1. An Overview of the Financial System

2. Function of Financial Markets
1. Allows transfers of funds from person or business without investment opportunities to one who has them
2. Improves economic efficiency
Make the distinction between primary and secondary markets.

3. Function of Financial Markets
Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds
Promotes economic efficiency by producing an efficient allocation of capital, which increases production
Directly improve the well-being of consumers by allowing them to time purchases better

4. Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC) Markets
Money and Capital Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments
Firms raise funds only at Primary offer stage, but the secondary markets give the primary markets liquidity and therefore increases the value.
1. Debt Markets
Short-term (maturity < 1 year) Money Market
Long-term (maturity > 1 year) Capital Market
2. Equity Markets
Common stocks
1. Primary Market
New security issues sold to initial buyers
2. Secondary Market
Securities previously issued are bought and sold
1. Exchanges
Trades conducted in central locations (e.g., New York Stock Exchange)
2. Over-the-Counter Markets
Dealers at different locations buy and sell

5. Principal Money Market Instruments

6. Capital Market Instruments

7. An Economic Analysis of Financial Structure

8. Sources of External Finance in U.S

9. Sources of Foreign External Finance
Banks are important here, but even more important abroad. This has been part of Japans economic problems the last 10 years.

10. Sources of Foreign External Finance
Data on stocks is a bit misleading since this is a flow of funds. The stock generates funds once, whereas a bond can be issued merely to pay off another bond therefore not raising the useable capital at all, however as measured by flow it will appear double stocks. This derives from the fact that equities don’t mature whereas debt instruments do. So the flow of debt instruments may or may not represent an actual increase in working capital for the firm.

11. Eight Basic Facts
Stocks are not the most important sources of external financing for businesses
Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
Indirect finance is many times more important than direct finance
Financial intermediaries are the most important source of external funds

12. Eight Basic Facts (cont’d)
The financial system is among the most heavily regulated sectors of the economy
Only large, well-established corporations have easy access to securities markets to finance their activities
Collateral is a prevalent feature of debt contracts
Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers

13. Demonstration How will a buyer determine what to offer?
How will the seller determine what to charge?
What if I offered to buy at $800?
Will everyone sell?
What happens to the average value of the cars offered for sale when I offer $800?
Hand out slips of paper to half of the class.

14. Function of Financial Intermediaries
1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric information

15. Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
Economies of scale
Expertise
Transactions Costs
1. Financial intermediaries make profits by reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies of scale

16. Function of Financial Intermediaries
Risk Sharing
1. Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation).
2. Also lower risk by helping people to diversify portfolios

17. Transaction Costs and Financial Structure
Transaction costs hinder flow of funds to people with productive investment opportunities
Financial intermediaries make profits by reducing transaction costs
1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs
Explains Fact 3

18. Asymmetric Information
“The secret of success is to know something nobody else knows” -Aristotle Onassis
Hot tip from the broker vs. insider trading
Lemons Problem (Akerlof)
The Nobel Laureates of
Apply asymmetric information to dating markets.
What are methods or ways in which asymmetric info is reduced? What happens to the number of matches, or what would you expect.
How important is asymmetric info in car market?
An anonymous correspondent sends me news of the young Henry Schneider, Yale Ph.d. student.  Here is the abstract to his Estimating the Effects of Adverse Selection in Used Car Markets:
In this paper, I address the long-standing question of whether adverse selection prevents used cars from reaching owners who value them most highly. In doing so, I confront the challenge of identifying the effects of adverse selection separately from the effects of efficient sorting of vehicles based on their conditions. This latter process would usually occur simultaneously to adverse selection and also affects the distribution of vehicles that trade. Using the prediction in Hendel and Lizzeri (1999), that adverse selection and efficient sorting both increase the rate of price depreciation, I propose to use their joint effect as an upper bound on the effect of adverse selection. My estimate of this joint effect, based on proprietary data on one million dealer used car sales and trade-ins, is close to zero, a result that indicates that adverse selection is unimportant. Using Consumer Expenditure Survey data, I provide additional support for this conclusion by showing that vehicles that were recently purchased from a dealership received approximately the same number of repairs as comparable continuously-held vehicles. I conclude with a discussion of the role that sellers’ concerns for their reputations may play in limiting information-based inefficiencies.
But Henry is no apologist for the market.  Here is his paper on how much auto mechanics rip you off.  Half of all the money spent on auto mechanics appears to be deadweight loss.  He does note they neglect urgent problems 77 percent of the time, which suggests some stupidity instead of (in addition to?) pure venality.
Here is Alex's earlier post on adverse selection.

