ECO 3311: Chapter 8

net worth and collateral

*incentive-compatible: having more net worth or collateral invested into the loan, makes you much less likely to take on a risky investment (such as diet ice cream), this aligns the incentives of the borrower with those of the lender. -reduces moral hazard

financial intermediation

-a bank can become an expert at producing information about firms, which will help them distinguish good credit risks from bad credit risks; then it will acquire funds from depositors and lend them out to good firms, while being able to earn higher return on it's loans than the interest it pays to depositors (earning a profit). --an important element of the bank's ability to profit is that is avoids the free-rider problem, the bank primarily makes private loans, meaning other investors can't watch what the bank is doing and then bid the loan's interest rates down to a break even point (like what is done in the securities market).

moral hazard

-an asymmetric information problem that occurs AFTER the transaction takes place. EX: the lender runs the risk that the borrower might engage in activities undesirable from the lender's perspective (gambling), because once the borrowers have obtained the loan, they are basically playing with someone else's money. -since moral hazard lowers the probability that the loan will be repaid, lenders may decide they would rather not make any loans.

adverse selection

-an asymmetric information problem that occurs BEFORE the transaction takes place. EX: potential bad credit risks are the ones most likely to seek out a loan, big risk takes or outright crooks are often the most eager to take out loans because they know they probably won't pay it back -because adverse selection increases the chance a bad loan might be made, lenders might decide not to make any loans, even though good credit risks exist in the market

production of information: monitoring (MH)

-auditing the firm frequently to check on what management is doing PROBLEM: monitoring process can be expensive in terms of time and money. *(costly state verification): makes equity contracts less desirable and explains it part why equity is not a more important part of the financial structure. --free rider problem still exists: decreases the amount of private information production that would reduce moral hazard EX: free-rider problem reduces monitoring -if you know that other stockholders are paying to monitor the activities of a company you hold shares in, you can take a free ride on their activities

sources of external funding for non-financial businesses

-bank loans (18%): from depository institutions -nonbank loans (38%): from other financial intermediaries -bonds (32%): include marketable debt securities like corporate bonds and commercial paper -stocks (11%): new issues of equity

main concept

-demonstrating the important link between the financial system and aggregate performance of the economy

financial intermediation (MH)

-financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard (another way to explain fact 3). *venture capital firms: pool the resources of their partners and help budding entrepreneurs start new businesses -in exchange for supplying the capital, the firms usually insist on having several of their own people participate as members of the managing body EX: have someone participate in the board of directors to be involved with management decisions -another benefit is that the shares the receive are private (not marketable) so other investors aren't able to take a free-ride on the venture capital firms verification activities --as a result the venture capitalist firm is able to gain the full benefits of its verification, and is given an appropriate incentive.

tools to help solve adverse selection problems in financial markets

-if purchasers can distinguish good firms from bad firms, they will be willing to pay the full value of securities issued by good firms, and firms will sell their securities.

monitoring and enforcement of restrictive covenants

-if you were able to ensure your friend only invested in the ice cream shop, you would have no reason NOT to make the loan. 4 types of restrictive covenants: 1. Discourage undesirable behavior: mandate that a loan be used only to finance specific activities, or restricting the borrowing firm from purchasing other businesses 2. Encourage desirable behavior: encourages the borrowing firm to keep net worth high because higher net worth reduces moral hazard, and makes it less likely for the lender to suffer a loss... EX: minimum holdings a certain asset relative to the firms size -OR- life insurance for the breadwinner of a household 3. Keep Collateral value: allows the lender to remain in possession until a loan is paid off EX: mortgage, car payments 4. Provide information: periodically provide updates via accounting and income reports, making it easier to monitor

fact 5

5. The financial system is among the most heavily regulated sectors of the economy. -governments regulate financial markets primarily to promote the provision of information and to ensure the stability of the financial system. --(AS): government regulation (SEC) helps explain why financial markets are so heavily regulated, it helps increase the information available for investors to reduce the adverse selection problem.

fact 6

6. Only large, well-established corporations have easy access to securities markets to finance their activities. -smaller corporations don't tend to issue marketable securities, but rather go to a bank for a loan --(AS): the larger and more well-establish a corporation is, the more likely it will be to issues securities to raise funds; this is because it's easier for investors to evaluate the quality of a firm and decide whether or not it's a good investment, there is also much more information publicly available about a well-known company like Apple/Amazon.

