Fundamental Characteristics of Financial Industry and Natural Evolution(I) Dr. J. D. Han

Relationship between Financial System and Corporate Financing : Macro Environment and Micro Response The first determines the characteristics of the second. Financial System Corporate Financing

When a Company needs funds for a project, how would it do? Internal financing: use accumulated funds from Undistributed Corporate Profits External financing: get the funding from outside of the company

Two External Financing Methods: Direct Finance vs. Indirect Finance Savers Households Investors Business Firms Indirect Finance Direct Finance Doing by itself Financial Market Through Financial Intermediaries

Financial Intermediaries consists of Depository Institutions (banks, trust co., credit unions), Investment Intermediaries (securities co., finance co.), And Contractual Savings Institutions (insurance co, pension funds). Financial Intermediaries channel surplus funds from Savers to Investors

Financial Instruments Bank Loans Bonds Stocks(equities) Debt Contract or Instruments Marketable Securities Direct indirect Indirect

Observation of Facts: Sources of External Corporate Financing in U. S. : Note: these are funds raised through issues of ‘New Securities-Stocks and Bonds’. Of course, stock exchanges trade ‘existing’ stocks as well, which account for the majority of the outstanding market values.

Puzzle 1: Stocks or Equities are relatively unimportant compared with Debt Contracts/Instruments (= Bonds + Loans)

Puzzle 2: Marketable Securities(=Bonds + Stocks) are not so important as Bank Loans

Puzzle 3 Direct Finance is insignificant compared to Indirect Finance. Financial Intermediaries buy most of Marketable Securities

Answers to All these Puzzles Transactions Costs : Financial Institutions or Intermediaries lower Transactions Cost Information Asymmetry : Some financial instruments have more severe problems of Information Asymmetry than others - Equities > Bonds > Bank Loans Capital Structure (Comparative Cost of Funding) : - interest payment is tax-deductible - real cost of borrowing is the (actual) real interest rate (=nominal interest rate – inflation rate) Issues of Management Control and a Possible Hostile Take Over

Information Asymmetry Ex-ante (Before Deal) May lead to Adverse Selection Problem “Lemon and Jewel problem” -Definition: Bad goods drives good goods out of the market Ex-post (After Deal) May lead to Moral Hazard Problem -Definition: The borrower is subject to the hazard that he has incentives to be engaged in riskier activities than are agreed with the lender

Marketable Securities(Direct Finance) versus Bank Loans (Indirect Finance) Information Asymmetry causes a severe Adverse Selection Problem or “Lemon & Jewel” Problem in the case of all marketable securities bank loans are less subject to information asymmetry(cause) or adverse selection(consequence). Why? The key lies in that enough information is generated about the demander of the fund in the case of bank loans while, due to information free rider problem, it is not the case for marketable securities. As bank loans are less risky than marketable securities- Thus, the financial investor prefers bank loans to marketable securities.

Closer Look reveals Debts(IOU) involve Restrictive Covenant, or Mandatory Monitoring (of the debtor’s financial conditions)

Equities as opposed to Debts Equities without Restrictive Covenant are subject to a more severe Moral Hazard Problem than debts with Restrictive Covenant are. This particular problem in equity contract is called the “Principal-Agent Problem” Thus, equities have doubly risky in the eyes of finanical investors, and get less fund(demand).

Adverse Selection: “Fatal Attraction” Called “Lemon & Jewel Problem” by G. Ackerloff Security price is set between value of a good firm and value of a bad firm The bad firm’s securities have lower prices and thus higher rates of returns, looking attractive.

* Illustration of “Lemons Problem” Second-Hand Car Market Market Price = Average Value of Bad and Good Cars Lemon: Market Price > Its Real Value (Low) Jewell: Market Price < Its Real Value (High) Jewell is not offered in the market

* Solutions to Adverse Selection Custom-Made Private Information Financial intermediaries are specialized in collecting and processing information -> explains why bank loans dominates. General Private Provision of Information: The Market sells Information : It is ultimately incomplete due to “Free Rider Problem” in the Financial Market Public Provision of Information is warranted and required for Securities Market -> explains why financial industry is heavily regulated

* Solutions to Moral Hazard Problem Production of Information: “Monitoring” - The most severe problem exists, and “costly state verification’ and free-rider problem will lead to insufficient monitoring in the stock market - The same is true, if to a lesser extent, in the bond market - The least severe problem, but collateral is inevitable in the bank loan market Government Regulation to increase Information: - “Disclosure Requirement” Directly Participating in Management - Venture Capital Firm - Japanese and German Banks

(Recap) Why should the financial industry be regulated by government? Because information asymmetry is an intrinsic problem of the industry: adverse selection and moral hazards -> First level of ‘Market Failure’ Unlike other sectors, due to free rider problem, information asymmetry is not to be rectified by Private Provision of Information -> Second level of ‘Market Failure’ Ultimately, Public Provision of Information is required,which calls for Government Regulation

* Canadian Puzzle: Equities account for a substantial share of external corporate financing (Refer to P.159 of Paper #1) Bank Loans have a relatively smaller share in Canada than elsewhere <- One answer: Due to the Canadian banks’ business operations

However ……. The above view is a majority view, but everyone does not agree with it. This revisionist view has been gaining an increasing popluarity in the era of finanical liberalization.

(Revisionist) Should the financial sector be regulated by government? Would enough information be generated in the unregulated or free- market financial sector so as to ensure that the investor with due diligence or prudence may be protected from frauds in a reasonable way to a certain acceptable degree? If so, government intervention is not necessary. Theoretically, it is possible, and empirically, there is a historical evidence from the Free Banking System experiences.