19. Asymmetric Information
Adverse selection occurs before the transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric information problems affect economic behavior
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

20. Adverse Selection: The Lemons Problem
If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at the price for average quality
The buyer will decide not to buy at all because all that is left in the market is poor quality items
This problem explains fact 2 and partially explains fact 1

21. Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7

22. Moral Hazard in Equity Contracts
Called the Principal-Agent Problem
Separation of ownership and control of the firm
Managers pursue personal benefits and power rather than the profitability of the firm

23. Principal-Agent Problem: Solutions
Monitoring (Costly State Verification)
Free-rider problem
Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation
Fact 3
Debt Contracts
1. Private Production and Sale of Information
Free-rider problem interferes with this solution
2. Government Regulation to Increase Information
Explains Puzzle 5
3. Financial Intermediation
A. Analogy to solution to lemons problem provided by used-car dealers
B. Avoid free-rider problem by making private loans
Explains Puzzles 3 and 4
4. Collateral and Net Worth
Explains Puzzle 7

24. Moral Hazard in Debt Markets
Borrowers have incentives to take on projects that are riskier than the lenders would like

25. Moral Hazard: Solutions
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4

27. Function of Financial Intermediaries: Indirect Finance
Lower transaction costs
Economies of scale
Liquidity services
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Asymmetric Information
Adverse Selection (before the transaction)—more likely to select risky borrower
Moral Hazard (after the transaction)—less likely borrower will repay loan

28. Internationalization of Financial Markets
Foreign Bonds—sold in a foreign country and denominated in that country’s currency
Eurobond—bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies—foreign currencies deposited in banks outside the home country
Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks
World Stock Markets
International Bond Market
1. Foreign bonds
2. Eurobonds
Now larger than U.S. corporate bond market
World Stock Markets
U.S. stock markets are no longer always the largest: Japan sometimes larger

29. Financial Intermediaries
Do not memorize the following charts, merely familiarize yourself with them. Types of institutions and their preferred habitat (sometimes required habitat by regulation)

30. Size of Financial Intermediaries
Note how large commercial banks are…discuss tax advantages and boom in credit unions.

31. Regulation of the Financial System
To increase the information available to investors:
Reduce adverse selection and moral hazard problems
Reduce insider trading
To ensure the soundness of financial intermediaries:
Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates
Two Main Reasons for Regulation
1. Increase information to investors
A. Decreases adverse selection and moral hazard problems
B. SEC forces corporations to disclose information
2. Ensuring the soundness of financial intermediaries
A. Prevents financial panics
B. Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures
3. Improve Monetary Control?

32. Regulatory Agencies
The industry is the most heavily regulated!! And there are constant calls for more regulation.

33. Regulatory Agencies

34. Conflicts of Interest
Type of moral hazard problem caused by economies of scope
Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
A reduction in the quality of information in financial markets increases asymmetric information problems
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be

35. Why Do Conflicts of Interest Arise?
Underwriting and Research in Investment Banking
Information produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ.
Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business

36. Why Do Conflicts of Interest Arise? (cont’d)
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and opinions to win consulting business
Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts
Auditors may provide an overly favorable audit to solicit or retain audit business

37. Conflicts of Interest: Remedies
Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act)
Increases supervisory oversight to monitor and prevent conflicts of interest
Establishes a Public Company Accounting Oversight Board
Increases the SEC’s budget
Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit

38. Conflicts of Interest: Remedies (cont’d)
Sarbanes-Oxley Act of 2002 (cont’d)
Beefs up criminal charges for white-collar crime and obstruction of official investigations
Requires the CEO and CFO to certify that financial statements and disclosures are accurate
Requires members of the audit committee to be independent

39. Conflicts of Interest: Remedies (cont’d)
Global Legal Settlement of 2002
Requires investment banks to sever the link between research and securities underwriting
Bans spinning
Imposes $1.4 billion in fines on accused investment banks
Requires investment banks to make their analysts’ recommendations public
Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that would provide research to their brokerage customers

40. Financial Development and Economic Growth
Financial Repression Leads to Low Growth: Why?
1. Poor legal system
2. Weak accounting standards
3. Government directs credit
4. Financial institutions nationalized
5. Inadequate government regulation

41. Appendix
Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book.
They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.

42. Financial Crises and Aggregate Economic Activity
Crises can be caused by:
Increases in interest rates
Increases in uncertainty
Asset market effects on balance sheets
Problems in the banking sector
Government fiscal imbalances

43. Events in U.S. Financial Crises

44. Events in Mexican, East Asian, and Argentine Financial Crises

45. Summary: Asymmetric Information Problems and Tools to Solve Them