2Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them2. Improves economic efficiencyMake the distinction between primary and secondary markets.
3Function of Financial Markets Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of fundsPromotes economic efficiency by producing an efficient allocation of capital, which increases productionDirectly improve the well-being of consumers by allowing them to time purchases better
4Structure of Financial Markets Debt and Equity MarketsPrimary and Secondary MarketsInvestment Banks underwrite securities in primary marketsBrokers and dealers work in secondary marketsExchanges and Over-the-Counter (OTC) MarketsMoney and Capital MarketsMoney markets deal in short-term debt instrumentsCapital markets deal in longer-term debt and equity instrumentsFirms raise funds only at Primary offer stage, but the secondary markets give the primary markets liquidity and therefore increases the value.1. Debt MarketsShort-term (maturity < 1 year) Money MarketLong-term (maturity > 1 year) Capital Market2. Equity MarketsCommon stocks1. Primary MarketNew security issues sold to initial buyers2. Secondary MarketSecurities previously issued are bought and sold1. ExchangesTrades conducted in central locations (e.g., New York Stock Exchange)2. Over-the-Counter MarketsDealers at different locations buy and sell
9Sources of Foreign External Finance Banks are important here, but even more important abroad. This has been part of Japans economic problems the last 10 years.
10Sources of Foreign External Finance Data on stocks is a bit misleading since this is a flow of funds. The stock generates funds once, whereas a bond can be issued merely to pay off another bond therefore not raising the useable capital at all, however as measured by flow it will appear double stocks. This derives from the fact that equities don’t mature whereas debt instruments do. So the flow of debt instruments may or may not represent an actual increase in working capital for the firm.
11Eight Basic FactsStocks are not the most important sources of external financing for businessesIssuing marketable debt and equity securities is not the primary way in which businesses finance their operationsIndirect finance is many times more important than direct financeFinancial intermediaries are the most important source of external funds
12Eight Basic Facts (cont’d) The financial system is among the most heavily regulated sectors of the economyOnly large, well-established corporations have easy access to securities markets to finance their activitiesCollateral is a prevalent feature of debt contractsDebt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
13Demonstration How will a buyer determine what to offer? How will the seller determine what to charge?What if I offered to buy at $800?Will everyone sell?What happens to the average value of the cars offered for sale when I offer $800?Hand out slips of paper to half of the class.
14Function of Financial Intermediaries 1. Engage in process of indirect finance2. More important source of finance than securities markets3. Needed because of transactions costs and asymmetric information
15Transaction CostsFinancial intermediaries have evolved to reduce transaction costsEconomies of scaleExpertiseTransactions Costs1. Financial intermediaries make profits by reducing transactions costs2. Reduce transactions costs by developing expertise and taking advantage of economies of scale
16Function of Financial Intermediaries Risk Sharing1. Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation).2. Also lower risk by helping people to diversify portfolios
17Transaction Costs and Financial Structure Transaction costs hinder flow of funds to people with productive investment opportunitiesFinancial intermediaries make profits by reducing transaction costs1. Take advantage of economies of scaleExample: Mutual Funds2. Develop expertise to lower transaction costsExplains Fact 3
18Asymmetric Information “The secret of success is to know something nobody else knows” -Aristotle OnassisHot tip from the broker vs. insider tradingLemons Problem (Akerlof)The Nobel Laureates ofApply asymmetric information to dating markets.What are methods or ways in which asymmetric info is reduced? What happens to the number of matches, or what would you expect.How important is asymmetric info in car market?An anonymous correspondent sends me news of the young Henry Schneider, Yale Ph.d. student. Here is the abstract to his Estimating the Effects of Adverse Selection in Used Car Markets:In this paper, I address the long-standing question of whether adverse selection prevents used cars from reaching owners who value them most highly. In doing so, I confront the challenge of identifying the effects of adverse selection separately from the effects of efficient sorting of vehicles based on their conditions. This latter process would usually occur simultaneously to adverse selection and also affects the distribution of vehicles that trade. Using the prediction in Hendel and Lizzeri (1999), that adverse selection and efficient sorting both increase the rate of price depreciation, I propose to use their joint effect as an upper bound on the effect of adverse selection. My estimate of this joint effect, based on proprietary data on one million dealer used car sales and trade-ins, is close to zero, a result that indicates that adverse selection is unimportant. Using Consumer Expenditure Survey data, I provide additional support for this conclusion by showing that vehicles that were recently purchased from a dealership received approximately the same number of repairs as comparable continuously-held vehicles. I conclude with a discussion of the role that sellers’ concerns for their reputations may play in limiting information-based inefficiencies.But Henry is no apologist for the market. Here is his paper on how much auto mechanics rip you off. Half of all the money spent on auto mechanics appears to be deadweight loss. He does note they neglect urgent problems 77 percent of the time, which suggests some stupidity instead of (in addition to?) pure venality.Here is Alex's earlier post on adverse selection.
