Money and Banking

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Money and Banking
Mr. Vaughan
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Financial-Structure Puzzles

• Eight, interrelated puzzles, about financial
  structure
• Financial system boasts a broad array of
  marketable securities and financial
  intermediariesand heterogeneity is increasing.
• Internal finance is more important than external
  finance for firmsnot just in U.S., but all over
  developed world.
• Firms seeking external finance rely more heavily
  on banks than securities marketsnot just in U.S.
  but all over developed world.
• Only large, well-established corporations can tap
  securities markets to finance operationsnot just
  in U.S. but all over developed world.
• Not listed in Mishkin.

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Financial-Structure Puzzles(continued)

• Eight, interrelated puzzles, about financial
  structure
• U.S. firms selling securities rely more heavily
  on bonds than on stocks. (Common, but not
  universal, pattern in developed world.
• Debt contracts typically are extremely
  complicated legal documents placing substantial
  restrictions on borrowers.
• Collateral is a common feature of debt contracts.
  
• As financial markets have grown more
  sophisticated, financial intermediation has
  become more important economically.
• Financial system is heavily regulatednot just in
  U.S., but all over developed world.
• Not listed in your text.

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Sources of External FinanceCross-Country
Comparisons
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Understanding Financial StructureModigliani-Mille
r Theorem

• Theorem In frictionless capital markets, firm
  value depends solely on cash flows from assets.
  Capital structurei.e., how assets are
  financedplays no role.
• Corollary NPV of investment projects doesnt
  depend on financing.
• Definition Frictionless capital market
• Perfect Competition
• No transactions costs
• No information asymmetries
• No tax/regulatory distortions

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Understanding Financial StructureModigliani-Mille
r Theorem

• Intuition
• Cash flows from assets determine the size of pie.
  
• Capital structuredebt/equity mixmerely slices
  pie.
• Firm cannot make pie larger by slicing it
  differently.

Debt
Equity
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Modigliani-Miller TheoremLogic

• Consider two firms with identical cash flows from
  assets
• One has debt (levered firm) in capital structure
  other (un-levered firm) does not.
• Investors can borrow privately on same terms as
  levered firm.
• Total value of firm is defined as market value of
  debt plus the market value of equity. So
• Total value of un-levered firm total value of
  outstanding shares
• Total value of levered firm total value of
  outstanding debt total value of outstanding
  shares.

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Modigliani-Miller TheoremLogic

• Levered Firm
• Cash Flows from Assets
• - Firms Debt Service
• Dividends Net Cash Flows

Un-levered Firm Cash Flows from Assets
Dividends - Private Debt Service Net Cash Flows

• Net cash flows are identical.
• Investors care only about net cash flows.
• Arbitrage guarantees total value of levered firm
  will equal total value of un-levered firm.

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Explanations for Financial-Structure Puzzles

• MM identifies frictions that make financing
  choices important
• Transactions costs
• Asymmetric information costs
• Taxation and Regulation
• Financing arrangements reflect efforts to
  minimize transactions costs, information costs,
  tax burden, and regulatory burden.

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Transactions Costs

• Definition Time/money spent channeling funds
  from surplus units to deficit units.
• Forms
• Search costs
• Negotiation costs
• Enforcement costs
• Implication Small firms and large firms needing
  small amounts of financing will rely on internal
  finance or bank finance.

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Transactions Costs

• Another Form Bankruptcy costs
• Definition Loss of firm value arising from
  financial distress
• Explicit bankruptcy costs lawyers and
  accountants fees, etc.
• Implicit bankruptcy costs loss of sales, loss of
  trade credit, key employees, etc.
• Implication Firms with intangible assets and
  attractive growth opportunities will shy away
  from debt financing.

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Asymmetric-Information Costs

• Definition Costs of overcoming two types of
  information problems
• Adverse selection separating good from bad risks
  before execution of financial contract.
• Moral hazard insuring economic agents with
  delegated authority live up to contract terms.

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Asymmetric-Information Costs Adverse Selection

• Example Lemons Problems
• If investors can't distinguish good and bad
  securities, they will offer only average value.
• Good securities will be undervalued, so firms
  won't issue them bad securities will be
  overvalued, so too many will be issued.
• Investors do not want bad securities, so market
  falls apart.

