FNAN 320: Chapter 11 - The economics of financial intermediation

Moral hazard in equity finance

- if you buy stock in a company, how do you know your money will be used in the way that is best for you, the stockholder? - it is more likely that the manager will use the funds in a way that is most advantageous to them, not you

Two principals for financial intermediaries

1. information 2. Risk - helps mitigate risk through information gathering

To be able to do this, intermediaries:

1. screen loan applicants 2. monitor borrowers 3. penalize borrowers by enforcing contracts

Conflicts of interest in finance

1. ways to deter conflicts of interest - increased transparency, improved market discipline, enhanced regulation, massive financial penalties and criminal prosecution 2. What else can be done? - break up large institutions into smaller ones with restricted scope - hold individuals more accountable - managers face greater personal financial liability - some mix of these

Restrictive Convenants

We can loan you the money but here are some requirements 1. have a funding account and have to put money in it each month 2. cannot exceed days in accounts receivable 3. cannot issue another bond issue without their permission - sometimes may require a seat on the board of directors

Information asymmetry/asymmetric information

borrowers have information that lenders don't - poses two important obstacles to the smooth flow of funds from savers to investors: 1. adverse selection 2. moral hazard

Monitoring to reduce moral hazard

intermediaries monitor both the firms that issue bonds and those that issue stocks to reduce moral hazard - many hold significant number of shares in individual firms - they may place a representative on the company's board of directors - for new companies, a financial intermediary called a venture capital firm does the monitoring 1. they specialize in investing in risky new ventures in return for a stake in the ownership and a share of the profits 2. they keep a close watch on the manager's actions - the threat of a takeover helps to persuade managers to act in the interest of the stock and bondholders

Liquidity

is a measure of the ease and cost with which an asset can be turned into a means of payment - financial intermediaries offer us the ability to transform assets into money at relatively low cost - banks can structure their assets accordingly, keeping enough funds in short term, liquid financial instruments ot satisfy the few people who will need them and lending out the rest - by collecting funds from a large number of small investors, the bank can reduce the cost of their combined investment, offering each inddivudual investor both liquidity and high rates of return - intermediaries offer both individuals and businesses lines of credit which provides customers with access to liquidity - a financial intermediary must specialize in liquidity management - it must design its balance sheet so that it can sustain sudden withdrawals examples: ATM's, debit cards, checks

Collateral

is something of value pledged by a borrower to the lender in the event of the borrower's default - it is said to back or secure a loan

Unsecured loans

like credit cards, are loans made without collateral - because of this they generally have very high interest rates

Principal agent problem

the separation of your ownership from their control creates what is called

Banks

are a place fo safekeeping - provide access to the payments system -- the network that transfers funds from the account of one person or business to the account of another - specialize in handing payments transactions, allowing them to offer these services relatively cheaply - financial intermediaries reduce the costs of financial transactions - have safety deposit boxes for safekeeping in a vault - can put all valuables in there

Adverse selection

arises before the transaction occurs - lenders need to know how to distinguish good credit risks from bad

Free rider

is someone who doesn't pay the cost to get the benefit of a good or service

Net Worth

is the owner's stake in a firm - the value of the firm's assets minus the value of its liabilities - net worth services the same purpose as collateral - if a firm defaults on a loan, the lender can make a claim against the firms net worth - from the perspective of the mortgage lender, the homeowner's equity serves exactly the same function as net worth in a business loan

hostile takeover

the acquisition of a company over the opposition of its management - you take more and more stock on and eventually own more than the management in the company and you take over

Moral Hazard

occurs after the transaction - will borrowers use the money as they claim?

Collateral and net worth

the important of net worth is reducing adverse selection is the reason owners of new businesses have so much difficulty borrowing money - most small business owners must put up their homes and other property as collateral for their business loans - only after establishing a successful business and built up net worth, can they borrow without personal property

Information asymmetry and securitization

- a key source of the financial crisis of 2007-2009 was insufficient screening and monitoring in the securitization of mortgages - originators eased standards and reduced screening to increase volume and short-term profitability - the firms that assembled the mortgages for sale, the distributors , could have required originators, to demonstrate a high level of net worth - when lending standards decline, securitization becomes a game of "hot-potato" - the game ends when defaults soar and someone is left with the loss - ratings agencies could have halted the game early, but intends gave their highest ratings to a large share of mortgage-backed securities - many investors and governments officials assumed agencies ratings were accurate - they were free riders

