Lecture 8 - Financial System
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This document provides an overview of key concepts related to the financial system including: - 8 basic facts about the global financial system such as the predominant role of banks and importance of debt over equity. - How transaction costs, asymmetric information, adverse selection, and moral hazard shape the structure and functioning of the financial system. - Tools used to address problems of adverse selection and moral hazard like monitoring, regulation, intermediation, collateral, and contract design. - Examples of how conflicts of interest and crises emerge from these issues and their economic impacts.
Lecture 8 - Financial System
- 1. An Economic Analysis of the Financial System Ryan Herzog, Ph.D. Associate Professor Economics
- 2. Preview • A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities.
- 3. Learning Objectives • Identify eight basic facts about the global financial system. • Summarize how transaction costs affect financial intermediaries. • Describe why asymmetric information leads to adverse selection and moral hazard. • Recognize adverse selection and summarize the ways in which they can be reduced.
- 4. Learning Objectives • Recognize the principal-agent problem arising from moral hazard in equity contracts and summarize the methods for reducing it. • Summarize the methods used to reduce moral hazard in debt contracts.
- 5. Basic Facts About Financial Structure 1. Stocks are not the most important sources of external financing for businesses. 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance is many times more important than direct finance 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.
- 7. Basic Facts About Financial Structure 5. The financial system is among the most heavily regulated sectors of the economy. 6. Only large, well-established corporations have easy access to securities markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers.
- 8. Transaction Costs • Financial intermediaries have evolved to reduce transaction costs. – Economies of scale – Expertise
- 9. Asymmetric Information: Adverse Selection and Moral Hazard • Adverse selection occurs before a transaction occurs. • Moral hazard arises after the transaction has developed. • Agency theory analyses how asymmetric information problems affect economic behavior.
- 10. The Lemons Problem: How Adverse Selection Influences Financial Structure • 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.
- 11. Tools to Help Solve Adverse Selection Problems • Private production and sale of information – Free-rider problem • Government regulation to increase information – Not always works to solve the adverse selection problem, explains Fact 5 • Financial intermediation – Explains facts 3, 4, & 6 • Collateral and net worth – Explains fact 7
- 12. The Enron Implosion • Enron Corporation declared bankruptcy in December 2001, up to that point the largest bankruptcy declaration in U.S. history • The Enron collapse illustrates that government regulation can lessen asymmetric information problems but cannot eliminate them. The Enron bankruptcy not only increased concerns in financial markets about the quality of accounting information supplied by corporations but also led to hardship for many of the firm’s former employees, who found that their pensions had become worthless
- 13. How Moral Hazard Affects the Choice Between Debt and Equity Contracts • Called the Principal-Agent Problem: – Principal: less information (stockholder) – Agent: more information (manager) • Separation of ownership and control of the firm – Managers pursue personal benefits and power rather than the profitability of the firm.
- 14. Tools to Help Solve the Principal-Agent Problem • Monitoring (Costly State Verification) – Free-rider problem – Fact 1 • Government regulation to increase information – Fact 5 • Financial Intermediation – Fact 3 • Debt Contracts – Fact 1
- 15. How Moral Hazard Influences Financial Structure in Debt Markets • Borrowers have incentives to take on projects that are riskier than the lenders would like. – This prevents the borrower from paying back the loan.
