1. Fundamentals of Financial Institutions
Part Five
Fundamentals of Financial Institutions

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

3. 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?
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4. 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
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5. 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
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6. 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.
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7. 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.
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8. Sources of Foreign External Finance

9. Data Source：China Annual Report on Financial and Futures Markets

10. 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

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

12. 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.
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13. 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.
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14. 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.
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15. 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.
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16. 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
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17. 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)
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18. 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.
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19. 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
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20. 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
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21. 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
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22. 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.
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23. 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?
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24. 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
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25. 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
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26. 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)
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27. 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
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28. Tools to Help Solve Adverse Selection (Lemons) Problems
Collateral and Net Worth
Explains Fact # 7, the importance of collateral in debt, slide 15-12
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29. 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
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30. 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.
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31. 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?
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32. 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
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33. 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.
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34. 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.
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35. 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
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36. 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
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37. Asymmetric Information Problems and Tools to Solve Them

38. 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.
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39. 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.
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40. Case: U.S. Financial Crisis
The U.S. has a long history of banking and financial crises, dating back to 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.
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42. 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
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43. 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%.
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44. 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
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45. 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
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46. 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
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47. 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

48. 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)