Obstacles to Matching Savers and Borrowers The financial system’s role in bringing savers and borrowers together can be complex. Due to transaction & info costs savers/borrowers might receive/pay lower/higher rate. Investors face various costs: Transactions costs of a trade or exchange, e.g., the brokerage commission. Small investors & small-medium borrowers use fin intermediaries for fin needs, including reducing transaction costs (through economies of scale – high volume lowers average costs: banks spread standardized contract costs over many loans) Information costs to determine borrowers’ creditworthiness and monitor use of funds. Asymmetric information when one transaction party has better info (crowd-funding of startups: raising small amounts from many people) leads to two problems: Adverse selection: how to distinguishing low from high-risk borrowers (bond seller know but investors unaware of rapidly declining sales and near bankruptcy). Regulations, collateral & fin intermediaries reduce but do not eliminate. Moral hazard: risk that one party’s action after entering transaction hurt the other (how to verify that borrowers use funds as intended). Board of directors, incentive compensation & fin intermediary only help.

Adverse Selection or “Lemons Problem” Because of asymmetric info (used car seller knows car’s condition better than buyer) the used car market adversely selects cars offered for sale. The prices buyers are willing to pay reflect their lack of info on true car condition. Price of a good/bad car is below/above its true value crowding out good cars. If buyers will pay $15,000/$7,000 for good/bad car, and 75% of used cars are good: At E(P) = 0.75*15, *7,000 = 13,000 only lemons offered for sale. “Lemons Problems” in fin markets If 90% of stocks are good with $50 price and 10% are lemons with $5 price E(P) = 0.9* *5 = 45.5 which is below the fundamental value of good stock. As bonds’ rates rise (creditworthiness of borrowers likely deteriorates) making adverse selection worse by increasing fraction of lemons among firms willing to pay high rates. Why banks limit loans in credit rationing instead of increasing the rate? High rates may attract less creditworthy borrowers, unconcerned with paying high rates if close to bankruptcy. In recession number of lemon borrowers increases. Credit rationing hurts all borrowers (good or lemons) making it harder for good ones.

Attempts to Reduce Adverse Selection Info disclosure to SEC reduces but doesn’t eliminate costs of adverse selection for: 1. Some good firms may be too young to have enough info to evaluate. 2. Lemons try to present info in the best possible to overvalue their securities. 3. Legitimate differences of opinion on reporting some of accounting statement items. Private firms collect firm’s info (from sources such as firms’ accounting statements and investment decisions) and sell them to reduce adverse selection costs. Free riders (gain access to info without paying) reduce the amount of info services. Lenders often require borrowers to have collateral (assets pledges to be seized if borrower defaults) and high net worth (firm’s assets minus its liabilities). Banks & fin intermediaries specialize in gathering info on borrowers’ default risk. Relationship banking (ability to assess credit risks based on borrowers’ private info) reduces the costs of adverse selection and explains the key role banks play in providing external financing to firms.

Has Securitization Increased Adverse Selection Problems in the Financial System? Securitization involves bundling loans, such as mortgages, into securities that can be sold in financial markets. The increase in securitization may have led to an increase in adverse selection by changing banks’ focus of relationship banking to the originate- to-distribute business model—banks sell loans to others rather than holding them to maturity. Securitization and the originate-to-distribute model increased adverse selection problems by reducing banks’ incentive to distinguish between good borrowers and lemon borrowers. It can be difficult for investor to evaluate riskiness of loans included in the securities.

Moral Hazard in the Stock Market Ownership-management separation in publicly traded corps can cause principal– agent problem: managers pursue their own rather than interest of shareholders. To reduce managers incentive to underreport profits in order to reduce dividends and retain the use of funds, the SEC requires managers to issue financial statements. Boards of directors meet infrequently and may not be independent of top managers. Incentive contracts used to align the goals of managers and shareholders, but it could lead managers to undertake risky investments. Moral Hazard in the Bond Market There is less moral hazard in the bond market than in the stock market. Because bond allows firm to keep profits in excess of fixed bond payments, managers have incentive to assume more risk to earn these profits than is in bond investors’ best interest. To reduce moral hazard in bond markets, investors insert restrictive covenants (clauses limiting borrower’s uses of funds or require paying off bond if the borrower’s net worth drops below certain level) into bond contracts.

How Financial Intermediaries Reduce Moral Hazard Problems Financial intermediaries have evolved to fill the gap left by the ban on banks making equity investments in nonfinancial firms. A venture capital firm raises equity capital from investors to invest in start- up firms. A private equity firm (or corporate restructuring firm) raises equity capital to acquire shares in other firms to reduce free-rider and moral hazard problems. A market for corporate control provides a means to remove top management that is failing to carry out the wishes of shareholders.

Three key features of the financial system: Fin intermediary loans the most important external source of $ for small-medium firms. They cannot borrow directly from savers (transactions costs are too high) or sell securities because of asymmetric information (adverse selection & moral hazard). Conclusions about the Structure of the US Fin System Small-Medium Firms rely on loans and trade credit as major sources of external finance.

Three key features of the financial system: Stock market is less important source of external funds to firms than is bond market. Most of trading on stock market involves existing shares, not new shares of stock. In recent years, corps bought back from investors more stock than they have issued. Moral hazard is less of a problem with debt contracts than with equity contracts. Conclusions about the Structure of the US Fin System Corporations rely on stocks and bonds as major sources of external funds.

Three key features of the financial system: Debt contracts usually require collateral or restrictive covenants. Large household loans use the good being purchased as collateral. Many corporate bonds also specify collateral. To reduce moral hazard, both loans and bonds typically contain restrictive covenants. By reducing transactions and info costs, fin intermediaries offer higher rates for savers and lower rates for borrowers. Commercial banks, investment banks, and other fin firms continually search for ways to earn a profit by expediting the flow of funds from savers to borrowers. Conclusions about the Structure of the US Fin System

Corporations Are Issuing More Bonds; Should You Buy Them? As T-bonds rates hit record lows, corp bonds demand increased, lowering their yields. Declining corp bonds yields reduced default risk premium (> T-bonds) while corp default risk did not change. Corp bonds with record low yields also subject to significant interest-rate risk in future. Index of yields on investment grade corp bonds prepared by Bank of America Merrill Lynch.