Why Do Financial Institutions Exist

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Chapter 15

• Why Do Financial Institutions Exist?

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Chapter Preview

• In this chapter, we take a look at why financial
  institutions exist and how they promote economic
  efficiency. We will examine topics such as
• Basic Facts About Financial Structure Throughout
  the World
• Transaction Costs
• Asymmetric Information Adverse Selection and
  Moral Hazard
• 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 Economic Activity

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Basic Facts About Financial Structure Throughout
the World

• The financial system is a complex structure
  including many different financial institutions
  banks, insurance companies, mutual funds, stock
  and bonds markets, etc.
• The financial institutions channel the money from
  savers to people with investment opportunities.
• The chart on the next slide show how nonfinancial
  business attain external funding in the U.S.,
  Germany, Japan, and Canada.

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Basic Facts About Financial Structure Throughout
the World
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Basic Facts About Financial Structure Throughout
the World

• Facts of Financial Structure
• Stocks 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.

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Basic Facts About Financial Structure Throughout
the World

• Indirect 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.

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Basic Facts About Financial Structure Throughout
the World

• The 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.

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Basic Facts About Financial Structure Throughout
the World

• Collateral 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.

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Transactions Costs

• Transactions costs influence financial structure
• E.g., a 5,000 investment only allows you to
  purchase 100 shares _at_ 50 / share (equity)
• Bonds even worsemost have a 1,000 size
• No diversification
• In sum, transactions costs can hinder flow of
  funds to people with productive investment
  opportunities

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Transactions Costs

• Financial intermediaries make profits by reducing
  transactions costs.
• They also allow small savers and borrowers to
  benefit from the existence of financial markets
• How do they reduce the transaction costs?
• Take advantage of economies of scale
• The financial intermediaries group together the
  funds of many investors.

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Transactions Costs

• They reduce the transaction costs per dollar of
  investment as the size (scale) of transactions
  increases.
• They group investors funds together and reduces
  transaction costs for each investor.
• Economies of scale exist because the total cost
  of carrying out a transaction in financial
  markets increases only as little as the size of
  the transaction grows.
• Example mutual fund

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Transactions Costs

• Develop expertise to lower transactions costs
• For example Their expertise in computer
  technology enables them to offer customer
  convenient services like being able to call a
  toll-free number for information.
• Also provides investors with liquidity services.

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Asymmetric Information Adverse Selection and
Moral Hazard

• Asymmetric information is a situation that arises
  when one partys insufficient knowledge about the
  other party involved in a transaction makes it
  impossible to make accurate decisions when
  conducting the transaction
• Two specific forms of asymmetric information
• Adverse selection
• Moral hazard

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Asymmetric Information Adverse Selection and
Moral Hazard

• Adverse Selection
• Occurs when one party in a transaction has better
  information than the other party.
• Before transaction occurs.
• Potential borrowers most likely to produce
  adverse outcome are ones most likely to seek loan
  and be selected.

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Asymmetric Information Adverse Selection and
Moral Hazard

• Moral Hazard
• Occurs when one party has an incentive to behave
  differently once an agreement is made between
  parties.
• After transaction occurs.
• Hazard that borrower has incentives to engage in
  undesirable (immoral) activities making it more
  likely that won't pay loan back.
• The analysis of how asymmetric information
  problems affect behavior is known as agency
  theory.

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Lemons Problem in Used Cars
• If we can't distinguish between good and bad
  (lemons) used cars, we are willing to pay only an
  average of good and bad car values.
• Result Good cars wont be sold, and the used car
  market will function inefficiently.
• What helps us avoid this problem with used cars?

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Lemons Problem in Securities Markets
• If we can't distinguish between good 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 want to buy bad securities, so
  market won't function well

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Tools to Help Solve Adverse Selection (Lemons)
  Problems
• Methods of elimination of asymmetric information
• Private Production and Sale of Information
• Furnishing the people who supply funds (lenders)
  with full details about the individuals or firms
  seeking to finance their investment activities
  (borrowers).
• Private companies who collect information from
  the firms balance sheets and investment
  activities publish the data and sell them to
  subscribers.
• For example SP or Moodys

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Free-rider problem interferes with this solution
• The free-rider problem occurs when people who do
  not pay for information take advantage of the
  information that other people have paid for.
• Government Regulation to Increase Information
• The government regulates the securities market in
  a way that encourages firms to reveal honest
  information about themselves so that the
  investors can determine how good or bad the firms
  are.
• For example, annual audits of public corporations

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Financial Intermediation
• A financial intermediary becomes an expert in
  producing information about firms, so that it can
  sort out good credit risk form bad ones.
• Banks can also avoid free-rider problem.
• It is making private loans
• Banks are more important in the financial systems
  of developing countries
• When the quality of information is better,
  asymmetric information problems will be less
  severe.

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Also the larger and more established a
  corporation is, the more likely it will be to
  issue securities to raise funds.
• Collateral and Net Worth
• Adverse selection negatively affects the
  functioning of financial markets only if a lender
  suffers a loss when a borrower defaults.

