Fundamentals of Financial Institutions Part Five Fundamentals of Financial Institutions

Why Do Financial Institutions Exist? Chapter 15 Why Do Financial Institutions Exist?

Chapter Preview A vibrant economy requires a financial system that moves funds from savers to borrowers. But how does it ensure that your hard-earned dollars are used by those with the best productive investment opportunities? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Preview In this chapter, we take a closer look at why financial institutions exist and how they promote economic efficiency. Topics include: Basic Facts About Financial Structure Throughout the World Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter Preview (cont.) The Lemons Problem: How Adverse Selection Influences Financial Structure How Moral Hazard Affects the Choice Between Debt and Equity Contracts How Moral Hazard Influences Financial Structure in Debt Markets Financial Crises and Aggregate Economy Activity Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Basic Facts About Financial Structure Throughout the World The financial system is a complex structure including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Basic Facts About Financial Structure Throughout the World The chart on the next slide show how nonfinancial business attain external funding in the U.S., Germany, Japan, and Canada. Notice that, although many aspects of these countries are quite different, the sources of financing are somewhat consistent, with the U.S. being different in its focus on debt. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Sources of Foreign External Finance

Data Source：China Annual Report on Financial and Futures Markets

Overall Scale to Be Further Enlarged At the end of 2006, the total value of securities assets constituted only 22% of China’s total financial assets Although this had increased to 37% by Sep 2007, the ratio remained relatively low and the overall scale of China’s capital market is till small

Structure to Be Further Optimized Relative size of bond and stock markets for selected countries (2007)

Facts of Financial Structure Stocks are not the most important source of external financing for businesses. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Facts of Financial Structure 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. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Facts of Financial Structure The financial system is among the most heavily regulated sectors of economy. Only large, well-established corporations have easy access to securities markets to finance their activities. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Facts of Financial Structure Collateral is a prevalent feature of debt contracts for both households and businesses. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Transactions Costs Transaction costs: costs involved in doing transactions; it includes information cost, monitoring cost, contracting costs, and trading costs such as commissions, bid-ask price spread, and security transaction taxes. Transaction costs can hinder flow of funds to people with productive investment opportunities Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Transactions Costs Financial intermediaries make profits by reducing transactions costs Take advantage of economies of scale (example: mutual funds) Develop expertise to lower transactions costs which explains Fact # 3, the importance of indirect finance (slide 15-10) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information: Adverse Selection and Moral Hazard In your introductory finance course, you probably assumed a world of symmetric information—the case where all parties to a transaction or contract have the same information, be that little or a lot In many situations, this is not the case. We refer to this as asymmetric information. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information: Adverse Selection and Moral Hazard Asymmetric information can take on many forms, and is quite complicated. However, to begin to understand the implications of asymmetric information, we will focus on two specific forms: Adverse selection Moral hazard Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information: Adverse Selection and Moral Hazard Occurs when one party in a transaction has better information than the other party Before transaction occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information: Adverse Selection and Moral Hazard Occurs when one party has an incentive to behave differently once an agreement is made between parties After transaction occurs Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information: Adverse Selection and Moral Hazard The analysis of how asymmetric information problems affect behavior is known as agency theory. We will now use these ideas of adverse selection and moral hazard to explain how they influence financial structure. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Lemons Problem in Used Cars The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons Problem in Used Cars If we can't distinguish between “good” and “bad” (lemons) used cars, we are willing pay only an average of good and bad car values Result: Good cars won’t be sold, and the used car market will function inefficiently. What helps us avoid this problem with used cars? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Lemons Problem in Securities Markets The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons Problem in Securities Markets If we can't distinguish between good and bad securities, willing pay only average of good and bad securities’ value Result: Good securities undervalued and firms won't issue them; bad securities overvalued so too many issued Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Lemons Problem in Securities Markets The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons Problem in Securities Markets Investors won't want buy bad securities, so market won't function well Explains Fact # 1 stocks and bonds are not the most important source of financing and # 2 the importance of bank finance (slide 15-9) Also explains Fact # 6 (slide 15-11): Less asymmetric info for well known firms, so smaller lemons problem Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Tools to Help Solve Adverse Selection (Lemons) Problems Private Production and Sale of Information – Free-rider problem interferes with this solution Government Regulation to Increase Information (explains Fact # 5, financial sector is most regulated, slide 15-11) – For example, annual audits of public corporations (although Enron is a shining example of why this does not eliminate the problem – we’ll discuss that briefly) Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Tools to Help Solve Adverse Selection (Lemons) Problems Financial Intermediation Analogy to solution to lemons problem provided by used car dealers Avoid free-rider problem by making private loans (explains Fact # 3 and # 4, the importance of indirect finance such as banks, slide 15-10) Also explains fact #6 – large firms are more likely to use direct instead of indirect financing Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Tools to Help Solve Adverse Selection (Lemons) Problems Collateral and Net Worth Explains Fact # 7, the importance of collateral in debt, slide 15-12 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts: the Principal-Agent Problem Result of separation of ownership by stockholders (principals) from control by managers (agents) Managers act in their own rather than stockholders' interest Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts An example of this problem is useful. Suppose you become a silent partner in an ice cream store, providing 90% of the equity capital ($9,000). The other owner, Steve, provides the remaining $1,000 and will act as the manager. If Steve works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts However, Steve doesn’t really value the $5,000 (his part), so he goes to the beach, relaxes, and even spends some of the “profit” on art for his office. How do you, as a 90% owner, give Steve the proper incentives to work hard? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts Tools to Help Solve the Principal-Agent Problem Production of Information: Monitoring Government Regulation to Increase Information Financial Intermediation (e.g, venture capital) Debt Contracts Explains Fact # 1, slide 15-9: Why debt is used more than equity Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Influences Financial Structure in Debt Markets Even with the advantages just described, debt is still subject to moral hazard. In fact, debt may create an incentive to take on very risky projects. This is important to understand. Let’s looks at a simple example. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Influences Financial Structure in Debt Markets Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount. For example, what if a firm owes $100 in interest, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Net Worth Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that … discourage undesirable behavior encourage desirable behavior keep collateral valuable provide information Dividend restrictions Restrictions on new debt issuing Copyright © 2009 Pearson Prentice Hall. All rights reserved.