- 16. Tools to Help Solve Moral Hazard in Debt Contracts • 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
- 17. 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 b 7/22/2020 GONZAGA UNIVERSITY 17
- 18. When do Conflicts 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 7/22/2020 GONZAGA UNIVERSITY 18
- 19. When do Conflicts Arise? • 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. • KPMG attempts to end conflicts 7/22/2020 GONZAGA UNIVERSITY 19
- 20. Asymmetric Information Problems and Tools to Solve Them Asymmetric Information Problem Tools to Solve It Explains Fact Number Adverse selection Private production and sale of information 1, 2 Government regulation to increase information 5 Financial intermediation 3, 4, 6 Collateral and net worth 7 Moral hazard in equity contracts (principal–agent problem) Production of information: monitoring 1 Government regulation to increase information 5 Financial intermediation 3 Debt contracts 1
- 21. Asymmetric Information Problem Tools to Solve It Explains Fact Number Moral hazard in debt contracts Collateral and net worth 6, 7 Monitoring and enforcement of restrictive covenants 8 Financial intermediation 3, 4 Asymmetric Information Problems and Tools to Solve Them
- 22. Moral Hazard and Crises • What causes financial crises? – Major disruptions in the financial markets characterized by sharp declines in asset prices and the failures of many financial and non-financial firms • What impact due financial crises have on economic activity? • Studying past problems helps prevent future occurrences 7/22/2020 22
- 23. Financial Crises • Increases in interest rates – Only attracts rms with risky opportunities – Reduces capital investment • Asset market effects on balance sheets – A decline in the stock market lowers a corporations net worth, lenders decreases loans – Firms will make riskier investments – Decreasing price level decreases net worth (interest rates are generally nominal), firms debt burdens increase 7/22/2020 GONZAGA UNIVERSITY 23
- 24. Financial Crises • Problems in the banking sector – Bank panics start to occur • Government fiscal balances worsen – Further drivers up interest rates – Increases in uncertainty • Harder to screen good credit risks from bad risks • Concern over government/bank defaults 7/22/2020 GONZAGA UNIVERSITY 24
- 25. Great Depression • Start with a deterioration in bank's balance sheet, a sharp increase in interest rates, steep stock market decline, and increases in uncertainty (price level) • These increase the severity of adverse selection and moral hazard problems making it less attractive for lenders to lend • A decrease in lending leads to a decline in economic activity and investment 7/22/2020 GONZAGA UNIVERSITY 25
- 26. The Effects of Asymmetric Information • The decline in economic activity increases uncertainty in the banking sector and depositors begin to withdraw their funds • The decline in the number of banks allow other banks to raise interest rates even further • At this point firms and banks were sorted out by bankruptcy proceedings and asymmetric information decreased 7/22/2020 GONZAGA UNIVERSITY 26
- 27. Cases of Adverse Selection • Fannie Mae and Freddie Mac – Both entities were considered government sponsored enterprises with an implicit government guarantee. – Why would this create an adverse selection problem? 7/22/2020 GONZAGA UNIVERSITY 27
- 28. Too Big To Fail • A case of adverse selection: – Large financial institutions were too large to let fail. – A failure on a large institution would have caused the whole system to fail. • Lehman Brothers? 7/22/2020 GONZAGA UNIVERSITY 28
- 29. Financial Development and Economic Growth • Financial repression created by an institutional environment is characterized by: – Poor system of property rights (unable to use collateral efficiently) – Poor legal system (difficult for lenders to enforce restrictive covenants) – Weak accounting standards (less access to good information) – Government intervention through directed credit programs and state-owned banks (less incentive to proper channel funds to its most productive use)
- 30. Financial Development and Economic Growth • The financial systems in developing and transition countries face several difficulties that keep them from operating efficiently. • In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, absence of corruption) functions poorly, making it hard to use these two tools effectively.
- 31. The Tyranny of Collateral To use property, such as land or capital, as collateral, a person must legally own it. Unfortunately, it is extremely expensive and time-consuming for the poor in developing countries to make their ownership of property legal. When the financial system is unable to use collateral effectively, the adverse selection problem worsens because the lender needs even more information about the quality of the borrower in order to distinguish a good loan from a bad one. Little lending will take place, especially in transactions that involve collateral, such as mortgages.
- 32. Is China a Counterexample to the Importance of Financial Development? As China gets richer, the strategy of maintaining a high savings rate to support economic growth is unlikely to continue to work. China will need to allocate its capital more efficiently, which requires that it improve its financial system. The Chinese leadership is well aware of this challenge; the government has announced that state-owned banks are being put on the path to privatization.
Editor's Notes
- #22: 1. Stocks are not the most important source of external financing. 2. Marketable securities are not the primary source of financing. 3. Indirect finance is more important than direct finance. 4. Banks are the most important source of external funds. 5. The financial system is heavily regulated. 6. Only large, well-established firms have access to securities markets. 7. Collateral is prevalent in debt contracts. 8. Debt contracts have numerous restrictive covenants.