…A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities…

Eight Basic Facts 1.Stocks are not most important source of external financing 2.Issuing marketable securities (debt and equity) not the primary way businesses finance operations 3.Indirect finance is much more important than direct finance 4.Financial intermediaries  the most important source of external funds 5.The financial system is heavily regulated … you ain’t seen noth’n’ yet 6.Only large, well-established corporations have (had) easy access to securities markets to finance their activities  need reputation and net worth 7.Debt contracts: trust … but collateral 8.Debt contracts: trust … but restrictive covenants

Why Intermediaries? … Transaction Costs –Economies of scale –Expertise: information specialists to handle adverse selection and moral hazard problems What went wrong? –Perverse incentives Asymmetric Information Problems Adverse selection before a transaction “Lemons problem” Moral hazard arises after the transaction Managers and principal - agent problem Debt and risky behavior Conflicts of interest Agency theory: how asymmetric information affects economic behavior

Countering Adverse Selection Private production and sale of information –Free-rider problem –Perverse incentives: who pays Moody’s? Government regulation to increase information Financial intermediation: information specialists Collateral and net worth Countering Moral Hazard: Principal - Agent Align manager incentives with owners’ Stock, stock options Monitor  venture capital firms Avoid being owner: debt not equity

Moral Hazard in Debt Markets Borrowers have incentives to take on risky projects Countering Moral Hazard in Debt Contracts Net worth and collateral –Incentive compatible … loss is borrower’s, not lenders Enforce Restrictive Covenants –Keep collateral valuable –Provide information

Economies of Scope and Conflicts of Interest Underwriting and Research in (what was) Investment Banking –Information produced by researching arm used to underwrite the securities. The bank simultaneously serves two client groups whose information needs differ. –Spinning: an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business Auditing and Consulting in Accounting Firms –Auditors skew opinions to win consulting business –May audit information systems or tax and financial plans put in place by their consulting counterparts –May provide an overly favorable audit to retain business Sarbanes-Oxley Act of 2002 Global Legal Settlement of 2002

Financial Crises and Aggregate Economic Activity Crises can be caused by: –Increases in interest rates –Increases in uncertainty –Asset market effects on balance sheets A bursting bubble –Problems in the banking sector –Government fiscal imbalances Vicious spirals Financial crises we have known: 1819, 1837, 1857, 1873, 1884, 1893, 1907, , 2008

Bank Management Liquidity Management excess reserves/secondary reserves/call loans Asset Management: return(ROA)/risk/liquidity Liability Management: CDs/Fed funds Capital Adequacy Management: ROE Credit Risk: Screen,Monitor,…,Collateral –Credit default swaps  regulatory arbitrage “The unbundling of credit risk probably should be a good thing, assuming the people picking up the elements of credit risk understand what they’re doing and the risks they’re incurring.” E. Gerald Corrigan, 1997 Interest-rate Risk: –Gap Analysis/Duration Analysis

Off-Balance-Sheet Activities Loan sales (secondary loan participation) Generation of fee income Trading activities and risk management techniques Futures, options, interest-rate swaps, foreign exchange Speculation Risk management techniques Limits on exposure Value at risk Stress testing