Financial Markets & Institutions (Term IV) 2012

#3 Why Do Financial Institutions Exist?

Lecture Objectives
Why financial institutions exist and how they promote economic efficiency. Why financial markets have a given financial Structure in every economy in the World How & Why transaction costs influences the financial structure How & Why information costs influences the financial structure What is Asymmetric Information and related concepts of Adverse Selection and Moral Hazard
Dr. Kulbir Singh (IMT-Nagpur)

3-2

Lecture Objectives (cont.)
What is 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 Importance of FIs through case of China & Soviet Union To understand another type of MH: CoI
Dr. Kulbir Singh (IMT-Nagpur)

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etc. Kulbir Singh (IMT-Nagpur) 3-4 . Dr.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.

S. Dr. with the U. and Canada. although many aspects of these countries are quite different. the sources of financing are somewhat consistent. Kulbir Singh (IMT-Nagpur) 3-5 . Germany. being different in its focus on debt. • Notice that. Japan.Basic Facts About Financial Structure Throughout the World • The chart on the next slide how nonfinancial business attain external funding in the U..S.

Kulbir Singh (IMT-Nagpur) 15-6 .Sources of Foreign External Finance Dr.

Facts of Financial Structure 1. Insurance. Stocks are not the most important source of external financing for businesses. Households limited participation…lacks confidence Crowding out by Govt. In case of India… equity market is much larger than corporate bond market… yet stocks are not important source of external finance…. Kulbir Singh (IMT-Nagpur) 3-7 . bonds Dr.why???? (see Slide 8 & 10) Why debt market in India underdeveloped… Predominance of bank loans FII’s participation is limited Pension.

511 42.485 68% 2007-08 54. Kulbir Singh (IMT-Nagpur) 3-8 .197 46.863 174.Mean IPO Size 3 4 Private Placements Euro Issues (GDR/ADR) TOTAL Non-Equity Resources Non-Equity Resources(%) NA 172.298 149.500 46.701 33.400 NA 196.500 2.996 118.781 99% 2009-10 2.No.635 NA 261.485 2008-09 1.135 82% 2010-11* 2.082 21 99 173.068 40 827 147.of which IPOs .872 215.597 76% Dr. of IPOs .696 39 633 212.737 24.082 2.Resource Raised: India RESOURCE MOBILIZATION THROUGH THE PRIMARY MARKET MODE 1 2 Debt Equity .281 NA 176.595 85 501 118.

Kulbir Singh (IMT-Nagpur) 3-9 . (see Slide 10 & 12) Dr.Facts of Financial Structure 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.

Resource Raised: India… Dr. Kulbir Singh (IMT-Nagpur) Source: RBI Annual Report 2010-11 (pp. 41) 3-10 .

Financial intermediaries. Kulbir Singh (IMT-Nagpur) 3-11 . (see Slide 10 & 12) 4.Facts of Financial Structure 3. in which businesses raise funds directly from lenders in financial markets. are the most important source of external funds used to finance businesses. is many times more important than direct finance. which involves the activities of financial intermediaries. particularly banks. Indirect finance. (see Slide 12 & 13) Dr.

Resource Raised: India… Source: RBI Annual Report 2010-11 (pp. Kulbir Singh (IMT-Nagpur) 3-12 . 51) Dr.

pp.Resource Raised: India… Source: A Hundred Small Steps (Planning Commission). Kulbir Singh (IMT-Nagpur) 3-13 . 81) Dr.

Facts of Financial Structure 5. Only large. Kulbir Singh (IMT-Nagpur) 3-14 . well-established corporations have easy access to securities markets to finance their activities. The financial system is among the most heavily regulated sectors of economy. (see Slide 15) 6. (see Slide 16) Dr.

126) Dr. Kulbir Singh (IMT-Nagpur) 3-15 . pp.Source: A Hundred Small Steps (Planning Commission).

Dr. 20) 3-16 . Kulbir Singh (IMT-Nagpur) Source: Handbook of Statistics on Indian Securities Market 2010(SEBI). pp.

Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. Dr. Collateral is a prevalent feature of debt contracts for both households and businesses.Facts of Financial Structure 7. 8. Kulbir Singh (IMT-Nagpur) 3-17 .