fact 7

7. Collateral (secured debt) is a prevalent feature of debt contracts for both households and businesses. -guarantees the person making the loan has something to fall back on, your automobile is collateral for your auto loan, your house is collateral for your mortgage. Smaller businesses and households usually won't have enough credit established to receive a massive loan. --(AS): lenders are much more likely to make a loan when they are guaranteed something to fall back on.

fact 8

8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. -NOT just a simple IOU, usually long legal documents that contain restrictive covenants stating what you are allowed to do with the loan. -For example an auto loan/mortgage require you maintain sufficient insurance on your automobile/home. --(MH): so complicated because the of how restrictive covenants are used to reduce moral hazard

collateral and net worth

-lenders are more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely that the loan will be made, perhaps even at a lower rate. --the more net worth a firm has, the less likely it is to default, because the firm's cushion of assets that it can use to pay off it's loans; when firms seeking credit have a high net worth, the consequences of adverse selection are less important, and lenders are more willing to make loans. "only the people who don't need money can borrow it"

transaction costs

-major problem in financial markets EX: you only have $5000 to invest -if you wanted to purchase stocks, the cost of the brokerage commissions will be a large percentage of your of your purchase. -if you wanted to purchase bonds, most bonds are only offered in increments of $10000. -since it's smart to diversify, you will want to purchase multiple stocks in smaller increments, which would lead to extremely high transaction costs.

government regulation to increase information

-one potential solution could be for the government to step in and inform the public which firms are good, and which firms are bad; however, this would require the government to release negative information on firms, which would get sticky in politics. -the solution the U.S. and other countries have come up with is to regulate the securities market in a way that encourages firms to put out honest information about themselves, allowing the public to make more informed decisions. EX: the (SEC) is a government agency that requires firms selling their securities to undergo independent audits, in which accounting firms certify the company is adhering to standard accounting principles, and disclosing accurate info about sales, assets, and earnings. --even though regulation helps reduce the adverse selection problem, it does NOT eliminate it entirely, because the statistics on paper don't tell the entire story; a firm with terrible management could find ways to slant the numbers and make their statistics look decent.

debt contracts (MH)

-requires less frequent need to monitor a firm, and thus lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital. **Fact 1: stocks are NOT the most important source of financing

financial intermediation (MH) debt contracts

-restrictive covenants help reduce moral hazard, but don't completely eliminate it (almost impossible to write covenants that rule out every risky activity). --another problem with covenants: must be monitored and enforced, which is costly, and the free-rider problem can also exist which would cause NOT enough resources to be dedicated to monitoring. *banks can make private loans, which is another reason why financial intermediaries play a larger role

government regulation to increase information (MH)

-same as with adverse selection, the government has an incentive to try and reduce the moral hazard problem created by asymmetric info (another way to explain fact 5) --governments everywhere have laws to enforce strict accounting principles, and stiff criminal penalties on people who commit fraud ---only partly effective because catching fraud is NOT easy, fraudulent managers have incentive to try and cover things up to make it harder for agencies to find proof.

asymmetric information

-situation that arises when one party has insufficient knowledge about the other party involved in a transaction, making it impossible for the first party to make accurate decisions EX: managers of a corporation know whether they are honest and usually have better information about how well their business is doing vs. stockholders knowledge -this leads to 2 problems...

private production and sale of information

-the solution to reduce asymmetric information is to supply investors with more details about the individual firm seeking financing. EX: companies that gather information on a firm's balance sheet positions and investment activities publish the data, then sells it to subscribers.(Standard & Poor's, Moody's, and Value Line) -this does NOT completely solve adverse selection because of the free-rider problem... --when people who don't pay for the information take advantage of the information that other people paid for. ---if several free-riding investors take advantage of this, the price of the undervalued security will be bid up immediately, and there will have been no benefit of paying for the service. ----this would also weaken the ability of private firms selling the information to make a profit, which means less information would be entering the marketplace, further interfering with the ability of the market to act efficiently.

