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Hsiangping H i i T i Tsai Spring 2013 Master
Suppose you invented the iRobot and you plan to produce it.
Walter inherited lots of funds
With financial markets,
you, Walter and the economy would all be better off. An understanding of General Structure and Operation of the Financial System is a good start!
O Overview i
Overview of the Financial System • Direct Finance/Indirect Finance Why are Financial Intermediaries (FIs) Special? They reduce • Transaction i costs/Risk/Asymmetric / i k/ i Information f i How Asymmetric Information Influences the Financial Structure? • Facts about Financial Structure/Tools to Solve the Problem Why Does the Financial System Receive Special Regulatory Attention? • Investor Protection/Ensure the Soundness of FIs
1 The Financial System: An Overview 1.
Indirect Finance 5 .Flow of Funds through the Financial System: Direct Finance vs.
they may never get together g 6 .Function of Financial Markets Function: Direct Finance (直接金融) Channeling of funds (Fig 2.1) Also called securities markets Why is this ‘channeling of funds’ so impo t nt? important? Because savers (lenders) ≠ entrepreneurs (borrowers) AND Without financial markets.
Structure of Financial Markets It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters. … • Nature: Debt Markets vs vs. Equity Markets • Seasoning: Primary Market vs. Over-theCounter • Original Maturity: Money Markets vs. Secondary Market • Secondary Markets: Exchanges vs. Capital Markets 7 .
. total value was $20.Nature Debt Markets • Short-Term (maturity < 1 year) • Long-Term (maturity > 10 year) • Intermediate term (maturity in-between) • In U.5 trillion at the end of 2009 • Disadvantage: residual claim • Advantage: share the extra profit of the firm 8 ..S. total value was $52.4 trillion at the end of 2009 Equity Markets • Pay dividends.S. in theory forever • Represents an ownership claim in the firm • In U.
Seasoning: A new issue or not Primary Market • New security issues sold to initial buyers • Typically involves an investment bank who underwrites the offering Secondary Market • Previously-issued securities are resold (traded) • Note: N t Issuing I i fi firms DO NOT get t any money from f the th secondary d market • Involves both brokers and dealers (do you know the difference?) ) • Classification of the secondary market • Functions of the secondary market 9 .
10 . (e.. Taiwan Stock Exchange (TWSE) ) Over-the-Counter (OTC) Markets • Dealers at different locations buy and sell. New York Stock Exchange(NYSE).g.Secondary Markets Classification Exchanges • Trades conducted in central locations (e.g.. the market for Treasury securities. Foreign Exchange Markets).
The Secondary y Market Two Crucial Functions Provide Liquidity • making it easy to buy and sell the securities of the companies Establish a Price • for the securities in the Seasoned-Equity Offerings (SEOs) • A note: t I Initial iti l P Public bli Off Offering i (IPO) 11 .
Original Maturity Money Market • Short-Term (maturity < 1 year) Capital Market • Long-Term (maturity > 1 year) • Best known capital market securities • Bonds & Stocks 12 .
.2 Why are Financial Intermediaries Special? 2.
Without FIs: Direct Investment Equity q y & Debt Households (net savers) C h Cash Corporations (net borrowers) 14 .
FIs’ Specialness Without FIs: Low level of fund flows. Information costs Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquidity Substantial price risk 15 .
With FIs FI Households Cash (Brokers) Corporations Equity q y & Debt FI (Asset Transformers) Deposits/Insurance D it /I Policies C h Cash 16 .
Functions of FIs Brokerage Direct Finance Direct Finance Indirect Finance Asset Transformer Other Special Services 17 .
Merrill Lynch. Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings 18 .Functions of FIs.g.Brokerage Brokers Acting as an agent for investors e.
Functions of FIs.Asset Transformer Purchase primary securities by selling financial claims to households These secondary securities (financial claims sold to households) often more marketable Transformation of financial risk Examples: Banks: deposits Insurance Companies: insurance policies Mutual Funds: mutual fund shares Investment banks: Stocks and bonds 19 .
investments in bonds/stocks / Banks Visa. Visa Master… Master Denomination intermediation Payment Services 20 . Banks. loans Mutual funds vs.Other Special Services Maturity Intermediation Banks: deposits vs.
Indirect Finance 21 .Flow of Funds through the Financial System: Direct Finance vs.
1 71 WHY? Transaction Costs Risk i k Sh Sharing i ( (Asset Transformation) f i ) Asymmetric y Information 22 .Indirect Finance is FAR MORE IMPORTANT than Direct Finance The fact: Fig 7.
Sources of External Funds 23 .
g. to t 24 .000 $1 000 loan • High costs freeze out individual lenders Can anyone come to the rescue? • FIs can. • So the lender decides to obtain a deposit account • Additionally.Transaction Costs The loan contract • e. e g costs $500 for a $1. can Why? Wh ? • Economies of scale: the reduction in transaction costs. Additi ll FI FIs provide id liquidity li idit services i t customers..
• In a sense.Risk Sharing (Asset Transformation) Risk sharing • A benefit from ‘low transaction costs’ • FIs help reduce the risk exposure of investors (e. investors Examples of risk sharing • Banks (deposits) • Insurance Companies (insurance policies) 25 .. risky assets are turned into safer assets for investors.g. depositors) • Also called ‘asset transformation’.
Asymmetric Information Definition • The borrower has better info f about the investment projects (potential returns & risks) than the lender does. It creates two problems • Adverse selection • Moral hazard (conflict of interest) FIs have expertise • to reduce information p problems 26 .
GetQ Aunt ( (Aunt G) ) rich-Quick • Similar problems occur with insurance where he e unhealthy h lth people l want t their th i known k medical problems covered 27 .Adverse Selection • B f Before transaction t ti occurs Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan • Loan decisions to Conservative Aunt (Aunt C) vs.