19Asymmetric Information Adverse selection occurs before the transactionMoral hazard arises after the transactionAgency theory analyses how asymmetric information problems affect economic behaviorAdverse Selection1. Before transaction occurs2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selectedMoral Hazard1. After transaction occurs2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan backFinancial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
20Adverse Selection: The Lemons Problem If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average qualitySellers of good quality items will not want to sell at the price for average qualityThe buyer will decide not to buy at all because all that is left in the market is poor quality itemsThis problem explains fact 2 and partially explains fact 1
21Adverse Selection: Solutions Private production and sale of informationFree-rider problemGovernment regulation to increase informationFact 5Financial intermediationFacts 3, 4, & 6Collateral and net worthFact 7
22Moral Hazard in Equity Contracts Called the Principal-Agent ProblemSeparation of ownership and control of the firmManagers pursue personal benefits and power rather than the profitability of the firm
23Principal-Agent Problem: Solutions Monitoring (Costly State Verification)Free-rider problemFact 1Government regulation to increase informationFact 5Financial IntermediationFact 3Debt Contracts1. Private Production and Sale of InformationFree-rider problem interferes with this solution2. Government Regulation to Increase InformationExplains Puzzle 53. Financial IntermediationA. Analogy to solution to lemons problem provided by used-car dealersB. Avoid free-rider problem by making private loansExplains Puzzles 3 and 44. Collateral and Net WorthExplains Puzzle 7
24Moral Hazard in Debt Markets Borrowers have incentives to take on projects that are riskier than the lenders would like
25Moral Hazard: Solutions Net worth and collateralIncentive compatibleMonitoring and Enforcement of Restrictive CovenantsDiscourage undesirable behaviorEncourage desirable behaviorKeep collateral valuableProvide informationFinancial IntermediationFacts 3 & 4
27Function of Financial Intermediaries: Indirect Finance Lower transaction costsEconomies of scaleLiquidity servicesReduce RiskRisk Sharing (Asset Transformation)DiversificationAsymmetric InformationAdverse Selection (before the transaction)—more likely to select risky borrowerMoral Hazard (after the transaction)—less likely borrower will repay loan
28Internationalization of Financial Markets Foreign Bonds—sold in a foreign country and denominated in that country’s currencyEurobond—bond denominated in a currency other than that of the country in which it is soldEurocurrencies—foreign currencies deposited in banks outside the home countryEurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banksWorld Stock MarketsInternational Bond Market1. Foreign bonds2. EurobondsNow larger than U.S. corporate bond marketWorld Stock MarketsU.S. stock markets are no longer always the largest: Japan sometimes larger
29Financial Intermediaries Do not memorize the following charts, merely familiarize yourself with them. Types of institutions and their preferred habitat (sometimes required habitat by regulation)
30Size of Financial Intermediaries Note how large commercial banks are…discuss tax advantages and boom in credit unions.
31Regulation of the Financial System To increase the information available to investors:Reduce adverse selection and moral hazard problemsReduce insider tradingTo ensure the soundness of financial intermediaries:Restrictions on entryDisclosureRestrictions on Assets and ActivitiesDeposit InsuranceLimits on CompetitionRestrictions on Interest RatesTwo Main Reasons for Regulation1. Increase information to investorsA. Decreases adverse selection and moral hazard problemsB. SEC forces corporations to disclose information2. Ensuring the soundness of financial intermediariesA. Prevents financial panicsB. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures3. Improve Monetary Control?
32Regulatory AgenciesThe industry is the most heavily regulated!! And there are constant calls for more regulation.
34Conflicts of InterestType of moral hazard problem caused by economies of scopeArise when an institution has multiple objectives and, as a result, has conflicts between those objectivesA reduction in the quality of information in financial markets increases asymmetric information problemsFinancial markets do not channel funds into productive investment opportunitiesThe economy is not as efficient as it could be
35Why Do Conflicts of Interest Arise? Underwriting and Research in Investment BankingInformation produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ.Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business
36Why Do Conflicts of Interest Arise? (cont’d) Auditing and Consulting in Accounting FirmsAuditors may be willing to skew their judgments and opinions to win consulting businessAuditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterpartsAuditors may provide an overly favorable audit to solicit or retain audit business
37Conflicts of Interest: Remedies Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act)Increases supervisory oversight to monitor and prevent conflicts of interestEstablishes a Public Company Accounting Oversight BoardIncreases the SEC’s budgetMakes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit
38Conflicts of Interest: Remedies (cont’d) Sarbanes-Oxley Act of 2002 (cont’d)Beefs up criminal charges for white-collar crime and obstruction of official investigationsRequires the CEO and CFO to certify that financial statements and disclosures are accurateRequires members of the audit committee to be independent
39Conflicts of Interest: Remedies (cont’d) Global Legal Settlement of 2002Requires investment banks to sever the link between research and securities underwritingBans spinningImposes $1.4 billion in fines on accused investment banksRequires investment banks to make their analysts’ recommendations publicOver a 5-year period, investment banks are required to contract with at least 3 independent research firms that would provide research to their brokerage customers
40Financial Development and Economic Growth Financial Repression Leads to Low Growth: Why?1. Poor legal system2. Weak accounting standards3. Government directs credit4. Financial institutions nationalized5. Inadequate government regulation
41AppendixSlides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book.They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.
42Financial Crises and Aggregate Economic Activity Crises can be caused by:Increases in interest ratesIncreases in uncertaintyAsset market effects on balance sheetsProblems in the banking sectorGovernment fiscal imbalances