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
-- summary indirect finance (bank loans) is more important than direct finance (stocksbonds). WHY?
4 Eight Basic Facts (contd)
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
-- summary financial markets are regulated and financial contracts are restrictive. WHY?
5 Transaction Costs
A major problem of financial markets and direct finance is the substantial transaction and information cost.
Financial intermediaries and indirect finance have evolved to reduce transaction costs
Economies of scale
6 Asymmetric Information
Asymmetric information is a situation that arises when one party of transaction has more information than the other party.
The presence of asymmetric information leads to adverse selection (before the transaction) and moral hazard (after the transaction).
The analysis of how asymmetric information affect economic behavior is called agency theory.
7 The Lemons Problem
There are two types of used cars good (50) and bad (50). A good car is worth 3000 and a bad car is worth 1000.
You cant tell whether a car is good or bad, but the seller can. asymmetric information
How will you offer a price for a car of which you dont know the quality? A reasonable strategy offer the expected value of the car 3000501000502000
The seller of a good car wont accept your offer since his car is worth more than 2000. The seller of a bad car would be very happy to sell his car by 2000 since his car is only worth 1000
Consequence Only bad cars will be available in the market. Good cars will exit. adverse selection
8 Lemons in the Stock and Bond Markets
An investor cannot distinguish between good firms and bad firms, so he will be willing to pay a price that reflects the average quality of firms.
The owners or managers of a firm know more information about the real quality of the firm. Hence they know whether their stocks/bonds are undervalued or overvalued.
The only firms willing to sell will be bad firms since their stocks/bonds are overvalued.
Adverse selection in financial markets explains why direct finance (bonds/stocks) is less important than indirect finance (bank loans).
9 Adverse Selection Solutions
Private production and sale of information
- examples SP and Moodys sell information
- not perfect free-rider problem
Government regulation to increase information
- SEC requires security issuers disclose accurate information
- explains why financial markets are the most heavily regulated
10 Adverse Selection Solutions (contd)
Financial intermediation (Get a used-car dealer)
- produces information avoids free-rider problem
- explains why indirect finance is more important than direct finance
- explains why the importance of indirect finance in developing countries is even larger than in developed countries, and why the role of banks in US is declining.
-explains why large firms are more likely to obtain funds from securities markets
Collateral and net worth
- reduces the consequence of adverse selection by reducing the loss from default
- net worth (equity capital), the difference between asset and liability, can perform a similar role to collateral because the firm can be liquidated after bankruptcy.
11 Moral Hazard
Moral hazard is the asymmetric information problem that occurs when one party of a transaction has the incentive to hide information and engage in activities that are undesirable for the other party.
A typical example is an insurance policy without any deduction or co-payment. The insured has the incentive to abuse the insurance.
12 Moral Hazard in Equity ContractsThe Principal-Agent Problem
Principals, who are the stockholders owning the firm, are not the same people as agents, who are the managers hired by the owners.
The separation of ownership and control involves moral hazard, in that the agents may act in their own interests rather than the principals interest.
The principals want to maximize profits, but the agents maybe want high wage, long vacation, and beautiful office, etc..
The principal-agent problem arise from asymmetric information that the agent has more information about his activities than the principal.
13 Moral Hazard Solutions
Production of information monitoring
-costly state verification makes the equity contract less desirable also free-rider
Government regulation for fraud
Venture capital firm
- explains why stock financing is less important than debt financing (fact 1)
14 Moral Hazard in Debt Markets
Debt contracts are still subject to moral hazard since the agent may default the debt
Net worth and collateral
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Avoid free-riders again
15 Summary 16 Conflicts of Interest
Conflicts of interest arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
Conflicts of interest is a type of moral hazard problem caused by economies of scope
Financial institutions providing multiple financial services have incentive to conceal information or disseminate misleading information.
-example Arthur Anderson provided both auditing and consulting services to Enron
17 Conflicts of Interest in Financial Markets
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
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
18 Conflicts of Interest Solutions
Sarbanes-Oxley Act of 2002
for accounting industry
- illegal for a CPA firm to provide any nonaudit service to a client contemporneously with an impermissible audit
Global Legal Settlement of 2002
- for investment banks
- sever the links between research and underwriting
19 Financial Crises
Financial crises are characterized by sharp declines in asset prices and the failures of many financial and non-financial firms.
-The last financial crisis is Black October , the October 1987 stock market crash
Financial crises occur when a disruption in the financial system causes such a sharp increase in adverse selection and moral hazard problems in financial markets that the markets are unable to channel funds efficiently from savers to investors, which results in a sharp contraction in economic activity.
20 Five Factors Causing Financial Crises
Increase in interest rates -gtadverse selection
Increase in uncertainty -gt adverse selection
Asset market effect on balance sheets
--decrease in net worth (collateral) -gtadverse selection moral hazard
Problems in the banking sector
-- bank panic-gtrole of reducing asymmetric information weakens -gt decline in lending
Governmental fiscal imbalance
-- fear of governmental debt default -gt banks are forced to buy governmental bonds-gtbank balance sheets weaken-gtdecline in lending