. the borrower has incentive to act in his/her own interest rather than the lender’s interest 28 . with insurance.Moral Hazard Aft transaction After t ti occurs The risk ( (hazard) ) that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back. back Again.g. people may engage in risky i k activities ti iti only l after ft b being i i insured d Also called ‘conflict of interest’ • • • e.
FIs Help Reduce Asymmetric Information FIs have expertise to produce information Expertise in Screening out bad credit risks from good ones (reduce loss from adverse selection) Expertise in monitoring the borrowers (reduce loss from moral hazard) 29 .
3. How Asymmetric Information Influences the Financial Structure ? .
6. 5. well-established firms have access to securities markets Collateral is prevalent in debt contracts Debt contracts have numerous restrictive covenants 31 .1 71 1. Marketable securities are not the primary source of finance 3. Indirect finance is more important than direct finance 4 Banks are the most important source of external funds 4. 7. 8. Stocks are not the most important source of external financing 2. The financial system is heavily regulated Only large.Facts about Financial Structure throughout the World Evidence E id f from Figure Fi Table T bl 7.
Sources of External Funds for Businesses 32 .
33 .Asymmetric Information: Adverse Selection and Moral Hazard We will now use these ideas of adverse selection and moral hazard to explain how they influence financial structure.
The Lemons Problem: How Adverse Selection Influences Financial Structure (1/2) Lemons Problem in Used Cars 1. and the used car market will function inefficiently. 2. If we can't distinguish g between “g good” and “bad” (lemons) used cars. • What helps us avoid this problem with used cars? 34 . we are willing pay only an average of good and bad car values Result: Good cars won’t be sold.
3. . . If we can't distinguish g between good g and bad securities. so market won't function well 35 2. bad securities overvalued so too many issued Investors won't buy y bad securities.The Lemons Problem: How Adverse Selection Influences Financial Structure (2/2) Lemons Problem in Securities Markets 1. willing pay only average of good and bad securities’ value Result: Good securities undervalued and firms won't issue them.
. a c g WHY? Collateral and Net Worth • Reduce the consequences of adverse selection 36 . Ex annual audits of public corporations Financial Intermediation • Make private loans (Avoid free-rider problem) rather than buy stocks/bonds from the open market • Large firms (well-known corporations) are more likely to use direct d ect instead stead of o indirect d ect financing.Tools to Help Solve Adverse Selection (Lemons) Problems Private Production and Sale of Information • Free-rider problem interferes with this solution Government Regulation to Increase Information • Increase the information available to investors • Ex.
37 . Result of separation of ownership by stockholders (principals) from control by managers (agents) Managers g act in own rather than stockholders' interest 2.How Moral Hazard Affects the Choice Between Debt and Equity Contracts (1/3) Moral Hazard in Equity Contracts: the Principal-Agent Problem 1.
The other owner. so he goes to the beach. Steve doesn’t really value the $5. and p some of the “profit” p on art for his even spends office.000 (his part). • However.000 and will act as the manager.000 of it. provides the remaining $1. and you are entitled to $45. store providing 90% of the equity capital ($9. • How do you. If Ste e works Steve o k hard.How Moral Hazard Affects the Choice Between Debt and Equity Contracts (2/3) A example: An l Equity E it • Suppose you become a silent partner in an ice cream store.000 $50 000 after expenses. h d the store to e will ill make m ke $50. relaxes. as a 90% owner. give Steve the proper incentives to work hard? 38 .000). Steve.
debt d b i is still ill subject bj to moral l hazard. h d In fact. debt may create an incentive to take on very risky projects.How Moral Hazard Affects the Choice Between Debt and Equity Contracts (3/3) Tools to Help Solve the Principal-Agent Principal Agent Problem (Equity) • Production of Information: Monitoring • Government Regulation to Increase Information • Financial Intermediation (e. • Most debt contracts require the borrower to pay a fixed amount (interest). so the borrower can keep any cash flow above this amount. venture capital) • Debt D bt C Contracts t t • Explains why debt (rather than equity) is the most important source of financing for business • However. 39 .g.
000 (requiring a 10% interest rate) he needs to set up his business. With your money. 40 . but Steve get a lot more you loss $9. but Steve loses • Failure: y nothing or $1. • YOU MAY DECIDE NOT TO MAKE THE LOAN.000 at most.How Moral Hazard Influences Financial Structure in Debt Markets (1/2) An example: Debt • Example: Suppose you lend Steve the $9.000. LOAN • Success: you get 10%. Steve may decide to use it for an innovation of diet ice cream (which is riskier) instead.
How Moral Hazard Influences Financial Structure in Debt Markets (2/2) Tools to Help Solve Moral Hazard in Debt Contracts • Net Worth • Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that … g undesirable behavior • discourage • encourage desirable behavior • keep collateral valuable • provide information • Financial Intermediation—banks and other intermediaries have special advantages in monitoring 41 .
Asymmetric Information Problems and Tools to Solve Them 42 .
4. Why Does the Financial System Receive Special Regulatory Attention? 43 .
Regulation of the Financial System Main reasons for regulation Investor protection p Information Disclosure: Increase information available to investors Ensure the soundness of financial intermediaries Information Disclosure Restrictions on Entry Restrictions on Activities Deposit Insurance 44 .
2012. G Eakins. Erederic ede c S S. Chapters 2 & 7 45 . Chapter 1. Fi i l Institutions Management. a s. Mishkin s and a d Stanley S a ey G. 2008 Financial 2008. 6th edition. Financial a ca Markets and Institutions. 0 .Reference Anthony A h Saunders S d and d Marcia M i Millon Mill C Conett. 6th edition.
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