chapter 15 why do financial institutions exist?. copyright © 2009 pearson prentice hall. all rights...

Chapter 15

Why Do Financial Institutions Exist?

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-2

Chapter Preview

In this chapter, we take a closer look at why financial institutions exist and how they promote economic efficiency. Topics include:

– Basic Facts About Financial Structure Throughout the World

– Transaction Costs

– Asymmetric Information: Adverse Selection and Moral Hazard


Chapter Preview (cont.)

– The Lemons Problem: How Adverse Selection Influences Financial Structure

– How Moral Hazard Affects the Choice Between Debt and Equity Contracts

– How Moral Hazard Influences Financial Structure in Debt Markets

– Financial Crises and Aggregate Economy Activity

15-4

Sources of Foreign External Finance

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 15-5

Facts of Financial Structure

1. Stocks are not the most important source of finance for businesses.

2. Issuing marketable securities is not the primary funding source for businesses.

3. Indirect finance (financial intermediation) is far more important than direct finance.

4. Banks are the most important source of external finance.5. The financial sector is among the most heavily regulated.6. Only large, well established firms have access to

securities markets.7. Collateral is a prevalent feature of debt contracts.8. Debt contracts are typically extremely complicated legal

documents with restrictive covenants.


Transactions Costs

• Transactions costs influence financial structure– E.g., a $5,000 investment only allows you to

purchase 100 shares @ $50 / share (equity)

– No diversification

– Bonds even worse—most have a $1,000 face value

• Transactions costs can hinder flow of funds to people with productive investment opportunities


Transactions Costs

• Financial intermediaries make profits by reducing transactions costs

1. Take advantage of economies of scale (example: mutual funds)

2. Develop expertise to lower transactions costs• Also provides investors with liquidity, which

explains Fact # 3 (indirect finance is far more important than direct finance.)


Asymmetric Information: Adverse Selection and Moral Hazard

• Asymmetric information occurs when one party to a transaction has more information than the other. We focus on two specific forms:

– Adverse selection

– Moral hazard

• The analysis of how asymmetric information problems affect behavior is known as agency theory.



• Adverse Selection

1. Occurs when one party in a transaction has better information than the other party

2. Before transaction occurs

3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected



• Moral Hazard

1. Occurs when one party has an incentive to behave differently once an agreement is made between parties

2. After transaction occurs

3. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely they won't pay loan back


The Lemons Problem: How Adverse Selection Influences Financial Structure

• Lemons Problem in Used Cars

1. If we can't distinguish between “good” and “bad” (lemons) used cars, we are only willing to pay the average price.

2. Result: Good cars won’t be sold, and the used car market will function inefficiently.

• What helps us avoid this problem with used cars?



• Lemons Problem in Securities Markets

1. If we can't distinguish between good and bad securities, we are only willing to pay for the average of good and bad securities’ value.

2. Result: Good securities are undervalued and firms won't issue them; bad securities are overvalued so too many are issued



• Lemons Problem in Securities Markets

3. Investors won't want to buy bad securities, so market won't function well

– Explains Fact # 1 and # 2• Stocks are not the most important source of finance.

• Marketable securities are not the primary funding source.

– Also explains Fact # 6: • Less asymmetric info for well known firms, so smaller lemons

problem


Tools to Help Solve Adverse Selection (Lemons) Problems

1. Private Production and Sale of Information

– Free-rider problem interferes with this solution

2. Government Regulation to Increase Information(explains Fact # 5)

– For example, annual audits of public corporations (although Enron is a shining example of why this does not eliminate the problem)


Tools to Help Solve Adverse Selection (Lemons) Problems

3. Financial Intermediation– Analogy to solution to lemons problem

provided by used car dealers

– Avoid free-rider problem by making private loans (explains Fact # 3 and # 4)

– Also explains fact #6 – large firms are more likely to use direct instead of indirect financing

4. Collateral and Net Worth– Explains Fact # 7


Moral Hazard in Equity Contracts QUIZ

• Define the Principal-Agent Problem

• Why does the Principal-Agent Problem make debt more attractive than equity to investors?


