An Overview of the Financial System

1. An Overview of the Financial System

2. Function of Financial Markets 1.Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

3. Function of Financial Markets • Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds • Promotes economic efficiency by producing an efficient allocation of capital, which increases production • Directly improve the well-being of consumers by allowing them to time purchases better

4. Structure of Financial Markets • Debt and Equity Markets • Primary and Secondary Markets • Investment Banks underwrite securities in primary markets • Brokers and dealers work in secondary markets • Exchanges and Over-the-Counter (OTC) Markets • Money and Capital Markets • Money markets deal in short-term debt instruments • Capital markets deal in longer-term debt and equity instruments

5. Principal Money Market Instruments

6. Capital Market Instruments

7. An Economic Analysis of Financial Structure

8. Sources of External Finance in U.S

9. Sources of Foreign External Finance

10. Sources of Foreign External Finance

11. Eight Basic Facts • 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

12. Eight Basic Facts (cont’d) • 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

13. Demonstration • How will a buyer determine what to offer? • How will the seller determine what to charge? • What if I offered to buy at $800? • Will everyone sell? • What happens to the average value of the cars offered for sale when I offer $800?

14. Function of Financial Intermediaries Financial Intermediaries 1. Engage in process of indirect finance 2. More important source of finance than securities markets 3. Needed because of transactions costs and asymmetric information

15. Transaction Costs • Financial intermediaries have evolved to reduce transaction costs • Economies of scale • Expertise

16. Function of Financial Intermediaries Risk Sharing 1. Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation). 2. Also lower risk by helping people to diversify portfolios

17. Transaction Costs and Financial Structure Transaction costs hinder flow of funds to people with productive investment opportunities Financial intermediaries make profits by reducing transaction costs 1. Take advantage of economies of scale Example: Mutual Funds 2. Develop expertise to lower transaction costs Explains Fact 3

18. Asymmetric Information • “The secret of success is to know something nobody else knows” -Aristotle Onassis • Hot tip from the broker vs. insider trading • Lemons Problem (Akerlof) • The Nobel Laureates of 2001. http://www.nobel.se/economics/laureates/2001/index.html

19. Asymmetric Information • Adverse selection occurs before the transaction • Moral hazard arises after the transaction • Agency theory analyses how asymmetric information problems affect economic behavior

20. Adverse Selection: The Lemons Problem • If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality • Sellers of good quality items will not want to sell at the price for average quality • The buyer will decide not to buy at all because all that is left in the market is poor quality items • This problem explains fact 2 and partially explains fact 1

21. Adverse Selection: Solutions • Private production and sale of information • Free-rider problem • Government regulation to increase information • Fact 5 • Financial intermediation • Facts 3, 4, & 6 • Collateral and net worth • Fact 7

22. Moral Hazard in Equity Contracts • Called the Principal-Agent Problem • Separation of ownership and control of the firm • Managers pursue personal benefits and power rather than the profitability of the firm

23. Principal-Agent Problem: Solutions • Monitoring (Costly State Verification) • Free-rider problem • Fact 1 • Government regulation to increase information • Fact 5 • Financial Intermediation • Fact 3 • Debt Contracts • Fact 1

24. Moral Hazard in Debt Markets • Borrowers have incentives to take on projects that are riskier than the lenders would like

25. Moral Hazard: Solutions • Net worth and collateral • Incentive compatible • Monitoring and Enforcement of Restrictive Covenants • Discourage undesirable behavior • Encourage desirable behavior • Keep collateral valuable • Provide information • Financial Intermediation • Facts 3 & 4

27. Function of Financial Intermediaries: Indirect Finance • Lower transaction costs • Economies of scale • Liquidity services • Reduce Risk • Risk Sharing (Asset Transformation) • Diversification • Asymmetric Information • Adverse Selection (before the transaction)—more likely to select risky borrower • Moral Hazard (after the transaction)—less likely borrower will repay loan

28. Internationalization of Financial Markets • Foreign Bonds—sold in a foreign country and denominated in that country’s currency • Eurobond—bond denominated in a currency other than that of the country in which it is sold • Eurocurrencies—foreign currencies deposited in banks outside the home country • Eurodollars—U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks • World Stock Markets

29. Financial Intermediaries

30. Size of Financial Intermediaries

31. Regulation of the Financial System • To increase the information available to investors: • Reduce adverse selection and moral hazard problems • Reduce insider trading • To ensure the soundness of financial intermediaries: • Restrictions on entry • Disclosure • Restrictions on Assets and Activities • Deposit Insurance • Limits on Competition • Restrictions on Interest Rates

32. Regulatory Agencies

33. Regulatory Agencies

34. Conflicts of Interest • Type of moral hazard problem caused by economies of scope • Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives • A reduction in the quality of information in financial markets increases asymmetric information problems • Financial markets do not channel funds into productive investment opportunities • The economy is not as efficient as it could be

35. Why Do Conflicts of Interest Arise? • 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. • Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business

36. Why Do Conflicts of Interest Arise? (cont’d) • 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

37. Conflicts of Interest: Remedies • Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act) • Increases supervisory oversight to monitor and prevent conflicts of interest • Establishes a Public Company Accounting Oversight Board • Increases the SEC’s budget • Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit

38. Conflicts of Interest: Remedies (cont’d) • Sarbanes-Oxley Act of 2002 (cont’d) • Beefs up criminal charges for white-collar crime and obstruction of official investigations • Requires the CEO and CFO to certify that financial statements and disclosures are accurate • Requires members of the audit committee to be independent

39. Conflicts of Interest: Remedies (cont’d) • Global Legal Settlement of 2002 • Requires investment banks to sever the link between research and securities underwriting • Bans spinning • Imposes $1.4 billion in fines on accused investment banks • Requires investment banks to make their analysts’ recommendations public • Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that would provide research to their brokerage customers

40. Financial Development and Economic Growth Financial Repression Leads to Low Growth: Why? 1. Poor legal system 2. Weak accounting standards 3. Government directs credit 4. Financial institutions nationalized 5. Inadequate government regulation

41. Appendix • Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book. • They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.

42. Financial Crises and Aggregate Economic Activity • Crises can be caused by: • Increases in interest rates • Increases in uncertainty • Asset market effects on balance sheets • Problems in the banking sector • Government fiscal imbalances

43. Events in U.S. Financial Crises

44. Events in Mexican, East Asian, and Argentine Financial Crises

45. Summary: Asymmetric Information Problems and Tools to Solve Them