50 / share (equity) No diversification Bonds even worse—most have a Rs1.000 size • In sum.Transactions Costs • Transactions costs influence financial structure – – – E. a Rs. 5. Kulbir Singh (IMT-Nagpur) 3-18 .000 investment only allows you to purchase 100 shares @ Rs. transactions costs can hinder flow of funds to people with productive investment opportunities • Percentage of Indian Households own any securities are small (see slide 19 & 20) Dr..g.

Source: RBI Annual Report 2010-11 pp. 173 Dr. Kulbir Singh (IMT-Nagpur) 3-19 .

Dr. Kulbir Singh (IMT-Nagpur) Source: A Hundred Small Steps (Planning Commission). pp. 52) 3-20 .

Take advantage of economies of scale (example: mutual funds) 2.Transactions Costs • Financial intermediaries make profits by reducing transactions costs 1. Kulbir Singh (IMT-Nagpur) 3-21 . Develop expertise to lower transactions costs • Also provides investors with liquidity. which explains Fact # 3 Dr.

Kulbir Singh (IMT-Nagpur) 3-22 . Information markets • In CF course.Asymmetric Information: Adverse Selection and Moral Hazard • Role of information in financial markets…. there is asymmetric informationa situation when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction Dr. assumed a world of symmetric information • In real market.

to begin to understand the implications of asymmetric information.Asymmetric Information: Adverse Selection and Moral Hazard • Asymmetric information can take on many forms. Kulbir Singh (IMT-Nagpur) 3-23 . However. and is quite complicated. we will focus on two specific forms: – Adverse selection – Moral hazard Dr.

Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected Dr.Asymmetric Information: Adverse Selection and Moral Hazard • Adverse Selection 1. Kulbir Singh (IMT-Nagpur) 3-24 . Before transaction occurs 3. Occurs when one party in a transaction has better information than the other party 2.

After transaction occurs 3. Kulbir Singh (IMT-Nagpur) 3-25 .Asymmetric Information: Adverse Selection and Moral Hazard • Moral Hazard 1. Occurs when one party has an incentive to behave differently once an agreement is made between parties 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Dr.

Kulbir Singh (IMT-Nagpur) 3-26 . Dr.Asymmetric Information: Adverse Selection and Moral Hazard • The analysis of how asymmetric information problems affect economic behavior is known as agency theory. • We will now use these ideas of adverse selection and moral hazard to explain how they influence financial structure.

Result: Good cars won’t be sold. If we can't distinguish between “good” and “bad” (lemons) used cars. • What helps us avoid this problem with used cars? 3-27 Dr.The Lemons Problem: How Adverse Selection Influences Financial Structure • Lemons Problem in Used Cars 1. Kulbir Singh (IMT-Nagpur) . we are willing pay only an average of good and bad car values 2. and the used car market will function inefficiently.

The Lemons Problem: How Adverse Selection Influences Financial Structure • Lemons Problem in Securities Markets 1. willing pay only average of good and bad securities’ value 2. If we can't distinguish between good and bad securities. Result: Good securities undervalued and firms won't issue them. Kulbir Singh (IMT-Nagpur) 3-28 . bad securities overvalued so too many issued Dr.

so market won't function well – – Explains Fact # 1 and # 2 Also explains Fact # 6: Less asymmetric inform. so smaller lemons problem Dr. Kulbir Singh (IMT-Nagpur) 3-29 .The Lemons Problem: How Adverse Selection Influences Financial Structure • Lemons Problem in Securities Markets 3. Investors won't want buy bad securities. for well known firms.

Kulbir Singh (IMT-Nagpur) 3-30 . Government Regulation to Increase Information (explains Fact # 5 – why financial mkts.Tools to Help Solve Adverse Selection (Lemons) Problems 1. Private Production and Sale of Information – Free-rider problem interferes with this solution – Can govt. disseminate such information to public? – Then what’s the solution??? 2. are among the most heavily regulated sectors in the economy) – …. annual audits of public corporations (although collapse of Enron & accounting scandal at Satyam Computers are shining examples of why this does not eliminate the problem Dr.does it work??? – For example.

