funds, and insurance cos. fund shadow banks by investing in their MediumTermNotes
12Economies of Scope and Conflicts of Interest Underwriting and Research in (what was) Investment BankingInvestment bank research used to underwrite securities serves sellers and buyers of the securities at same time…do not make negative or controversial comments about clientsJack Klugman/Citi dotcom research/pre-school recommendationsSpinning: investment bank can allocate hot, underpriced, IPOs to executives of other companies in return for their companies’ future businessAuditing and Consulting in Accounting Firms INCESTAuditors may skew opinions to get consulting businessMay audit information systems or tax and financial plans put in place by their consulting counterpartsMay provide an overly favorable audit to retain businessSarbanes-Oxley Act of 2002: SEC Oversight/CPA independenceAudit committee independence/CEO-CFO signoff/…Global Legal Settlement of 2002: Separate research & underwriting
13Chapter 8 QuestionsWould the lemons problem be more severe for stocks traded on the New York Stock Exchange, where only large-cap(italization) companies are listed, or stocks traded over-the-counter?Hint: Bernie Madoff once headed NASDAQWhich firms are most likely to use bank financing rather than issue bonds or stocks to finance their activities? Why?How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?Why can the provision of several types of financial services by one firm lead to lower costs of information production?Why can the provision of several types of financial services by one firm lead to conflicts of interest?