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Eight Basic Facts

…A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities…. Eight Basic Facts. Stocks are not most important source of external financing

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Eight Basic Facts

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  1. …A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities…

  2. Eight Basic Facts • Stocks are not most important source of external financing • Issuing marketable securities (debt and equity) not the primary way businesses finance operations • Indirect finance is much more important than direct finance • Financial intermediaries  the most important source of external funds • The financial system is heavily regulated … you ain’t seen noth’n’ yet • Only large, well-established corporations have (had) easy access to securities markets to finance their activities  need reputation and net worth • Debt contracts: trust … but collateral • Debt contracts: trust … but restrictive covenants

  3. Why Intermediaries? … Transaction Costs • Economies of scale • Expertise: information specialists to handle adverse selection and moral hazard problems • What went wrong? • Perverse incentives • Asymmetric Information Problems • Adverse selection before a transaction • “Lemons problem” • Moral hazard arises after the transaction • Managers and principal - agent problem • Debt and risky behavior • Conflicts of interest • Agency theory: how asymmetric information affects economic behavior

  4. Countering Adverse Selection • Private production and sale of information • Free-rider problem • Perverse incentives: who pays Moody’s? • Government regulation to increase information • Financial intermediation: information specialists • Collateral and net worth Countering Moral Hazard: Principal - Agent • Align manager incentives with owners’ • Stock, stock options • Monitor  venture capital firms • Avoid being owner: debt not equity

  5. Moral Hazard in Debt Markets • Borrowers have incentives to take on risky projects Countering Moral Hazard in Debt Contracts • Net worth and collateral • Incentive compatible … loss is borrower’s, not lenders • Enforce Restrictive Covenants • Keep collateral valuable • Provide information

  6. Economies of Scope and Conflicts of Interest • Underwriting and Research in (what was) Investment Banking • Information produced by researching arm used to underwrite the securities. The bank simultaneously serves two client groups whose information needs differ. • Spinning: an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business • Auditing and Consulting in Accounting Firms • Auditors skew opinions to win consulting business • May audit information systems or tax and financial plans put in place by their consulting counterparts • May provide an overly favorable audit to retain business Sarbanes-Oxley Act of 2002 Global Legal Settlement of 2002

  7. Financial Crises and Aggregate Economic Activity • Crises can be caused by: • Increases in interest rates • Increases in uncertainty • Asset market effects on balance sheets • A bursting bubble • Problems in the banking sector • Government fiscal imbalances Vicious spirals Financial crises we have known: 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930 - 33, 2008

  8. Bank Management • Liquidity Management excess reserves/secondary reserves/call loans • Asset Management: return(ROA)/risk/liquidity • Liability Management: CDs/Fed funds • Capital Adequacy Management: ROE • Credit Risk: Screen,Monitor,…,Collateral • Credit default swaps  regulatory arbitrage “The unbundling of credit risk probably should be a good thing, assuming the people picking up the elements of credit risk understand what they’re doing and the risks they’re incurring.” E. Gerald Corrigan, 1997 • Interest-rate Risk: • Gap Analysis/Duration Analysis

  9. Off-Balance-Sheet Activities • Loan sales (secondary loan participation) • Generation of fee income • Trading activities and risk management techniques • Futures, options, interest-rate swaps, foreign exchange • Speculation • Risk management techniques • Limits on exposure • Value at risk • Stress testing

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