) – Greater role of banks in develop’g countries… inform about private firms harder to get…greater role of fin. Financial Intermediation – Analogy to solution to lemons problem provided by used car dealers – Avoid free-rider problem by making private loans (explains Fact # 3-why indirect finance is so much more impt. use direct instead of indirect financing – pecking order hypothesis – Also explains fact #6 – large firms are more likely to Dr.why banks are the most impt.Tools to Help Solve Adverse Selection (Lemons) Problems 3. Kulbir Singh (IMT-Nagpur) 3-31 . source of external funds for financing businesses. than direct finance and # 4. Intermed.

Tools to Help Solve Adverse Selection (Lemons) Problems 4. Kulbir Singh (IMT-Nagpur) 3-32 . Collateral and Net Worth – Explains Fact # 7 Dr.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts • Moral Hazard in Equity Contracts: the Principal-Agent Problem 1. Managers act in own rather than stockholders' interest Dr. Result of separation of ownership by stockholders (principals) from control by managers (agents) 2. Kulbir Singh (IMT-Nagpur) 3-33 .

Dr. Suppose you become a silent partner in an ice cream store. providing 90% of the equity capital ($9. the store will make $50.000 of it. Ravi.000 after expenses.000). Kulbir Singh (IMT-Nagpur) 3-34 .How Moral Hazard Affects the Choice Between Debt and Equity Contracts An example of this problem is useful.000 and will act as the manager. The other owner. and you are entitled to $45. If Ravi works hard. provides the remaining $1.

give Ravi the proper incentives to work hard? Dr. relaxes. and even spends some of the “profit” on art for his office. Ravi doesn’t really value the $5.How Moral Hazard Affects the Choice Between Debt and Equity Contracts However. so he goes to the beach.000 (his part). as a 90% owner. Kulbir Singh (IMT-Nagpur) 3-35 . How do you.

Government Regulation to Increase Information 3.VC members on BoD • No free-ride on VC’s verification activities 4.. Debt Contracts • Contract structure allows reduced need to monitor managers…… explains fact #1 Dr. so.additional explanation for fact #1. Financial Intermediation (e.g.How Moral Hazard Affects the Choice Between Debt and Equity Contracts • Tools to Help Solve the Principal-Agent Problem 1. Production of Information: Monitoring • Costly state verification…. venture capital) • Eliminates moral hazard pbm…. 2.. Kulbir Singh (IMT-Nagpur) 3-36 .……fact #1explained • Free-rider problem decreases monitoring…. Makes equity contracts less desirable.

Dr. Let’s looks at a simple example.How Moral Hazard Influences Financial Structure in Debt Markets • Debt contracts are better than equity contracts… as debt reduces moral hazard problem… – ……but does it ELIMINATES nearly/ completely???? • In fact. This is important to understand. debt may create an incentive to take on very risky projects. Kulbir Singh (IMT-Nagpur) 3-37 .

but only has $90? It is essentially bankrupt. Dr.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. what if a firm owes $100 in interest. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash. • For example. Kulbir Singh (IMT-Nagpur) 3-38 .

Examples are covenants that … 1..provide information…. and easier it is for the firm or household to borrow.How Moral Hazard Influences Financial Structure in Debt Markets • Tools to Help Solve Moral Hazard in Debt Contracts 1. the greater the borrowers incentive to behave in the way the lender expects and desires.encourage desirable behavior….discourage undesirable behavior…. the smaller the moral – hazard problem in the debt contract.periodic reports…. 2.loan to finance specific activities 2.right to audit & inspect firm’s books anytime Dr. Monitoring and Enforcement of Restrictive Covenants. Net Worth & Collateral • Incentive compatible – greater the borrower’s net worth and collateral pledged. Home loan owner’s life insurance 3.keep collateral valuable……keep in good condition & in possession 4.. Kulbir Singh (IMT-Nagpur) 3-39 .

Kulbir Singh (IMT-Nagpur) 3-40 .How Moral Hazard Influences Financial Structure in Debt Markets • Tools to Help Solve Moral Hazard in Debt Contracts – Explains the fact #8 : Why debt contracts are often complicated legal documents with numerous restrictions on borrower’s behavior Dr.

