1. Review of Chapters 2 and 8, and Advanced Discussion
Eco PPP #3
Review of Chapters 2 and 8, and Advanced Discussion
Dr. J. D. Han

2. When a Company needs funds for a project, how would it do?
- It is in the Primary Market, not in Secondary Market, that a non-financial corporation raises the fund
Internal financing: use accumulated funds from Undistributed Corporate Profits
External financing: get the funding from outside of the company

3. Out of two External Financing Methods, Indirect Financing predominates.
Direct Finance vs. Indirect Finance
Indirect Finance
Through Financial Intermediaries
Savers
Households
Investors
Business Firms
Financial Market
Direct Finance
Doing by itself

4. Proprietary Trading Securitization
*Please, note that the above graph does not include updated currents of significant financial business/services, such as
Proprietary Trading
Securitization
For the details, please refer to the PPP of the banking current that we covered in the first class.

5. Who does Indirect Financing?
Financial Intermediaries, which consists of
Depository Institutions (banks, trust co., credit unions),
Investment Intermediaries (securities co., finance co.),
And Contractual Savings Institutions (insurance co, pension funds).

6. What are being Dealt in? Financial Instruments
Indirect
Bank Loans
Bonds
Stocks(equities)
Debt Contract/ Instruments
Marketable
Securities
indirect
In theory, they can be instruments for Direct Financing as well. However it is pretty small.

7. (Review ) Observation of Facts: Sources of External Corporate Financing in U. S. : 1970-1985
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.

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

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

10. Puzzle 3 Direct Finance is insignificant compared to Indirect Finance.
Financial Intermediaries buy most of Marketable Securities(Institutional Buyers account for most of marketable securities dealings)

11. The Same Answers to /Common Underlying Causes of All these Puzzles
1) FI Lowers Transactions Costs
due to expertise and EOS
2) Information Asymmetry
3) Capital Structure
- interest payment is tax-deductible
- real cost of borrowing is the (actual) real interest rate (=nominal interest rate – inflation rate)
4) Issues of Management Control and a Possible Hostile Take Over

12. The most important one is 2) Information Asymmetry: In an effort to overcome Information Asymmetry and its derived risks, the entire financial system has been evolving in the observed manners (more debts than stocks; more loans than marketable securities; more indirect financing than direct financing).

13. Information asymmetry and its derived risks:
Provides rationales for Financial Institutions ; they can deal with it better.
Provides grounds for Government Regulations of Financial Institutions/Financial Sector; ultimately, left over information asymmetry has to be dealt with by the external forces, government.

14. In Chapter 2, we have learned that government regulation is necessary because of the intrinsic problem of the Financial Sector, that is, Information Asymmetry. In case of indirect financing, Information Asymmetry occurs at 2 levels: between lenders and FI, and FI and borrowers.
*Etymology: “A-sym-metry” means Not-the sameness-of proportions, from Greek word from asymmetros, from a- "not" + symmetros "commensurable."

15. Financial Risks Default Risk at Individual level(borrower)
Market Risks at sector level(financial system)
Macroeconomic Risks at economy level(entire economy)
Operational Risk at Institutional level(borrower; or/and financial institution itself)

16. Let’s focus on the last one: Operational Risk

17. Information Asymmetry leads to:
Ex-ante (Before Deal)
May lead to Adverse Selection Problem
“Lemon and Jewel problem”
-Definition: Bad financial intermediaries/assets look better than good financial intermediaries/assets.
Ex-post (After Deal)
May lead to Moral Hazard Problem
-Definition: Once being given money, the so-far-good borrower is subject to the hazard to be engaged in riskier activities than are agreed with the lender.

18. 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: Securities Market (overvalue/undervalue) bad borrowers’ securities and (overvalue/undervalue) good borrowers’ securities.

19. Now, how can we reduce/resolve Information Asymmetry?
Information Production
=Monitoring
To what degrees are Financial Institutions successful in generating Information?
-”Not Complete”, and “Varying Degrees”:
Thus it is argued that Government Regulation should fill in for Information Generation/Revelation, and different Financial Institutions are to be faced with different degrees of market receptions and government regulations

20. IA: Marketable Securities versus Bank Loans
bank loans are less subject to information asymmetry than Marketable Securities. Thus, the financial investor prefers bank loans to marketable securities.
Why? The key lies in that enough information is generated about the borrower in the case of bank loans which can use Restrictive Covenant, which makes possible Monitoring for information generation. This in turn reduces information asymmetry.

21. Still banks cannot completely remove Moral Hazards of borrowers.
Japanese banks may have the answer for a further reduction of IA and Moral Hazards by allowing a higher level of monitoring- bank personnel can be part of the board of directors and actively participate in management of the borrower.
In U.S., it was allowed before the Anti-Trust Act was passed in the 1930s.

22. IA: Equities versus 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).

23. (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
Information Asymmetry is not to be completely resolved in the currently allowed financial market system and institutions.
Ultimately, Public Provision/Creation/Disclosure of Information is required, which calls for Government Regulation.

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

25. First, Information Asymmetry is a fact of life, and does not have to automatically ask for government intervention.
Marriage is subject to IA.
However, there is no room for public intervention in private marriage.
The reason is that “enough, if not complete, information is produced/demanded by individuals.

