MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 1 Basic Facts About Financial Structures 1. Stocks are not the most important source of external financing for businesses  The stock market accounted for only about 11% of external financing for American businesses from Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations  Bonds account for about 32% of external financing in the U.S.  However, stocks & bonds combined account for only 43% of external financing in the U.S. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance in which businesses raise funds directly from lenders in financial markets  Direct finance involves the sale of marketable securities such as stocks and bonds directly to individuals, groups, firms, etc.  Only about 5% of marketable securities are sold directly to investors  The rest are sold to investors through financial institutions; this is “indirect” finance 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance business  About 56% of external funding for businesses come from loans made by banks and other non-bank financial intermediaries such as insurance companies, pension funds and finance companies Ch 7: Why Do Financial Institutions Exist?

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 2 Basic Facts About Financial Structures (continued) 5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well established corporations have easy access to securities markets to finance their activities  Individuals and smaller businesses that are not well established are less likely to raise funds via financial markets; they obtain their funding through banks 7. Collateral is a prevalent feature of debt contracts for both households and businesses 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 3 Financial Institutions  Called “financial intermediaries” because they intermediate between investors and investees  Banks, securities firms, insurance companies, pension funds, etc. The Role of Financial Intermediaries Pooling of Savings:  Accepting resources from a large number of small savers/lenders in order to provide large loans to major borrowers  Banks (and other financial intermediaries) typically charge a little bit more for the loans they make than they pay savers/lenders for the use of their funds; this is how banks make a profit  Banks and other financial institutions must attract substantial numbers of small savers; they do this by convincing savers of the soundness of their bank and that their investments are safe Safekeeping and Accounting:  Banks (and other financial intermediaries) need to safeguard the investments and valuables of their depositors; hence there are vaults and safe deposit boxes  Banks must provide to depositors easy access to their investments and valuables; hence there are bank tellers, credit cards, ATM machines, internet banking services and cell phones apps  Ensure that proceeds are issued properly  Banks must also provide accurate and up-to-date accounting of depositor assets in order to keep those accounts  Banks provide all sorts of other services (i.e. financial management advise, estate planning, etc.) to attract and maintain depositors  Most of the above activities require the writing of contracts which further enhances depositor confidence

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 4 The Role of Financial Intermediaries (continued) Providing Liquidity:  Definition of Liquidity: the ability to convert a non-cash asset into cash quickly and without significant loss in value  Banks and other financial intermediaries provide this through the services discussed on the previous page; some investment companies even provide mutual fund based checking accounts  Wells Fargo/Bank of the West/First Security example  9/11/01 example  Economies of scale; by pooling of funds from many savers, banks can lend large amounts of money to big time corporations to fund large projects very efficiently and relatively cheaply  this greatly reduces transaction costs and allows individual with modest amount of money to invest to participate in financial markets  Banks offer businesses lines of credit and cash advances to make it much easier for companies to run day-to-day operations Diversifying Risk:  Banks take in funds from many (millions) depositors and make thousands of loans; each depositor has only a small stake in any single loan made by the bank  FDIC guarantees accounts of up to $250,000 Collecting and Processing Information:  Banks monitor debtors to ensure that they use the funds they borrowed for intended purposes  Helps reduce the problem of Information Asymmetry  Reduce information cost of screening and monitoring borrowers to ensure credit worthiness

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 5 Types of Financial Institutions The Role of Financial Intermediaries (continued) Collecting and Processing Information:  Banks monitor debtors to ensure that they use the funds they borrowed for intended purposes  Helps reduce the problem of Information Asymmetry  Reduce information cost of screening and monitoring borrowers to ensure credit worthiness  Many financial institutions offer a wide variety of products & services, the achieve “economies of scope” by lowering the cost of information production by applying one information source to many different services

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 6 Information Asymmetry  The analysis of how information asymmetry problems affect economic behavior is called “agency theory”  Potential borrows know much more about their own business, its prospects and their industry than do potential lenders; this is a form of Information Asymmetry  This tends to discourage lending  Reducing this asymmetry is the key to making our financial system work as well as it does  Why does eBay work?  how can buyers be sure that the item they are bidding on is accurately described?  why are people willing to send in their money for stuff they’ve never seen in person from people they don’t know?  how can buyers be sure they won’t be disappointed with their purchases or be sure they’ll even arrive?  sellers have much more information about what they’re selling and their own reliability than do buyers: information asymmetry  eBay addresses these problems by:  offering insurance to buyers  having a system to assemble info on buyers & sellers to identify and exclude unreliable participants  Banks do much the same thing

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 7 Information Asymmetry There are two other issues associated with or resulting from information asymmetry: 1. Adverse Selection: arises before a transaction occurs  When investors and investees have access to different information (information asymmetry), traders with better private information about the quality of a product will selectively participate in trades which benefits them the most (at the expense of other traders)  Lenders can’t distinguish between good and bad credit risks which discourages transactions from taking place  Some types of securities are more prone to adverse selection than others. Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers since managers will only offer stock when they know the offer price exceeds their private assessments of the company's value. Outside investors therefore require a high rate of return on equity to compensate them for the risk of buying a "lemon".  Consider buy stock from one of two firms, one with good prospects and the other with bad prospects  if you can’t tell the difference between the two, you will be willing to pay a price based only on their average quality  the stock of the good company will be undervalued while the stock of the bad company will be overvalued  since the owners of the good company know their stock will be undervalued, they may not issue it at all  that leaves only the firm with the bad prospects in the market  Why is this a problem?

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 8 Information Asymmetry (continued) 1. Adverse Selection: (continued)  Another Example:  borrowers with bad credit are the greatest potential risks  they are the ones who are the most eager to borrow money because they are not likely to pay it back  some of these types of borrowers likely know ahead of time that they won’t pay off the loan; thus adverse selection Addressing Adverse Selection:  The adverse selection problem is addressed by disclosing as much info as possible  government-required disclosure  private collection and publication of information  Do these efforts solve the problem?  Banks do extensive screening of potential borrowers; however, this increases the cost of doing business  Credit scores  Bond ratings

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar 16 9 Information Asymmetry (continued) 2. Moral Hazard:  Moral hazard occurs when one person takes more risks because someone else bears the burden of those risks  First observed in the insurance industry; insurance policies change the behavior of those who are insured  Moral hazards arise when we cannot observe people’s actions and so cannot judge whether a poor outcome was intentional or just the result of bad luck  In the finance world, moral hazard arises because providers of capital (equity & loans) may not be able to observe whether the recipients of capital are using these funds appropriately and for the purposes they said they intend to use them for  this may cause another problem called the “principle-agent problem”; this is due the separation of control of capital from providers of that capital  Instead of using provided capital to improve the profitability of the company, managers may use it to buy luxurious offices, limousines, art work and corporate jets  Debt financing allows corporate borrowers to keep all profits gained from using borrowed funds in excess of interest; this encourages risk taking

MGT 470 Ch Why Do Financial Institutions Exist? (me8ed) v1.0 Mar Information Asymmetry (continued) 2. Moral Hazard: (continued) Addressing Moral Hazard:  Very specific loan contracts that bind the borrower to using loaned funds for specific purposes can lessen the problem  bonds can be issued with restrictive covenants  borrows may be required to maintain a certain level of net worth  borrowers may be required to carry various types of insurance managers who borrow funds may be required to report to lenders  Several companies do business by offering monitoring services to lending firms that can’t do it themselves  Some venture capital firms specialize in risky investments and provide monitoring for a stake in the profits  Threat of hostile takeover