How Moral Hazard Affects the Choice Between Debt and Equity Contracts

• Moral Hazard in Equity Contracts: the Principal-Agent Problem

1. Result of separation of ownership by stockholders (principals) from control by managers (agents)

2. Managers act in own rather than stockholders' interest



Suppose you become a silent partner in an ice cream 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 Steve works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of the profits.



However, Steve doesn’t really value the $5,000 (his part), so he goes to the beach, relaxes, and even spends some of the “profit” on art for his office.

How do you, as a 90% owner, give Steve the proper incentives to work hard?



• Tools to Help Solve the Principal-Agent Problem

1.Production of Information: MonitoringCostly State Verification makes equity less desirable than debt

2.Government Regulation to Increase Information

3.Financial Intermediation (e.g, venture capital)

4.Debt Contracts

• Explains Fact # 1: Why debt is used more than equity


How Moral Hazard Influences Financial Structure in Debt Markets

• Even with the advantages just described, debt is still subject to moral hazard. In fact, debt may create an incentive to take on very risky projects. This is important to understand. Let’s looks at a simple example.



• Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount.

• What if General Growth owes $100m in interest and principle, but only has $90m in assets? It is bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash.



• Tools to Help Solve Moral Hazard in Debt Contracts1. Net Worth

2. Monitoring and Enforcement of Restrictive Covenants.

3. Financial Intermediation—banks and other intermediaries have special advantages in monitoring

• Explains Facts # 1–4

15-26

Asymmetric Information Problems and Tools to Solve Them


Case: Financial Development and Economic Growth QUIZ

• Use the theory of financial structure (previous 26 slides!) to explain some of the causes of financial repression (an underdeveloped financial system) in developing economies. Why does financial repression lead to slow economic growth?


Case: Financial Development and Economic Growth

• Financial repression leads to low growth

• Why?

1. Poor legal system

2. Weak accounting standards

3. Government directs credit (state-owned banks)

4. Financial institutions nationalized

5. Inadequate government regulation

• Financial markets channel funds to those with productive investment opportunities. If the financial system does not function well, then the economy cannot operate efficiently.


Financial Instability and Crises

• Financial Instability:Financial instability occurs when shocks to the financial system interfere with information flows so that the financial system cannot do its job of channeling funds to those with productive investment opportunities.

• Financial Crises:If the financial instability is severe enough, it may lead to a near complete failure of financial markets to channel funds, i.e. a financial crisis.


Causes of Financial Instability

1. Deterioration of Financial Sector Balance Sheet

– If bank capital is reduced, banks must reduce lending or raise new capital. (capital ratio = BK/Assets)

– Insufficient capital leads to bank closure and possible panics.

– both can lead to contraction in lending and therefore economic activity.1. Borrow from other banks or corporations

Assets Liabilities

Reserves $9 million Deposits $100 million

Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million 0


Causes of Financial Instability

2. Increase in interest rates– asymmetric information and adverse selection

problems can lead to credit rationing.

– higher rates can have negative effects on bank balance sheets (due to mismatch of maturities)

3. Increases in uncertainty for example from failure of large bank.– makes it more difficult for lenders to screen– reduces lending.


Causes Financial Instability

4. Deterioration of Nonfinancial Balance Sheets– The state of the balance sheet of nonfinancial firms is

the most critical factor determining the severity of asymmetric information problems in the financial system.

– role of collateral– Stock market effects on net worth– increasing interest rates affect collateral and net

worth.– Unanticipated deflation or devaluation– Cash flow effects

5. Bank panics


Financial Liberalization Often Leads to Instability

• Leads to lending boom when interest rate ceilings and lending restrictions are lifted.• Rapid credit growth is aided by capital inflows.• Credit growth is so rapid that excessive risk taking occurs.• According to the Securities Industry and Finance Association (SIFMA), aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007.•See NPR Global Pool of Money


Excessive Risk Taking

1. Managers of banking institutions did not have expertise to manage risk when financial markets were liberalized to allow for new types of lending activity.

2. Rapid credit growth makes it difficult for banks to add expertise fast enough.

3. Inadequate Regulatory/Supervisory system. 4. Even without explicit government safety net,

depositors and foreign lenders to East Asian banks expected government protection.


Excessive Risk Taking and Capital Flows

1. Implicit government guarantee makes moral hazard worse because banks are not worried about monitoring by foreign lenders and depositors.