• Explains Facts # 3 & #4 Dr. in debt contracts? NO. 4.How Moral Hazard Influences Financial Structure in Debt Markets • Tools to Help Solve Moral Hazard in Debt Contracts 3. Financial Intermediation . Kulbir Singh (IMT-Nagpur) 3-41 . Does restrictive covenants completely eliminate moral pbm. Why???? – Impossible to write covenants that rule out every risky activities – Borrowers will still find out loopholes in covenants to circumvent – Covenants need to be monitored and enforced – Monitoring and enforcement of covenants lead to free-rider pbm.banks & other intermediaries have special advantages in monitoring due their private loans and also eliminates free-rider pbm.

Kulbir Singh (IMT-Nagpur) 3-42 .Asymmetric Information Problems and Tools to Solve Them Dr.

poorly developed & corrupt legal system makes enforcement of Restr.. Kulbir Singh (IMT-Nagpur) 3-43 . Coven. Poor legal system……AS pbm arises… lenders seek more information about borrowers 2. • Financial repression leads to low growth. Weak accounting standards…. Why? • Two important tools to help solve AS and MH in credit market are: Collateral & restrictive covenants • Repressed system are marked with 1. financial systems are repressed……financial systems are underdeveloped. difficult Dr.Case: Financial Development and Economic Growth • In transition/developing economies.

@ below market rate Irs……. Kulbir Singh (IMT-Nagpur) • These factors explain why some nation poor or rich.thru state-owned development institutions …. 3-44 . & lend to borrowers with most productive investment opportunities..no incentive to allocate their capital to most productive uses.themselves or favored sectors……. • Repressed financial system are marked with 3. Financial institutions nationalized……. Government directs credit .Case: Financial Development and Economic Growth • Private FIs have an incentive to solve AS & MH pbms.. However…….O/C: less efficient investment and slower economic growth 4.retards provision of adequate information to the market place Dr. 5.. Inadequate government regulation…..

About creditors – Regulation of banks in formative stages – Banking sector is dominated by state-owned banks • Yet Chinese economy has enjoyed one of the highest growth rates in world in last 20 years? • How has China been able to grow so rapidly given its low level of financial development? Dr. – Legal systems are weak…financial contracts difficult to enforce – Accounting standards are lax… no high-quality inform. China’s financial development is still in an early stage. Kulbir Singh (IMT-Nagpur) 3-45 .Is China a Counter-example? • Even with its booming economy.

.Is China a Counter-example? • ANSWER – Highest savings rate……averaging 40% – Shifted underutilized labor from subsistence agriculture to productive industry sector • RESULT…. Kulbir Singh (IMT-Nagpur) 3-46 .high growth…due to – Huge increase in capital – Gains in productivity • But this will not run for a long-time.but ignored development of FIs during highgrowth periods of 1950s and 1960s Dr. Why? – Soviet Union……1950s & 1960s shared same situation as China today….

has announced that – State-owned banks will be privatized – Legal reforms in contracts & bankruptcy • MORAL FOR YOU….Is China a Counter-example? • MORAL FOR CHINA – Allocate capital more efficiently which requires to improve its financial system. Chinese govt. Dr. Kulbir Singh (IMT-Nagpur) 3-47 . – Financial Institutions are important for the development of an economy….

• So, we have understood…..
– WHY FINANCIAL INSTITUTIONS EXIST?!?!

Dr. Kulbir Singh (IMT-Nagpur)

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What Are Conflicts of Interest and Why Are They Important? • Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies of scope. • However, these services may be competing with one another, and this creates the potential for a conflict of interest.
Dr. Kulbir Singh (IMT-Nagpur)

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What Are Conflicts of Interest and Why Are They Important?
• The conflicts of interest may arise as the concealment of information for the dissemination of misleading information. • Why should we care this CoI? • Because a reduction in the quality of information increases the presence of symmetric information.

Dr. Kulbir Singh (IMT-Nagpur)

16-50

Dr.Ethics and Conflicts of Interest • Conflicts of interest generate incentives to provide false or misleading information. so that they are less likely to engage in unethical behavior. • One way to limit these conflicts is to make workers aware of the ethics issues at stake. This behavior is considered unethical. Kulbir Singh (IMT-Nagpur) 16-51 .

