Chapter 11 Reducing Transactions Costs and Information Costs

Banks vs. Bonds

PE Ratios

Objectives 1.Differentiate Adverse Selection and Moral Hazard 2.Identify 5 different types of financial institutions.

Unit Overview Transactions Costs Asymmetric Information Costs Adverse Selection Moral Hazard Securities Market Institutions Investment Institutions Contractual Savings Institutions Depository Institutions Government Financial Institutions

Facts of Finance Issuing marketable debt and securities is not the primary source of finance for businesses. (In G-7, less than 20% of all finance). –Internal finance (retained profits) is an important source of funds for business. –Securities markets play a small (but growing) role in external finance in all markets outside North America. Banks are the source of half of external finance in North America and 75-80% outside NA. –Only most well known companies issue debt securities. –Direct sale of securities from issuers to savers play a tiny role in finance. Most securities held by financial institutions.

Transactions Costs Debt serves a useful purpose in matching those who currently have greater income than consumption to those with greater consumption than income. However, matching buyers and sellers involves some costs. Institutions develop to reduce these costs. –Economies of scale –Specialization

Information Costs As noted, all debt involves some risk that the borrower will be unable to repay. Part of transactions costs involve acquiring information about this likelihood. Information asymmetry between borrowers and lenders. Borrowers always know more about their chances than lenders.

Asymmetric Information Asymmetric Information A condition that occurs when borrowers have some information about their opportunities or activities that they do not disclose to lenders, creditors or insurers. Two categories of imbalanced information 1.Borrower has more information about their own prospects before the loan was made. 2.Borrower has more information about and control over the way funds are used after the loan has been made.

Costs of Asymmetric Information Two types of problems 1.Adverse Selection – A lender’s problem of distinguishing the good-risk applicants from the bad-risk applicants before making an investment. 2.Moral Hazard – Borrowers incentives will not align with lenders and will behave in ways that are not conducive to repaying debt.

Lemon Problem: Used Cars Two indistinguishable (to buyers) types of cars: lemons (often breaking down) and creampuffs (never breaking down). If buyers are willing to pay a price equal to the average value of lemon and creampuffs, they will offer a price higher than the value of a lemon, but less than the value of the creampuff. Only sellers would be lemon owners.

Lemon Problem: Bond Market Some firms have risky prospects (lemons) and some firms have safe prospects (creampuffs). Bond buyers cannot distinguish between them. They offer bond prices which are an average of the price of creampuff bonds and lemon bonds. [Another way of putting this is that interest rates are an average of creampuff and lemon rates]. Potential borrowers with creampuff prospects may finance their own projects. Only borrowers with lemon prospects will join bond markets.

Reducing Adverse Selection Through Information Gathering 1.Information Gathering – Bond rating agencies perform the function of analyzing possibility of repayment. 2.Free Rider Problem – Gathering information about firms is costly, but once gathered it can be shared very cheaply. Information firms do not receive funds from all who benefit from their services. Information may be underprovided by markets. 3.Government Regulation – One solution to the free rider problem is for the government to issue rules requiring sellers of securities to provide honest information about their firms.

Collateral/Net Worth Most debt is backed by some sort of collateral. In the case of default, lender takes possession of some physical or financial asset of relatively clear value. Lenders will only lend to firms with a high net worth. This means lenders can make claims on the outstanding assets of companies in the case of debt default.

Moral Hazard Once funds have been lent, borrowers have control. If borrowers take risky actions and lose, they share the losses with their debtors by defaulting. If borrowers take risky actions and win, they keep all the extra winnings themselves.

Moral Hazard Example Lender lends $100 to borrower at 5% interest. Borrower can choose between two investment projects each of which require an upfront pay-off of $100. Project A is a risky project but potentially lucrative. With an 80% probability, project A will generate 0 payoff. With a 20% probability project A will generate a $205 payoff. Project B is a non-risky project which will generate a pay-off of $110 with an 80% probability and a pay-off of $95 with an 20% probability. Three Questions 1.Which project will A choose if he is risk-neutral. 2.Which project would B choose if he is risk-neutral 3.Which project is most advantageous to a risk-neutral society.