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The Lemons Problem How Adverse Selection
Influences Financial Structure

• Collateral reduces the consequences of adverse
  selection because it reduces the lenders losses
  in the event of a default.
• Net worth (equity capital), the difference
  between a firms assets and its liabilities, can
  perform a similar role to collateral.

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How Moral Hazard Affects the Choice Between Debt
and Equity Contracts

• Moral Hazard in Equity Contracts the
  Principal-Agent Problem
• Result of separation of ownership by stockholders
  (principals) from control by managers (agents)
• Managers act in own rather than stockholders'
  interest

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How Moral Hazard Affects the Choice Between Debt
and Equity Contracts

• An example of principal-agent problem 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 it.

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How Moral Hazard Affects the Choice Between Debt
and Equity Contracts

• However, Steve doesnt 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?

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How Moral Hazard Affects the Choice Between Debt
and Equity Contracts

• Tools to Help Solve the Principal-Agent Problem
• Production of Information Monitoring
• The stockholders may engage in a type of
  information production, the monitoring of firms
  activities auditing the firm frequently and
  checking on what the management is doing

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How Moral Hazard Affects the Choice Between Debt
and Equity Contracts

• Government Regulation to Increase Information
• Financial Intermediation
• Financial intermediaires have the ability to
  avoid the free-rider problem in the face of moral
  hazard
• Debt Contracts
• The debt contract is a contractual agreement and
  guarantees that the borrower pays a fixed amount
  to the lender.

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How Moral Hazard Influences Financial Structure
in Debt Markets

• Most debt contracts require the borrower to pay a
  fixed amount (interest) and keep any cash flow
  above this amount.
• Debt contracts are also subject to moral hazard.
  
• Debt may create an incentive to take on very
  risky projects.
• For example, what if a firm owes 100 in
  interest, but only has 90? It is essentially
  bankrupt. The firm has nothing to lose by
  looking for risky projects to raise the needed
  cash.

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How Moral Hazard Influences Financial Structure
in Debt Markets

• Tools to Help Solve Moral Hazard in Debt
  Contracts
• Net Worth and Collateral
• When borrowers have more at stake because their
  net worth is high or collateral they have pledged
  to the lender is valuable, the risk of moral
  hazard will be reduced

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How Moral Hazard Influences Financial Structure
in Debt Markets

• Monitoring and Enforcement of Restrictive
  Covenants
• Restrictive covenants are directed to reduce
  moral hazard either by ruling out undesirable
  behaviour or by encouraging desirable behaviour
• Financial Intermediation
• Banks and other intermediaries have special
  advantages in monitoring

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Financial Crises and Aggregate Economic Activity

• Financial crises are major disruptions in
  financial markets.
• Financial crises are characterized by sharp
  declines in asset prices and the failures of many
  financial and nonfinancial firms.
• Financial crises occur when a disruption in the
  financial system causes an increase in adverse
  selection and moral hazard problems in financial
  markets that the markets are unable to channel
  funds efficiently from savers to people with
  productive investment oppotunities.

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Financial Crises and Aggregate Economic Activity

• Factors Causing Financial Crises
• Increases in Interest Rates
• If market interest rates are increased because of
  increased demand for credit or because of a
  decline in the money supply, good credit risks
  are less likely to want to borrow while bad
  credit risks are still willing to borrow.
• Due to increase in adverse selection, lenders
  will no longer want to make loans.

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Financial Crises and Aggregate Economic Activity

• So there is going to be decline in lending and in
  investment followed by a decline in aggregate
  economic activity.
• An increase in interest rates also leads to
  higher interest payments and a decline in firms
  cash flows. Thus with less cash flow, the firm
  has fewer internal funds and must raise fund from
  an external source, such as a bank.

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Financial Crises and Aggregate Economic Activity

• Increases in Uncertainty
• A dramatic increase in uncertainty in financial
  markets (the failure of a bank, a recession or
  stock market crash) makes it harder for lenders
  to screen good from bad credit risk.
• Asset Market Effects on Balance Sheets
• Stock market effects on net worth
• Unanticipated deflation
• Unanticipated depreciation of the domestic
  currency

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Financial Crises and Aggregate Economic Activity

• Problems in the Banking Sector
• If banks suffer a deterioration in their balance
  sheets there will be a contraction in their
  capital, they will have fewer resources to lend
  so bank lending will decline.
• If the deterioration in bank balance sheets is
  severe enough, banks will start to fail, and fear
  can spread from one bank to another, causing even
  healthy banks to bankrupt.
• The multiple bank failures are known as bank
  panic.

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Financial Crises and Aggregate Economic Activity

• Government Fiscal Imbalances
• In emerging market economies government fiscal
  imbalances may create fears of default on the
  government debt.
• If the price of securities decline, interest rate
  on them increases then the balance sheets of
  banks will weaken.
• Also fears of default on government debt starts a
  foreign exchange crises.