Types of Conflicts of Interest Three areas of financial service activities that harbor the greatest potential for generating conflicts of interest. Kulbir Singh (IMT-Nagpur) 16-52 . These are: – Underwriting and research in investment banking – Auditing and consulting in accounting firms – Credit assessment and consulting in credit-rating agencies Dr.

Underwriting and Research in Investment Banking • Some investment banks both underwrite new securities sold the public. and provide research (buy/sell recommendations) to the investing public • When revenues from underwriting exceed brokerage commissions. Dr. favorable research will attract more business. at the expense of unbiased recommendations to the investing public. Kulbir Singh (IMT-Nagpur) 16-53 .

Underwriting and Research in Investment Banking • In initial public offerings of equity. many of these shares are immediately sold for a profit (called spinning). This immediate “profit” may appear as nothing more than payment for future business. • Since most IPOs are underpriced. Kulbir Singh (IMT-Nagpur) 16-54 . underwriters direct the new shares as they wish. Dr. typically to their best clients or potential new clients.

Kulbir Singh (IMT-Nagpur) 16-55 . Queen. and Jack of the Internet” & – “Frank Quattrone and Spinning” Dr.Underwriting and Research in Investment Banking • Refer such two cases in the book: – “The King.

Dr.Auditing and Consulting in Accounting Firms • Role of auditors in public firms – to provide an unbiased view of the financial reports to reduce asymmetric information between the firm’s management and the investing public. Kulbir Singh (IMT-Nagpur) 16-56 . the auditor has an incentive to fudge the audit if the fees from other services are substantial. • By also providing management advisory services (such as systems support).

• In case of Satyam Computers.action? Dr. Kulbir Singh (IMT-Nagpur) 16-57 . the auditor may lose the auditing business as well.Auditing and Consulting in Accounting Firms • Auditors also have a conflict of interest since they are paid by the firm they audit. • A well known case of the failure of auditors to provide unbiased reports was Arthur Andersen’s audit of Enron. PricewaterhouseCoopers (PwC)…. If the auditor gives an unfavorable audit report.

have an incentive provide “better” ratings to attract business.Credit Assessment and Consulting in Credit-Rating Agencies • Bond investors rely on credit-rating agency assessment of firm’s debt (debt ratings). Agencies. ratings are only provided when the firm pays the agency. • However. • Rating agencies have also started providing firms with other services. then. Kulbir Singh (IMT-Nagpur) 16-58 . and have the same conflicts as auditors in this regard Dr.

What Has Been Done to Remedy Conflicts of Interest? Two major policies were implemented following the scandals of the late 1990s and early 2000s. Kulbir Singh (IMT-Nagpur) 16-59 . These are: – Sarbanes-Oxley Act of 2002 (USA) – Global Legal Settlement of 2002 (USA) Dr.

The act. 2. 3.Sarbanes-Oxley Act of 2002 Passed following the public outcry over corporate scandals. Established the Public Company Accounting Oversight Board to supervise accounting firms. has the following six major components: 1. Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing. Kulbir Singh (IMT-Nagpur) . Members of the board’s audit committee must be independent. in summary. 16-60 Dr.

Kulbir Singh (IMT-Nagpur) 16-61 . has the following six major components: 4. 5. Dr. Appropriated additional funding for the SEC.Sarbanes-Oxley Act of 2002 Passed following the public outcry over corporate scandals. Increased the charges for white-collar crimes and obstruction. Required the reporting of off-balance sheet activities. The act. 6. in summary.

Firms must make public analyst recommendations and target prices. Merrill Lynch.P. Morgan. investment banks .S. Lehman Brothers. 3. Goldman Sachs. Credit Suisse First Boston. Spinning is banned. Deutsche Bank. Kulbir Singh (IMT-Nagpur) 16-62 . Firms must severe the link between underwriting and research activities. Salomon Smith Barney. Morgan Stanley. 2.Global Legal Settlement of 2002 • This was a settlement reached between the New York Attorney General and several of the largest U.Bear Stearns. & UBS Warburg • The key terms of the agreement included: 1. Dr. J.

5.Global Legal Settlement of 2002 The key terms of the agreement included: 4. Brokerage firms required to obtain third-party. Dr.4 billion in fines. independent research for their clients. Kulbir Singh (IMT-Nagpur) 16-63 . $1.

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