Expected Value We can use the statistical concept of expected value to answer these questions. Expected payoff to a project with two possible outcomes Payoff E = Prob(Outcome 1 )*Payoff 1 +Prob(Outcome 2 )*Payoff 2

Which project is socially beneficial? Expected payoff to project A is.8∙$0 +.2·$205 = $41 Since cost is $100, the expected payoff to project A is less than the cost. To a risk neutral or risk averse society this project will be bad. Expected payoff to project B is.8∙$ ·$95 = $107 Since cost is $100, the expected payoff to pro ject B is more than cost. To a risk neutral society this project is good (though the risk might be to large for a suffiiciently risk-averse society).

Pay-off to Borrower and Lender Project A. With 80% probability, the payoff to the project will be $0 so both the borrower and lender get $0. With 20% probability, the pay-off to the project will be $205, so the lender will be repaid $105 and the borrower will keep $205-$105 = $100. The expected payoff to the project for the lender will be.2∙$105+.8∙0=$21. The expected payoff to project A for the borrower is.2∙$100+.8∙0=$20. Project B. With 20% probability, the payoff to the project will be $95, so the lender will only be repaid $95 and the borrower keeps $0. With 80% probability, the payoff to the project will be $110, so the lender is repaid $105 and the borrower keeps $5. The expected payoff to the project for the lender will be.2∙$95+.8∙$105 =$103. The expected payoff to project A for the borrower is.2∙$0+.8∙$5=$4

Which project will be undertaken? If the borrower has control of the funds, then he will choose project A. The expected value of the payment to him is higher for the riskier project. This is because the lender bears all of the upside of a risky investment and none of the downside. The lender of course prefers the reverse. He would choose the socially beneficial project B. This example demonstrates the problem of moral hazard in debt markets. Because he shares none of the downside, the borrower will choose inefficiently risky projects once he has control of the funds.

Restrictive Covenants Debt agreements place restrictions on activities of borrowers. –Restrict spending of funds –Require maintenance of minimum net worth –Require maintenance of value of collateral

Financial Intermediaries Most funds raised internally through owners savings or retaining earnings. Banks specialize in acquiring information and reducing monitoring costs. Typically, they do not share information so do not face the free rider problem as severely.

Adverse SelectionMoral Hazard Debt Market Problems Credit Rationing – High Interest Rates Attract Bad Risks Assumption of Greater Risk by Borrowers Solutions 1.Collateral 2.Net Worth Requirements Restrictive Covenants 1.Restrict Activities 2.Require Net Worth Equity Market Problems High Growth Companies Do Not List Shares Principal Agent Problem Managers Serve Themselves Solutions ?Leveraged Buyouts

Chapter 12 Financial Institutions

Savers Borrowers Financial Markets 1. Primary: Investment Banks 2. Secondary: Exchanges 3. Secondary: Brokers & Dealers Depository Institutions 1.Banks 2.RLB’s & DTC’s Investment & Contractual Savings Mutual Funds Hedge Funds Pension Funds Insurance Investment Finance Companies Government Mortgage Companies

Security Market InvestmentContract Savings DepositoryGovernment Information Investment Banks Finance Companies Commercial Banks Risk Brokers Dealers Markets OTC Mutual Funds Insurance Pension Funds Liquidity Brokers Dealers Markets OTC Mutual Funds Pension Funds Commercial Banks Mortgage Companies

Types of Financial Institutions Security Market Institutions Investment Institutions Contractual Savings Institutions Depository Institutions Government and Quasi-Government Institutions

Security Market Institutions: Primary Markets Investment Banks – Advise and aid firms in issuing bonds and stocks to primary markets. Underwriting – Underwriter guarantees a price for bonds, makes profits if they can sell it for more. Syndicates – Groups of investment banks gathered by a lead bank to share in underwriting.

Secondary Market Institutions: Secondary Markets Exchanges – ( Hong Kong Exchanges and Clearing Ltd.) –Hong Kong Stock Exchange Main Board: Established Companies Growth Enterprise Market Bond Market –Hong Kong Futures Exchange. Main Product: Hang Seng Futures Indexes Brokers match buyers and sellers. Dealers own stocks of assets Stocks traded through a centralized clearing system Central Clearing and Settlement System (CCASS) operated by HK Securities Clearing Company Limited.