How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Financial Intermediation—banks and other intermediaries have special advantages in monitoring Explains Facts # 1–4, stocks are not the most important sources of financing, debt and banks are more important, slides 15-9 & 15-10 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asymmetric Information Problems and Tools to Solve Them

Financial Crises and Aggregate Economic Activity Our analysis of the effects of adverse selection and moral hazard can also assist us in understanding financial crises, major disruptions in financial markets. Then end result of most financial crises is the inability of markets to channel funds from savers to productive investment opportunities. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Financial Crises and Aggregate Economic Activity Factors Causing Financial Crises 1. Problems in banking sector 2. Government Fiscal Imbalances and resulting higher interest rate 3. Balance of payments problems 4. Burst of asset bubbles As shown in the next slide, most U.S. financial crises have begun with a deterioration in banks’ balance sheets. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Case: U.S. Financial Crisis The U.S. has a long history of banking and financial crises, dating back to 1819. Our analysis can explain why these took place and why they were so damaging. The next figure outlines the events leading to a financial crisis. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Case: The Great Depression In 1928 and 1929, stock prices doubled in the U.S. The Fed tried to curb this period of excessive speculation with a tight monetary policy. But this lead to a collapse of stock market more than 60% in October of 1929. Further, between 1930 and 1933, one-third of U.S. banks went out of business Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Case: The Great Depression Adverse selection and moral hazard in credit markets became severe. Firms with productive uses of funds were unable to get financing. The prolonged economic contraction lead to an unemployment rate around 25%. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asian Financial Crisis High short-term foreign debt used to finance long-term domestic projects (double mis-match) High leverage and asset bubbles Governance problems in both public sector and private sector Serious real impact: lost of output, Japan, 17.6%, Malaysia, 50%, South Korea 50.1%, Indonesia 67.9%, Thailand 97.7% of 1997 GDP Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asian Financial Crisis: Hong Kong Linked Exchange Rate System since 1983 Strong economy but asset bubbles Attack of hedge funds such as Quantum Funds of George Soros Defense of HK government Initial stage: raise inter-bank lending rate Second stage: direct intervention in stock market Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Asian Financial Crisis: China Similar problems such as weakness in financial systems, high leverage in corporations, large non-performing loans, lax regulations But relative less short-term foreign debt Restrictions on capital account Not devaluate its RMB during the crisis and played a stable role Copyright © 2009 Pearson Prentice Hall. All rights reserved.

2007-credit crisis Started in the beginning of 2007 and deepened in September 2008 From sub-prime crisis to credit crisis Declining real estate price since 2006 due to higher interest since 2004 Sub-prime MBS AAA Bond Sold worldwide $1.3 triilion，total home loan 12 trillion，GDP 14 trillion CDS Rating Company CDS market 65 trilion

Factors contribute to the crisis Policy failures -lax monetary policy since 2001 -Government intervention in real estate market *Freddie Mac and Fannie Mae dominates MBS * Interest deduction for home loans * American dream, encourage home ownership, even for low-income people -Deregulation since Regan years 2. Market failures -“Greedy bankers” excessive lending -excessive financial engineering and innovations * 400 trillion derivatives market, including 65 trillion CDS market, while the total corporate bond market is 26 trillion * AIG insures about 440 billion CDS * Although Bear Stearns only has 190 billion debt, the CDS for it is 2 trillion -corporate governance in financial institutions: conflict of interests between shareholders(principal) and managers (agent)