CHAPTER 01 WHY ARE FINANCIAL INTERMEDIARIES SPECIAL?

Hsiangping H i i T i Tsai Spring 2013 Master

Preview

iRobot

Suppose you invented the iRobot and you plan to produce it.

http://resources.irobot.com/index.php/video/US/11305111

Walter inherited lots of funds

With financial markets,

you, Walter and the economy would all be better off. An understanding of General Structure and Operation of the Financial System is a good start!
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O Overview i
Overview of the Financial System Direct Finance/Indirect Finance Why are Financial Intermediaries (FIs) Special? They reduce Transaction i costs/Risk/Asymmetric / i k/ i Information f i How Asymmetric Information Influences the Financial Structure? Facts about Financial Structure/Tools to Solve the Problem Why Does the Financial System Receive Special Regulatory Attention? Investor Protection/Ensure the Soundness of FIs
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1 The Financial System: An Overview 1.

Flow of Funds through the Financial System:

Direct Finance vs. Indirect Finance

Function of Financial Markets

Function: Direct Finance ()

Channeling of funds (Fig 2.1) Also called securities markets

Why is this channeling of funds so impo t nt? important?

Because savers (lenders) entrepreneurs (borrowers)

AND
Without financial markets, they may never get together g
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Structure of Financial Markets

It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters,
Nature: Debt Markets vs vs. Equity Markets Seasoning: Primary Market vs. Secondary Market Secondary Markets: Exchanges vs. Over-theCounter Original Maturity: Money Markets vs. Capital Markets
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Nature
Debt Markets
Short-Term (maturity < 1 year) Long-Term (maturity > 10 year) Intermediate term (maturity in-between) In U.S., total value was $52.4 trillion at the end of 2009

Equity Markets
Pay dividends, in theory forever Represents an ownership claim in the firm In U.S., total value was $20.5 trillion at the end of 2009 Disadvantage: residual claim Advantage: share the extra profit of the firm

Seasoning: A new issue or not

Primary Market
New security issues sold to initial buyers Typically involves an investment bank who underwrites the offering

Secondary Market
Previously-issued securities are resold (traded) Note: N t Issuing I i fi firms DO NOT get t any money from f the th secondary d market Involves both brokers and dealers (do you know the difference?) ) Classification of the secondary market Functions of the secondary market

Secondary Markets Classification

Exchanges Trades conducted in central locations (e.g., New York Stock Exchange(NYSE), Taiwan Stock Exchange (TWSE) ) Over-the-Counter (OTC) Markets Dealers at different locations buy and sell. (e.g., the market for Treasury securities, Foreign Exchange Markets).

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The Secondary y Market

Two Crucial Functions
Provide Liquidity
making it easy to buy and sell the securities of the companies

Establish a Price
for the securities in the Seasoned-Equity Offerings (SEOs) A note: t I Initial iti l P Public bli Off Offering i (IPO)

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Original Maturity
Money Market Short-Term (maturity < 1 year) Capital Market Long-Term (maturity > 1 year) Best known capital market securities Bonds & Stocks

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2 Why are Financial Intermediaries Special? 2.

Without FIs: Direct Investment

Equity q y & Debt

Households (net savers)

C h Cash

Corporations (net borrowers)

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FIs Specialness

Without FIs: Low level of fund flows.

Information costs

Economies of scale reduce costs for FIs to screen and monitor borrowers

Less liquidity Substantial price risk

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With FIs
FI

Households
Cash

(Brokers)

Corporations
Equity q y & Debt

FI (Asset Transformers)

Deposits/Insurance D it /I Policies

C h Cash

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Functions of FIs

Brokerage

Direct Finance Direct Finance Indirect Finance

Asset Transformer

Other Special Services

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Functions of FIs- Brokerage

Brokers

Acting as an agent for investors

e.g. Merrill Lynch, Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings

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Functions of FIs- Asset Transformer

Purchase primary securities by selling financial claims to households

These secondary securities (financial claims sold to households) often more marketable Transformation of financial risk

Examples:

Banks: deposits Insurance Companies: insurance policies Mutual Funds: mutual fund shares Investment banks: Stocks and bonds

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Other Special Services

Maturity Intermediation

Banks: deposits vs. loans Mutual funds vs. investments in bonds/stocks / Banks Visa, Banks, Visa Master Master

Denomination intermediation

Payment Services

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Flow of Funds through the Financial System:

Direct Finance vs. Indirect Finance

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Indirect Finance is FAR MORE IMPORTANT than Direct Finance

The fact: Fig 7.1 71 WHY?

Transaction Costs Risk i k Sh Sharing i ( (Asset Transformation) f i ) Asymmetric y Information

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Sources of External Funds

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Transaction Costs
The loan contract
e.g., e g costs $500 for a $1,000 $1 000 loan High costs freeze out individual lenders

Can anyone come to the rescue?

FIs can. can Why? Wh ? Economies of scale: the reduction in transaction costs. So the lender decides to obtain a deposit account Additionally, Additi ll FI FIs provide id liquidity li idit services i t customers. to t

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Risk Sharing (Asset Transformation)

Risk sharing
A benefit from low transaction costs FIs help reduce the risk exposure of investors (e.g., depositors) Also called asset transformation, In a sense, risky assets are turned into safer assets for investors. investors

Examples of risk sharing

Banks (deposits) Insurance Companies (insurance policies)
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Asymmetric Information
Definition
The borrower has better info f about the investment projects (potential returns & risks) than the lender does.