2. Rapid credit growth can be financed because of capital inflows. -- high yields in East Asian banks are implicitly insured by government, and exchange rate is pegged to $!


Leads to Loan Losses

1. Share of nonperforming loans to total loans rose to between 15 and 35% in East Asia.

2. Deterioration in Bank Balance Sheet leads banks to restrict lending to improve capital ratios.

3. Mismatch of maturities

• Loan losses may increase-- credit risk goes up.

• More restriction of lending due to adverse selection.


Deteriorating Bank Balance SheetsMay Lead to Currency crisis

1. Makes it difficult for Central Bank to protect currency.2. Raising interest rates to protect currency hurts banking

sector because of mismatch of maturities• Loan losses may increase-- credit risk goes up.• More restriction of lending due to adverse

selection.3. When currency investors realize the condition of the

banking system, their incentives to speculate against currency increase. Expected profits from selling currency increase.

4. Deterioration of Banking Sector is a Fundamental Cause of currency crises.


Currency Crisis:Devaluation leads to Financial Crisis

Characteristic of Emerging Market Debt Contracts play key role

• Debt contracts typically have very short maturities.

• Debt contracts are typically denominated in foreign currency.

These features of Emerging Markets result in three different channels for currency crisis to increase asymmetric information problems and lead to Financial Crises.

Quiz: List and explain the 3 channels!


1) Currency Crisis -impacts firm balance sheets

1. Devaluation of domestic currency increases firms debt burden by raising value of debt (liabilities) and debt payments.

2. No simultaneous increase in value of firms assets denominated in domestic currency.

3. Adverse selection problem worsens because of reduced collateral (net worth).

4. Moral hazard also increases since firms have increased incentives to take on risk.

5. Lending declines


2) Currency Crisis - may lead to Inflation

1. Devaluation of domestic currency raises cost of all imported goods. A 75% devaluation as occurred in Indonesia leads to a four fold increase in the price of imported goods.

2. Mexico’s inflation rose to 50% in 1995

3. Increasing expected inflation leads to higher interest rates. Remember the Fisher Effect.• Adverse selection worsens.• Short term debt contracts leads to huge increase in

interest payments and worsening cash flow, plus balance sheet effects.

• Lending declines


1. Banks have liabilities in foreign currency.-- These liabilities are usually short term.

2. Firms and households cannot pay back loans

3. Banks balance sheets get squeezed from both sides and lending is reduced.

4. Rapid increase in cost of short term debt leads to liquidity problem for banks.

5. Shutting down insolvent banks reduces lending available in economy.

3) Currency Crisis -directly weakens bank balance sheets


Initial Conditions


Case: Financial Crises in Emerging Market Countries: Mexico, East Asia, and Argentina

• Argentina was particularly interesting. It had a well-supervised banking system (unlike Mexico and East Asia). The fiscal problems of the government weakened the banking system balance sheet when the government forced banks to take-on gov’t debt. Confidence in the government failed, and the banks’ dent values (assets) fell dramatically.


Case: Financial Crises in Emerging Market Countries: Mexico, East Asia, and Argentina

• The Mexican and Argentine crises were also preceded by rising international interest rates. This lead to increased rates in these countries, and an accompanying increase in information problems. Stock market declines were also in the mix; although in Asia, it occurred simultaneously instead of before the crisis.


Case: U.S. Financial Crisis

• The U.S. has a long history of banking and financial crises, dating back to 1819. Our analysis can explain why these took place and why they were so damaging.

• The next figure outlines the events leading to a financial crisis.

See NPR Global Pool of Money


Chapter Summary

• Basic Facts About Financial Structure Throughout the World: we reviewed eight basic facts concerning the structure of the financial system

• Transaction Costs: we examined how transaction costs can hinder capital flow and the role financial institutions play in reducing transaction costs


Chapter Summary (cont.)

• Asymmetric Information: Adverse Selection and Moral Hazard: we defined asymmetric information along with two categories of asymmetric information—adverse selection and moral hazard

• The Lemons Problem: How Adverse Selection Influences Financial Structure: we discussed how adverse selection effects the flow of capital and tools to reduce this problem



• 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 equity

• How 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



• 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

chapter 15 why do financial institutions exist?. copyright © 2009 pearson prentice hall. all rights...

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