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Asymmetric-Information Costs Adverse Selection

• Solutions to Lemons Problems
• Information production by disinterested third
  party
• Limited by free-rider problem
• Signaling
• collateral
• net worth
• reputation (a form of collateral)
• Government regulation
• Financial intermediation

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Financial Frictions in Action Pecking Order
Theory of Financing

• Adverse selection make some financing vehicles
  much more expensive than others.
• Example
• Managers want to issue new stock only when it is
  overvalued.
• Stock issuance is bad signal.
• Stock issuance causes price of outstanding stock
  to fall.
• Decline in stock price is part of cost of
  external finance.

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Financial Frictions in Action Pecking Order
Theory of Financing

• Firms use financing with smallest adverse
  selection costs (i.e., smallest information
  asymmetries) first.
• Pecking order
• Internal Funds
• Bank Debt
• Public Debt
• Public Equity

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Financial Frictions in Action Pecking Order
Theory of Financing

• Implications
• Financial slack is valuable.
• Observed capital structures reflect availability
  of positive net present value projects.
• No optimal debt/equity mix.

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Asymmetric-Information Costs Moral Hazard

• Principal-Agent Problem Principal designates
  agent to act on his behalf. Because monitoring/
  disciplining are costly, agent has scope to
  pursue his own interest at the expense of
  principal.
• Examples
• Separation of ownership from control allows
  managers to use firm resources to pursue personal
  interests instead of maximizing shareholder
  value.
• Separation of savers/investors allows investors
  to use surplus funds to pursue personal interests
  rather than accepting capital projects with
  highest NPV.

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Asymmetric-Information Costs Moral Hazard

• Solutions to moral-hazard problems
• Debt finance
• Motivates managers to maximize shareholder value
  by absorbing free cash flow
• Reduces costs of monitoring investors
• Government regulation
• Financial intermediation

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Asymmetric-Information Costs Moral Hazard

• Features of debt contracts that reduce
  moral-hazard problems
• Restrictive covenants
• Collateral requirements
• Net worth requirements
• Reputation (a form of collateral or net worth)

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Catalysts in Financial Markets
Economic and Political Shocks

• ? Technology

? Transactions Costs ? Information Costs
? Relative Return from Granting Rents
? Taxation and Regulation
? Shape of financialintermediaries and markets
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Catalysts in Financial Markets

• Technological improvements
• Advances in finance and statistical theory
• Advances in computing speed, power, and storage
  space
• Advances in transportation and telecommunication

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Regulation of Financial Markets

• Justification (according to Mishkin)
• 1. Increase Information to Investors
  
• Decreases adverse selection/moral hazard problems
  
• 2. Ensuring Soundness of Financial Intermediaries
• Chartering, reporting requirements, restrictions
  on assets and activities, deposit insurance, and
  anti-competition measures.
• 3. Improving Monetary Control
• Reserve requirements
• Deposit insurance

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Regulation of Financial Markets

• Two better reasons (in MDVs view)
• Hysterical political reaction to real/ perceived
  crisis
• Rent seeking
• Use of government power to secure return above
  opportunity cost (economic rents)

Technological and political/economic shocks
alter returns to taxing/regulating.
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Regulation of Financial MarketsGlass-Steagall
Act (1933)

• Example of hysterical political reaction to real
  or perceived crisis plus rent seeking
• Glass-Steagall (1933)
• Established firewall between investment and
  commercial banking.
• Based on idea that investment banking would
  increase risk of commercial banking and conflict
  of interest existed.

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Regulation of Financial MarketsGlass-Steagall
Act (1933)

• But...
• Portfolio theory indicates combining commercial
  and investment banking actually reduces risk.
• Evidence from 1920s indicates bonds underwritten
  by investment bank subs of commercial banks
  performed well (no evidence of massive fraud).
• Public benefits from economies of scope available
  by combining commercial and investment banking.

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Recent Trends in Financial Markets

1. Financial entrepreneurship
2. Globalization
3. Democratization
4. Deregulation
5. Evolution of financial intermediation

All these trends have their roots in
technological or political/economic shocks!
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Questions over
Money and Banking Mr. Vaughan