Introduction

- intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities - intermediaries increase investment and economic growth at the same time that they reduce investment risk and economic volatility - without a stable, smoothly functioning financial system, no country can prosper - we can see that there are not any rick countries with very low levels of financial development

Disclosure of information

- an obvious way to solver the hidden attributes problem is to provide more information - in most advanced economies, public companies are required to disclose voluminous amounts of information - public companies are those that issue stock and bonds that are bought and sold in public financial markets - for example, in the U.S., the securities and exchange commission (SEC) requires firms to produce public financial statements that are prepared according to standard accounting practices - although account practices have changed, information problems persist - in a limited sense, there is private information collected and sold to investors - research services like Moody's, value line and Dun and Bradstreet collect information directly from firms and produce evaluations - to be credible, companies cannot pay for this research so investors have to - private information services face a free-rider problem - use rating companies for stock and bonds - companies/people have to report things to government that are public

Your first credit card

- as a student, you usually have no credit history 1. a credit card company will assume the worst - issuers charge high interest rates as compensation for the risk they are taking - remember that with a high interest rate, borrowing is very expensive

The importance of financial intermediaries

- banks are still critical providers of financing around the world - intermediaries determine which firms can access the stock and bond markets - banks decide the size of a loan and interest rate to be charged - securities firms set the volume and price of a new stocks and bond issues when they purchase them for sale to investors

Some companies have been created to try and solve the asymmetrical information problem

- consumer reports has long published information on particular models - more recently CARFAW provides potential buyers with detailed history on any car - You can also hire a mechanic to look over a car for you before you buy it - finally, many car manufacturers are beginning to offer "certified" used cars, which usually come with warranties - help mitigate risk by gathering information to make best decisions

Deflation, net worth, and information costs

- deflation is harmful because it aggravates information problems in ways that inflation does not - it reduces a company's net worth - when price fall: 1. the dollar value of the firm's liabilities reminds the same 2. the value of the firm's assets fall with the price level - deflation drives down a firm's net worth, making it less trustworthy as a borrower

Solving the moral hazard problem in equity financing

- during the 1990's, a concerted attempt was made to align managers interests with those of stockholders 1. executives were given stock options that provided lucrative payoffs if a firm's stock price rose above a certain level - this gave managers incentives to misrepresent companies profits - at this time, there is no foolproof way of ensuring managers will behave in the owner's best interest

Diversifying Risk

- financial institutions enable us to diversify our investments and reduce risk - banks take deposits from thousands of individuals and make thousands of loans with them 1. each depositor has a very small stake in each one of the loans - all financial intermediaries provide a low-cost way for individuals to diversify their investments - doesn't just go into one type of lending because of company's that go bankrupt, etc. - Banks protect us by doing this

Safekeeping, payments systems access and accounting

- financial intermediaries facilitate the exchange of goods or services - this principal of comparative advantage leads to specialization so that each of us ends up doing just one job and being paid in some form of money - financial intermediaries help our economy to function more efficiently - financial intermediaries also help us manager our finances - they provide us with bookkeeping and accounting services, noting all our transactions for us - these force financial intermediaries to write legal contracts - but one can be written and used over and over again - reducing the cost of each - much of what financial intermediaries do take advantage of economies of scale - FDIC is an insurance company that is funded by banks - not all banks are backed by the FDIC

The role of financial intermediaries

- financial markets are important because they price economic resources and allocate them to their most productive uses - intermediaries, including banks and securities firms, continue to play a key role in both direct and indirect finance - from the table we can see: 1. to make comparisons across countries of vastly different size, we measure everything relative to GDP 2. there is no reason that the value of a country's stock market, bongs outstanding, or bank loans cannot be bigger than its GDP - when you add up all the types of financing, direct and indirect, as a percentage of GDP, the numbers will generally sum to more than 100 in an advanced economy - financial intermediaries are important because of information - lending and borrowing involves both transactions costs and information costs - financial institutions exist to reduce these costs - helps allocate our savings