principal-agent problem

-when a manger (agent) only holds a small fraction of equity (common stock) in the firm he works for, he might be more likely to act in their own best interest rather than act in the stockholders (principals) best interest (maximizing profits). EX: friend needs $10k initial investment to run a store, he only has $1k (10% ownership) while you front the other $9k (90% ownership) -if he works hard, provides great service and has a good year the store will make $50k, he will receive his salary + an additional $5k, you will receive $45k. --however, he might decide that an extra $5k to be a good manager isn't really worth his time, then he could use the $50k in profits to purchase artwork for the store (unproductive investment) and take a vacation to the beach, then the store would show $0 profit, and you would be out of luck. ---assuming the store might be a cash business, he could also pocket the $50k and lie to you about it KEY: the principal-agent problem would NOT arise if owners had complete information about what managers were up to, and could prevent unproductive expenditures and even some cases of fraud.

how financial intermediaries reduce transaction costs (part 1)

1. Economies of scale -bundling the funds of several investors together can significantly reduce transaction costs for each individual investor, the cost of arranging the purchase of 10,000 shares is not much greater than the cost of purchasing 50 shares. -the best example of financial intermediaries reducing transaction costs are mutual funds: the financial intermediary sells shares to individuals, then invests the proceeds in stocks/bonds. Because it buys large blocks of stocks/bonds, these cost savings are passed on to the individual investor after the mutual fund takes its cut in the form of management fees. Another benefit is that individual investors can build a well-diversified portfolio of securities, further reducing their risk. -economies of scale can also benefit the financial intermediary, for example they might need specific computer technologies to accomplish their tasks, once they set up a telecommunications system it can be used for a huge number of transactions at a low cost per transaction.

tools to help solve the principal-agent problem

1. Production of information: Monitoring 2. Government Regulation to increase info 3. Financial Intermediation 4. Debt Contracts

fact 1

1. Stocks are NOT the most important source of external financing for businesses. -lots of media attention is focused on the stock market, which can lead to the impression that stocks are the most important source of financing --(AS): "lemons" prevent stock and bond markets from being effective in channeling funds from savers to borrowers --(MH): if you know that other stockholders are paying to monitor the activity of the firm you hold stock in, you can be a free-rider, in theory all stockholders can take a free-ride and no one will spend any resources on monitoring the firm.

tools to help solve moral hazard in debt contracts

1. net worth and collateral 2. monitoring and enforcing of restrictive covenants 3. financial intermediation

how financial intermediaries reduce transaction costs (part 2)

2. Expertise -financial intermediaries are better able to develop expertise that can be used to lower transaction costs, the expertise in computer technology enables them to offer convenient services such a check-writing privileges and toll-free numbers to call for the customer to check out how their investments are performing. -lower transaction costs can also enable financial intermediaries to provide their customers with liquidity services, which make it easier to conduct transactions. EX: money market mutual funds not only pay shareholders relatively high interest rates, but also allow them to write check for convenient bill paying.

fact 2

2. Issuing marketable debt and equity securities is NOT the primary way businesses finance their operations. -bonds are a far more important source of financing than stocks in the United States (32%) vs. (11%), but even combined they supply less than half of the external funds needed by U.S. corporations. --(AS): due to "lemons" and adverse selection: an investor may struggle to distinguish between good firms and bad firms; if a firm's manager has better information than the investor, he will know that their security is either underpriced or overpriced and will make the decision on whether or not to sell their security based on the price the investor is willing to pay. This causes the market to perform inefficiently, meaning few firms will want to sell securities to raise capital.

fact 3

3. Indirect finance (financial intermediaries) is MANY times more important than direct financing (raising funds from lenders in financial markets). -even though 43% of funds come from direct financing, that number is very misleading because the majority of new corporate bonds, commercial paper, and stocks issued are sold to financial intermediaries NOT American households. --(AS): the ability to reduce transaction costs makes financial intermediaries a huge player in the industry --(AS): indirect finance allow the corporations to borrow from banks with non-tradeable loans, and NOT have to give up shares in their company, or pay higher rates on corporate bonds because the bank does it's own internal research.

fact 4

4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. -the primary source of external funds are loans made by banks, and other non-bank financial intermediaries (insurance companies, pension funds, and finance companies). --(AS): because banks hold a large number non-traded loans, they play a greater part in moving funds to corporations than the securities market do.

how moral hazard influences financial structure in debt markets

EX: loaning your friend $9k for an ice-cream business.. -you loan the $9k at 10% interest, which you believe to be a sure-fire investment.. however, your friend might be more inclined to take on a riskier investment such as chemical research to try and produce a new "diet" ice cream --because of the moral hazard (what he might do after he receives the funds) you might decide NOT to make the loan, even though the ice cream store would be a good investment that provided benefits to everyone.