It creates two problems

Adverse selection Moral hazard (conflict of interest)

FIs have expertise

to reduce information p problems
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Adverse Selection

B f Before transaction t ti occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan

Loan decisions to Conservative Aunt (Aunt C) vs. GetQ Aunt ( (Aunt G) ) rich-Quick

Similar problems occur with insurance where he e unhealthy h lth people l want t their th i known k
medical problems covered
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Moral Hazard

Aft transaction After t ti occurs The risk ( (hazard) ) that borrower has incentives to engage in undesirable (immoral) activities making it more likely that wont pay loan back. back
Again, with insurance, people may engage in risky i k activities ti iti only l after ft b being i i insured d Also called conflict of interest

e.g., the borrower has incentive to act in his/her own interest rather than the lenders interest
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FIs Help Reduce Asymmetric Information

FIs have expertise to produce information

Expertise in Screening out bad credit risks from good ones (reduce loss from adverse selection) Expertise in monitoring the borrowers (reduce loss from moral hazard)

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3. How Asymmetric Information Influences the Financial Structure ?

Facts about Financial Structure throughout the World

Evidence E id f from Figure Fi Table T bl 7.1 71 1. Stocks are not the most important source of external financing 2. Marketable securities are not the primary source of finance 3. Indirect finance is more important than direct finance 4 Banks are the most important source of external funds 4.

5. 6. 7. 8.

The financial system is heavily regulated Only large, well-established firms have access to securities markets Collateral is prevalent in debt contracts Debt contracts have numerous restrictive covenants
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Sources of External Funds for Businesses

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Asymmetric Information: Adverse Selection and Moral Hazard

We will now use these ideas of adverse selection and moral hazard to explain how they influence financial structure.

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The Lemons Problem: How Adverse Selection Influences Financial Structure (1/2)

Lemons Problem in Used Cars

1.

If we can't distinguish g between g good and bad (lemons) used cars, we are willing pay only an average of good and bad car values Result: Good cars wont be sold, and the used car market will function inefficiently.

2.

What helps us avoid this problem with used cars?

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The Lemons Problem: How Adverse Selection Influences Financial Structure (2/2)

Lemons Problem in Securities Markets

1.

If we can't distinguish g between good g 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 Investors won't buy y bad securities, , so market won't function well
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2.

3.

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 Increase the information available to investors Ex., Ex annual audits of public corporations Financial Intermediation Make private loans (Avoid free-rider problem) rather than buy stocks/bonds from the open market Large firms (well-known corporations) are more likely to use direct d ect instead stead of o indirect d ect financing. a c g WHY? Collateral and Net Worth Reduce the consequences of adverse selection
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How Moral Hazard Affects the Choice Between Debt and Equity Contracts (1/3)

Moral Hazard in Equity Contracts: the Principal-Agent Problem

1.

Result of separation of ownership by stockholders (principals) from control by managers (agents) Managers g act in own rather than stockholders' interest

2.

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How Moral Hazard Affects the Choice Between Debt and Equity Contracts (2/3)
A example: An l Equity E it Suppose you become a silent partner in an ice cream store, 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 Ste e works Steve o k hard, h d the store to e will ill make m ke $50,000 $50 000 after expenses, and you are entitled to $45,000 of it. However, Steve doesnt really value the $5,000 (his part), so he goes to the beach, relaxes, and p some of the profit p on art for his even spends office. How do you, as a 90% owner, give Steve the proper incentives to work hard?
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How Moral Hazard Affects the Choice Between Debt and Equity Contracts (3/3)
Tools to Help Solve the Principal-Agent Principal Agent Problem (Equity)
Production of Information: Monitoring Government Regulation to Increase Information Financial Intermediation (e.g, venture capital) Debt D bt C Contracts t t Explains why debt (rather than equity) is the most important source of financing for business However, debt d b i is still ill subject bj to moral l hazard. h d In fact, debt may create an incentive to take on very risky projects. Most debt contracts require the borrower to pay a fixed amount (interest), so the borrower can keep any cash flow above this amount.
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How Moral Hazard Influences Financial Structure in Debt Markets (1/2)

An example: Debt
Example: Suppose you lend Steve the $9,000 (requiring a 10% interest rate) he needs to set up his business. With your money, Steve may decide to use it for an innovation of diet ice cream (which is riskier) instead. YOU MAY DECIDE NOT TO MAKE THE LOAN. LOAN Success: you get 10%, but Steve get a lot more you loss $9,000, but Steve loses Failure: y nothing or $1,000 at most.

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How Moral Hazard Influences Financial Structure in Debt Markets (2/2)

Tools to Help Solve Moral Hazard in Debt Contracts
Net Worth Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that g undesirable behavior discourage encourage desirable behavior keep collateral valuable provide information Financial Intermediationbanks and other intermediaries have special advantages in monitoring

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Asymmetric Information Problems and Tools to Solve Them

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4. Why Does the Financial System Receive Special Regulatory Attention?

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Regulation of the Financial System

Main reasons for regulation

Investor protection p

Information Disclosure: Increase information available to investors

Ensure the soundness of financial intermediaries

Information Disclosure Restrictions on Entry Restrictions on Activities Deposit Insurance

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Reference

Anthony A h Saunders S d and d Marcia M i Millon Mill C Conett, 2008 Financial 2008, Fi i l Institutions Management, 6th edition, Chapter 1. Erederic ede c S S. Mishkin s and a d Stanley S a ey G. G Eakins, a s, 2012, 0 , Financial a ca Markets and Institutions, 6th edition, Chapters 2 & 7

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