Why do financial institutions exist.ppt

Part FiveFundamentals of Financial Institutions

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Chapter 15Why Do Financial Institutions Exist?


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter PreviewWe examine the differences between fixed and managed exchange rate systems. We also look at the controversial role of capital controls and the IMF in the international setting. Topics include:Basic Facts About Financial Structure Throughout the WorldTransaction CostsAsymmetric Information: Adverse Selection and Moral Hazard


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter Preview (cont.)The Lemons Problem: How Adverse Selection Influences Financial StructureHow Moral Hazard Affects the Choice Between Debt and Equity ContractsHow Moral Hazard Influences Financial Structure in Debt MarketsFinancial Crises and Aggregate Economy Activity


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Basic Facts About Financial Structure Throughout the WorldThe financial system is a complex structure including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc.The chart on the next slide indicates how American businesses finance their activities with external funds.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Basic Facts About Financial Structure Throughout the WorldThe chart on the next slide 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Sources of Foreign External Finance Figure 15.2 Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany, Japan, and Canada


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Facts of Financial StructureStocks 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Facts of Financial StructureIndirect 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Facts of Financial StructureThe 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Facts of Financial StructureCollateral 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Transactions CostsTransactions costs influence financial structureE.g., a $5,000 investment only allows you to purchase 100 shares @ $50 / share (equity)No diversificationBonds even worsemost have a $1,000 sizeIn sum, transactions costs can hinder flow of funds to people with productive investment opportunities


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Transactions CostsFinancial intermediaries make profits by reducing transactions costs Take advantage of economies of scale (example: mutual funds)Develop expertise to lower transactions costsAlso provides investors with liquidity, which explains Fact # 3 (slide 15-10)


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Asymmetric Information: Adverse Selection and Moral HazardIn your introductory finance course, you probably assumed a world of symmetric informationthe case where all parties to a transaction or contract have the same information, be that little or a lotIn many situations, this is not the case. We refer to this as asymmetric information.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Asymmetric Information: Adverse Selection and Moral HazardAsymmetric 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 selectionMoral hazard


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Asymmetric Information: Adverse Selection and Moral HazardAdverse SelectionOccurs when one party in a transaction has better information than the other partyBefore transaction occursPotential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Asymmetric Information: Adverse Selection and Moral HazardMoral HazardOccurs when one party has an incentive to behave differently once an agreement is made between partiesAfter transaction occursHazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Asymmetric Information: Adverse Selection and Moral HazardThe 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.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*The Lemons Problem: How Adverse Selection Influences Financial StructureLemons Problem in Securities MarketsIf can't distinguish between good and bad securities, willing pay only average of good and bad securities valueResult: Good securities undervalued and firms won't issue them; bad securities overvalued so too many issued


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*The Lemons Problem: How Adverse Selection Influences Financial StructureLemons Problem in Securities MarketsInvestors won't want buy bad securities, so market won't function wellExplains Fact # 1 and # 2 (slide 15-9)Also explains Fact # 6 (slide 15-11): Less asymmetric info for well known firms, so smaller lemons problem


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Tools to Help Solve Adverse Selection (Lemons) ProblemsPrivate Production and Sale of Information Free-rider problem interferes with this solutionGovernment Regulation to Increase Information (explains Fact # 5, slide 15-11) For example, annual audits of public corporations Does not eliminate the problem


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Tools to Help Solve Adverse Selection (Lemons) ProblemsFinancial IntermediationAnalogy to solution to lemons problem provided by used car dealersAvoid free-rider problem by making private loans (explains Fact # 3 and # 4, slide 15-10)Collateral and Net Worth Explains Fact # 7, slide 15-12


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*How Moral Hazard Affects the Choice Between Debt and Equity ContractsMoral Hazard in Equity Contracts: the Principal-Agent ProblemResult of separation of ownership by stockholders (principals) from control by managers (agents)Managers act in own rather than stockholders' interest


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*How Moral Hazard Affects the Choice Between Debt and Equity ContractsTolls to Help Solve the Principal-Agent ProblemProduction of Information: MonitoringGovernment Regulation to Increase InformationFinancial Intermediation (e.g, venture capital)Debt ContractsExplains Fact # 1, slide 15-9: Why debt is used more than equity


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*How Moral Hazard Influences Financial Structure in Debt MarketsBecause of the design of debt contacts, borrowers only pay a fixed amount and keep any cash flow above this amount. In some circumstances, this creates an incentive for borrowers to take on riskier projects.For example, if a firm owes $100 but only has $90, it will be bankrupt. The firm has nothing to lose by looking for risky projects to raise the needed cash.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*How Moral Hazard Influences Financial Structure in Debt MarketsTools to Help Solve Moral Hazard in Debt ContractsNet WorthMonitoring and Enforcement of Restrictive CovenantsFinancial Intermediationbanks and other intermediaries have special advantages in monitoringExplains Facts # 14, slides 15-9 & 15-10


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Case: Financial Development and Economic GrowthFinancial repression (in Developing & Ex-Comm. Countries) leads to low growthWhy?Poor legal systemWeak accounting standards Government directs creditFinancial institutions nationalizedInadequate government regulationFinancial Crises


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Financial Crises and Aggregate Economic ActivityOur analysis of the affects 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 in the inability of markets to channel funds from savers to productive investment opportunities.


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Financial Crises and Aggregate Economic ActivityFactors Causing Financial CrisesIncreases in Interest RatesIncreases in UncertaintyAsset Market Effects on Balance Sheets Stock market effects on net worth Unanticipated deflation Cash flow effects


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Financial Crises and Aggregate Economic ActivityFactors Causing Financial CrisesBank PanicsGovernment Fiscal ImbalancesAs shown in the next slide, most U.S. financial crises have begun with a deterioration in banks balance sheets.


Figure 15.3 Sequence of Events in U.S. Financial Crises

Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Case: Financial Crises in Emerging Market Countries: Mexico, East Asia, and ArgentinaThe three countries show how a country can shift from a path of high growth just before a financial crises.An important factor was the deterioration in banks balance sheets due to increasing loan loses.


Figure 15.4 Sequence of Events in Mex., Arg. and E. Asian Crises

Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter SummaryBasic Facts About Financial Structure Throughout the World: we reviewed eight basic facts concerning the structure of the financial systemTransaction Costs: we examined how transaction costs can hinder capital flow and the role financial institutions play in reducing transaction costs


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter Summary (cont.)Asymmetric Information: Adverse Selection and Moral Hazard: we defined asymmetric information along with two categories of asymmetric informationadverse selection and moral hazardThe Lemons Problem: How Adverse Selection Influences Financial Structure: we discussed how adverse selection effects the flow of capital and tools to reduce this problem


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter Summary (cont.)How Moral Hazard Affects the Choice Between Debt and Equity Contracts: we reviewed the principal-agent problem and how moral hazard influences the use of more debt than equityHow Moral Hazard Influences Financial Structure in Debt Markets: we discussed how moral hazard and debt may lead to increased risk-taking, and tools to reduce this problem


Copyright 2006 Pearson Addison-Wesley. All rights reserved.15-*Chapter Summary (cont.)Financial Crises and Aggregate Economy Activity: we discussed how adverse selection and moral hazard influence financial crises, and showed examples from both the U.S. and abroad


Why do financial institutions exist.ppt

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