Investment Institutions Investment Institutions match retail lenders/borrowers with security markets. 1.Mutual Funds raise funds in retail markets and use the funds to invest in securities markets. 2.Finance Companies raise funds in securities markets and make loans in retail markets. 3.Hedge Funds are partnerships of wealthy people investing in financial markets. Purpose: Direct participation in security markets may involve too great transaction costs for some borrowers/savers.

Mutual Funds Mutual Funds – Intermediaries that raise funds from investors and use the funds to buy securities. For savers, a cheap way of acquiring a share of a diversified portfolio. (AKA Unit Trusts) Types of Funds 1.Closed End vs. Open End: Closed end funds are not redeemable at will but shares are traded. Open end funds can be redeemed from initial issuer. Value of shares are based on value of portfolio assets. 2.Load vs. No Load – Purchasers of load funds pay commissions. No load funds pay only management fees based on earnings. 3.Indexed vs. Managed Funds – Indexed Funds have portfolios that proportionally matches a broad pre-determined set of assets like the S&P 500 or the Hang Seng Index. Managed Funds try to use strategy to maximize returns. 4.Money Market – MMMF’s hold short-term assets. Popular since deposits are checkable.

Finance Companies Finance companies issue commercial paper or securities to raise funds. The funds are then lent to retail borrowers to finance purchases of assets. Types of finance companies –Consumer: Make loans to households –Business: Make short-term loans to businesses. –Sales: Manufacturers own finance companies that lend to people who purchase their products. (Toyota Motor Credit).

Hong Kong Finance Companies Restricted License Banks – Can take deposits of at least HK$500,000, no maturity restrictions. {Merchant Banks, Business Finance} Deposit Taking Companies Can take deposits of HK$100,000 or more with three month maturity. Typically consumer finance arms of banks.

Maturity Requirements SizeNames Restricted License Banks None$500,000 GE Capital Hang Seng Finance Deposit Taking Companies 3 Months$100,000 Dao Heng Finance Wing Lung Finance

Hedge Funds Hedge funds are partnerships which require large contributions from their subscribers. Advantage of this structure is that the funds are largely unregulated allowing them to use innovative, unique, or arcane financial strategies. Some hedge funds may keep strategies secret even from partners. Some hedge funds often active in derivatives markets. Some have criticized hedge funds as destabilizing to the financial system.

Contractual Savings Some institutions channel funds to securities markets whose source is regular, required payments. Contractual Savings institutions includes: 1.Insurance Companies 2.Pension Funds

Insurance Companies Risks like accidental death or fire are unpredictable at the individual level but are easily quantifiable among large groups. Insurance companies get regular up front payments (premiums) from group members worried about some risk and make large payments (claims) to unlucky victims. Premiums are invested in securities markets. Returns are used to pay insurance companies costs and generate profits for insurance companies.

Types of Insurance Property and Casualty – Insurance for fire, car accidents, etc. Life Insurance –Term life: Regular payments are made to the insurance company. If you die while covered, your estate files a claim. Otherwise, the insurer keeps the premium. –Whole life: Regular payments are made to the company for many years. If you do not die by some final date, the insurance company makes a final payment to you or sets up a series of annual payments until your death.

Pension Funds Employers set aside some of their compensation as contributions to investment funds that will pay retirement benefits to workers. In the United States, there are tax advantages to paying wages through this channel. In Hong Kong, less so and pension funds are less important. Types of Pension Funds –Defined Benefit: The employer promises to make certain payments when employees retire. –Defined Contribution: Employer makes a specific contribution to a fund often invested by employees themselves.

Mandatory Provident Funds Since last years, employees without a retirement plan must enroll in an investment fund. Both the employer and employee are required to put 5% into a fund. Funds are invested in a set of essentially mutual funds chosen by the employer and employee. Savings can be shifted across funds at some costs.

Depository Institutions Depository Institutions collect potentially small deposits in retail markets and make direct loans to borrowers. Commercial banks play an important role in evaluating risks and monitoring borrowers. Licensed Banks

Government Institutions Hong Kong Mortgage Corporation set up in Begin operating in secondary mortgage market in two phases. 1.Issue securities and purchase mortgages for its own portfolio. 2.Sell mortgage backed securities.