Truth or consequences: Ponzi schemes and other frauds

- fraud is the most extreme type of moral hazard - Ponzi scheme: fraud in which an intermediary collects funds from new investors, but instead of investing them, uses the funds to pay off earlier investors - Bernie madoff is a recent example - The Madoff scandal was a classic Ponzi scheme: 1. fraud in which an intermediary collects funds from new investors, but instead of investing them, uses the funds to pay off earlier investors - investors fails to screen and monitor the managers who receive their funds - people are saying that social security falls under the Ponzi scheme too

Solving the adverse selection problem

- from a social perspective, the problems of adverse selection are not good 1. some companies will pass up good investments 2. economy will not grow as rapidly as it could - we must find ways for investors and lenders to distinguish well-run firms from poorly fun firms

Information asymmetries and information costs

- information plays a central role in the structure of financial markets and financial institutions - if the cost of information is too high, markets cease to function - issuers of financial instruments know more about their business prospects and willingness to work than potential lenders/investors

How companies finance growth and investment

- instead of distributing profits to shareholders, a firm can reinvest the earnings into the firm - a vast majority of investment financing comes from internal sources - the fact that managers have superior information about the way in which their firms are and should be run makes internal finance the rational choice

Solving moral hazard problem in debt finance

- legal contract can solve the moral hazard problem inherent in debt finance - bonds and loans carry restrictive covenants that limit the amount of risk a borrower can assume - the firm may have to maintain a certain level of net worth, a minimum credit rating, or a minimum bank balance - for example: home mortgages require home insurance, fire insurance, etc. - can have internal and external auditors come in too 1. Internal - has the freedom from management to go straight to the board 2. external - looks at whatever information they need/want and give the information to the board on what to improve to make sure management is doing it correctly

Collecting and processing information

- the fact that the borrower knows whether he or she is trustworthy, while the lender faces substantial cost to obtain that information results in an information asymmetry - by collecting and processing standardized information, financial intermediaries reduce the problems that information asymmetries create - they are information gatherers - gather all kinds of information on you to make decisions on where to put the money

Screening and certifying to reduce adverse selection

- the lender uses the number to identify you to a company that collects and analyzes credit information, summarizing it for potential lenders in a credit score - every time someone request a credit score, they have to pay, eliminating the free rider problem - banks can collect information on a borrower that goes beyond their credit report and loan application - underwrites screen and certify firms seeking to raise funds directly in the financial markets 1. underwriters are large investment banks like Goldman Sachs, JPMorgan Chase, and Morgan Stanley - without certification by one of these firms, companies would find it difficult to raise funds

Pooling Savings

- the most straightforward economic function of a financial intermediary is to pool the resources of many small savers. 1. by accepting many small deposits, banks empower themselves to make large loans - in order to do this, the intermediary: 1. must attract substantial numbers of savers 2. must convince potential depositors of the institution soundness - we have liquid demand for funds - attract depositors to get more people to make banks better - have to make sure you have funds for this

Moral hazard: problem and solutions

- the phase moral hazard originated when economists who were studying insurance noted that an insurance policy changes the behavior of the person who is insured - moral hazard arises when we cannot observe people's actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck - a second information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project - moral hazard affects both equity and bond financing - stockholders think of it as a long term investment but management thinks of it as a short-term investment

Used cars and the market for lemons:

- used car buyers can't tell good cars from bad - buyers will at most pay the expected value of good and bad cars - sellers know if they have a good car, so they won't accept less than the true value - if buyers are only willing to pay average value, good car sellers will withdraw cars from the market - then the market has only the bad cars

Moral hazard in debt finance

- when the managers are the owners, moral hazard in equity finance disappears - because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking - lenders need to find ways to make sure borrowers don't take too many risks - people with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their collateral

Adverse selection in financial markets

1. if you can't tell good from bad companies - stocks of good companies are undervalued - owners will not want to sell them 2. If you can't tell good from bad bonds - owners of good companies will have to sell bonds for too low a price - good bonds won't be sold want to do it

In their role as financial intermediaries, financial institutions perform five functions:

1. pooling the resources of small savers 2. Providing safekeeping and account services, as well as access to payments system 3. Supplying liquidity by converting savers balances directly into a means of payment whenever needed 4. providing ways to diversify risk 5. collecting and processing information in ways that reduce information costs

Much of the information that financial intermediaries collect is used too:

1. reduce information costs 2. minimize the effects of adverse selection and moral hazard

Bond owners

can't do anything because they aren't an owner in the company - just a debt owner - but you can do something before you buy the bond and get a loan of money