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 them2. 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

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Principal Money Market Instruments

6

Capital Market Instruments

An Economic Analysis of Financial Structure

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Sources of External Finance in U.S

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Sources of Foreign External Finance

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Sources of Foreign External Finance

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Eight Basic Facts

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 are the most important source of external funds

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Eight Basic Facts (cont’d)

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

8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers

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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?

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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

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Transaction Costs

Financial intermediaries have evolved to reduce transaction costs– Economies of scale– Expertise

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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

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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

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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

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Asymmetric Information

Adverse selection occurs before the transaction

Moral hazard arises after the transaction

Agency theory analyses how asymmetric information problems affect economic behavior

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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

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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

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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

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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

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Moral Hazard in Debt Markets

Borrowers have incentives to take on projects that are riskier than the lenders would like

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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

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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

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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

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Financial Intermediaries

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Size of Financial Intermediaries

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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

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Regulatory Agencies

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Regulatory Agencies

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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Events in U.S. Financial Crises

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Events in Mexican, East Asian, and Argentine Financial Crises

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Summary: Asymmetric Information Problems and Tools to Solve Them