26. Second, Government Intervention should be preceded by Private Information Market Failure.(defined as: “The free market system cannot supply good enough of information while there is demand”).
And this private information market failure can happen in case of Information Free Rider Problem
Only then, public intervention is justified, but even it is not the only solution and is not for ever.

27. To Recap, Private Information Market fails (to coordinate Demand and Supply of information) if there is Free Rider Problem.
This is the case of Securities Market, where multiple lenders(financial investors) buy a lender(borrower)’s securities.
“Who is willing to pay for information?”

28. *Can you again explain how the Private Information Market may fail in the securities market?
Demand of Information
Supply of Information
Why wouldn’t be enough of supply of information so that the information market fails?

29. Does the Private Information Market fail in reality
Does the Private Information Market fail in reality? (so that should the government really intervene for the generation/disclosure of information?)
Would the financial market be chaotic with deceits and turbulence if it is left alone?

30. We can find some Financial Industry Endogenous Solutions to Information Asymmetry, which are working really well:
Information Revolution may resolve Information Free Rider Problem
New Forms of Financing Formats with monitoring(Mezzanine Financing by Private Equities)
Merger & Acquisitions
The last and most drastic cases are Historical Examples of Free Banking/Financial Markets

31. The government may be restricting these endogenous functions, which are conducive for information generation.
Without government restrictions on these, the free market may be working well to generate/transmit enough information and no serious information asymmetry.

32. Historical Evidence also tells us:
Would enough, if not complete, information be generated in the unregulated 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.

33. Free Banking: Free Entry and Self Regulated Note Issues
Historical Instances of Self-Regulated, or Free-Market Financial Industry
Scotland:
U. S. A.: 1836/7-1863
Canada: prior to Bank of Canada 1935
Sweden: 19C
Hong Kong: Contemporary

34. Were They Stable? Conventional Wisdom
-> Yes, Scotland, Canada, Sweden and HK
-> “No”, U. S. A.
 We would like to challenge the second part of Conventional Wisdom

35. Scottish Free Banking:
Period:
How did it work?:
-Banks could print out paper monies, or notes as long as they do not default on redemption request of the notes for species
-No government charter needed;
Self regulated, competitive (free market driven) supply of money and banking practices

36. * Evaluation of the Scottish Free Banking
Compared with the Contemporary British Banking Experience
Stability: no major bankruptcy
-exception: Ayr Bank
Availability: more banking services per capita
Competition: small banks along with large ones
Efficiency:
spontaneous evolution of a clearing house (payment association)
Rapid propagation of information

37. American Experiences Free Banks were viciously called “Wildcat Banks”.
However, Revisionist Studies by A. Rolnick and W. Weber have proved that they were Not So Bad.
Why?

38. *Three Point Arguments
The bank note holders(lenders) had been well informed of the true value of the assets/notes from Minnesotan Free Banks.”
: Free Market is more efficient in propagating information than we might expect
(Evidence: Well conversed the New York/Chicago Market Value of Government/Railway Bonds as Major Assets and Reserves of the Banks)

39. Lessons to be Learned from Free Banking Experiences
Self-Regulated,
Regulation-Free,
Banking/Financial Industry may be Viable
and even be superior to the government regulated banking system.

40. How about Securities Market with most severe degree of information asymmetry?
From studies on the Amsterdam Bourse of the 17th century, Edward Stringham of UC San Jose, concludes:
“…In the 1600s, the first century when equities were traded, we can see that there was a considerable degree of financial innovation. We also see that most of the financial instruments were officially outlawed by the state. Brokers discovered new trading instruments and abided by their contracts not because of legal compulsion but because of market incentives. The regulations were not advancing the market, they were trammeling it, though the market developed in spite of the law. Contrary to the idea that the government is needed for financial innovation and contractual performance, the case of the Amsterdam Bourse provides evidence that securities markets can function successfully with little assistance from the state…..”

41. Currently, one new question is whether it is really possible for the government to control/regulate all the financial institutions/players:
What will be a side effect of government regulations? Financial sector will find a way to go around government regulations Regulation-Circumventing Regulation is an endless game

42. Two New Banking beyond Government Regulations
Shadow Banking, including Securitization and other activities(Refer to the first class PPP).
On-line currencies, such as Bitcoin

43. References
Read Neil Reynolds’s inspiring article on the Dutch Securities market of the 16th Century, entitled, “Self-regulation: The Dutch had it right,” The Globe and Mail, Aug.12, 2006.
Edward Stringham, “The extralegal development of securities trading
in seventeenth-century Amsterdam”, The Quarterly Review of Economics and Finance, 43 (2003) 321–344
J. Bradford De Long, Harvard University, “Did J. P. MORGAN’S MEN Add Value?: An Economist’s Perspective on Financial Capitalism, 1995.
Kam Hon Chu “ Is Free Banking More Prone to Bank Failures than Regulated Banking?”, Cato Journal, Vol. 16 No. 1

44. Sun Bae Kim, “Banking and Commerce: The Japanese Case”, Federal Reserve Bank of San Francisco Weekly Newsletter, March 1991.
A.J.R. Rolnick and W. Weber, "New Evidence on the Free Banking Era," American Economic Review, 1983, Vol. 73, No. 5:
A.J.R. Rolnick and W. Weber, "Explaining the Demand for Free Bank Notes," Journal of Monetary Economics, 1988, Vol. 21: