1. Financial System and Economic Growth Flashcards
Make-up of Financial System
Financial assets, financial institutions, financial markets, financial services
Classifications of Financial Markets
- By Nature of Claim: Debt v Equity
- By Maturity of Claim: Money v Capital
- By Seasoning of Claim: Primary v Secondary
- By Timing of Delivery: Cash Spot v Derivatives
- By Organisational Structure: Auction v Over-thecounter
How do Well-Functioning Financial Systems Accelerate Economic Growth?
- Allocating funds to their most productive uses.
How do Well-Functioning Financial Systems Accelerate Economic Growth? (Low to Intermediate Levels of Financial Depth)
- There is a positive relationship between the size of the financial system and economic growth.
How do Well-Functioning Financial Systems Accelerate Economic Growth? (High Levels of Financial Depth)
- More finance is associated with a higher likelihood of financial crises and lower growth.
What can a Financial System do?
- Record transactions.
- Reduce Transaction Costs e.g pooling funds.
- Trade, transform and manage risks
- Reduce Information costs e.g screening projects and monitoring investments.
Examples of Institutional Quality (regulation, policy) matters
- Property rights protection and contracts enforcement e.g collateral, covenants, corruption.
- Information provision (transparency): reducing asymmetric information.
- Soundness of Financial institutions: deposit insurance, chartering process
- Health competition: branching, restrictions on interest rates.
How can Financial Markets promote efficient allocation of funds?
- Facilitate price discovery: disseminate information.
- Reduce transaction costs: agglomeration and standardised trading mechanisms.
- Execute clearing and arrangements.
What are the challenges when financial markets promote efficient allocation of funds?
Information asymmetry with transaction costs.
What Information asymmetries are there across financial markets?
- Asset sellers are better informed than buyers.
- Borrowers know more about their own likelihood of repayment than lenders.
- Firms know more about their costs and risks than investors or the government.
- Agents take actions that are party unobservable. (Stakeholders).
Adverse Selection in financial transactions
- Occurs before.
- One side has better information than the other (insurance v buyers)
- Cost of information (screen ability and free-rider) aggravates the problem
- Akerlof’s market for lemons theory.
How can the Lemons problem be applied to Security markets?
- Investors can’t distinguish the quality of securities (uniformly distributed) and pay only the average value.
- Good (low risk) securities tends to be undervalued and issued less.
- Bad ones overvalued and issued more.
- Investors know and would not buy bad securities.
- Market cannot function.
- Therefore, equity is expensive to issue.
- Only large, established firms have access to securities markets.
When does Moral Hazard occur in a financial transaction?
- One side has incentive to deviate from the commitment.
- E.g. Borrowers v Lenders, Manager v Lenders/Shareholders, Insurance v Buyers.
- Cost of information (verifiability of state or action and free-rider) aggravates the problem.
- Principal-Agent Problem.
How can Financial Intermediaries Promote Efficient Allocation of Funds?
- Reduce transaction costs.
- E.g. Economies of Scale: Trade in blocs, pooling diversification, toolboxes. E.g. Expertise: e.g. equipments and knowledge.
E.g. Liquidity services for investors
E.g. Achieve Economies of Scope - lower cost of information production, but conflict of interest. - Reduce Asymmetric Information Problems
- E.g. Adverse Selection: screening and private information production, private loans (pecking order hypothesis)
E.g. Moral Hazard: monitoring and restrictive contracts, venture capital. - Financial intermediaries allow for small players in the market.
What Asymmetric Information Problems are Related to Features of Financial Systems?
- Stocks are not the most important source of external financing (Debts > Equities)
- Marketable securities are not the primary source of financing (Low Bonds + Equities)
- Indirect finance is still more important than direct finance (bonds+equities increase)
- Banks are still the most important source of external funds (bank/other credits dominate)
- Financial system is heavily regulated (unincentivise)
- Large, well established firms have easier access to securities markets financing.
- Collateral is prevalent in debt contracts (secured v unsecured debt)
- Debt contracts have substantial restrictive covenants.
What are the characteristics of financial markets and institutions?
They involve moving huge quantities of money, affect the profits of business and affect the types of goods and services produced in an economy.
Financial Markets Definition
Markets in which funds are transferred from those who have excess funds available to those who have a shortage of available funds.
Bond Definition
A debt security that promises to make payments periodically for a specified period of time.
Stock definition
A security that is a claim on the earnings and assets of a corporation.
Role of Financial Intermediaries
- Act as middlemen, borrowing funds from those who have saved and lending these funds to others.
- Play an important role in determining the quantity of money in the economy.
- Help promote a more efficient and dynamic economy.
Securities Definition
Securities are assets for the person who buys them, but liabilities for the individual/firm that sells them.
Money Market Definition
The market in which short-term debt instruments are traded.
Liquidity Services Definition
Banks providing depositors with checking accounts that enable them to pay their bills easily.
Economies of Scale in Financial Intermediaries
They can substantially reduce transaction costs per dollar of transactions because their large size.
Adverse Selection Example
When a potential borrower are most likely to default are the ones most actively seeking a loan.
Moral Hazard Example
When a borrower engages in activities that make it less likely that the loan will be repaid.
Conflict of Interest Definition
When one party in a financial contract has incentives to act in its own interest rather than in the interests of the other party.
Economies of Scope Definition
A financial institution that can achieve cost saving by engaging in multiple activities.
Lenders actions in Adverse Selection Problem
- May make a disproportionate amount of loans to bad credit risks.
- May refuse loans to individuals with low net worth.
- Reluctant to make loans that are not secured by collateral.
Characteristics of a Bank
- Has the ability to profit from the information it produces.
- Avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market.
- Becomes an expert in determining good firms from bad firms.
Moral Hazard is a problem associated with debt and equity contracts arising from…
- Borrowers incentive to undertake highly risky investments.
- Owners inability to ensure that managers will act in the owners interest.
Examples of Financial Institutions
Banks, insurance companies, finance companies
SVB Mid Quarter Q1 23 Strategy Update
- Securities Portfolio Sale and Capital Raising: The group sold its available-for-sale securities to restructure its balance sheet. Additionally, plans were made to sell common and convertible preferred stocks.
- High Uninsured Deposits: A large portion of SVB’s deposits were uninsured, making them more sensitive to shifts in depositor confidence.
- Client Base Concentration: A significant percentage of SVB’s deposits came from technology and life science/healthcare sectors, leading to increased risk due to the lack of diversification.
- Asset-Liability Mismatch: Investments in held-to-maturity securities, using excess post-pandemic funds, led to a mismatch as deposit outflows increased unexpectedly.
- Bank Closure Due to Rapid Withdrawals: Following the restructuring announcement, rapid depositor withdrawals occurred, leading to regulatory closure and FDIC receivership.
- Venture Capital Slowdown and Interest Rate Impact: A decline in venture capital activities and rising interest rates significantly affected the bank’s financial stability, with increased borrowing and reduced deposits.
SVB Shutdown FT
- SVB Shutdown: Silicon Valley Bank was shut down by U.S. regulators on March 10, 2023.
- Bank’s Size: It was the 16th-largest bank in the U.S., primarily serving tech startups.
- Liquidity and Insolvency Issues: The closure was due to inadequate liquidity and insolvency.
- FDIC as Receiver: The Federal Deposit Insurance Corporation (FDIC) was appointed as receiver.
- Depositor Access to Funds: Insured depositors were assured access to their funds by March 13, 2023.
- Share Price Drop: SVB’s shares fell 66% in premarket trade before trading was halted.
- Tech Community Impact: The shutdown raised concerns in the tech sector, particularly among startups.
Assets and Deposits: As of December 31, 2022, SVB had about $209 billion in assets and $175.4 billion in deposits.
AT1 Bonds
- Credit Suisse’s AT1 bonds, valued at over $17 billion, were written down to zero by the Swiss regulator as part of a rescue merger with UBS.
- AT1 bonds, also known as contingent convertibles or CoCo bonds, are designed to absorb shocks if a bank’s capital falls below a certain level, and can be converted into equity or written off.
- These bonds are considered the riskiest type of bank-issued bond and typically offer higher returns.
- In the Credit Suisse case, the Swiss regulator’s decision allowed shareholders to receive compensation, but left AT1 bondholders with nothing, contrary to the usual hierarchy where bondholders are paid before shareholders.
- This decision has caused a drop in the value of other European banks’ AT1 bonds and raised concerns about the future of the AT1 bond market, making investors wary of purchasing such bonds.
What do activities in financial markets directly impact?
- Individuals wealth
- Behaviour of businesses
- Efficiency of economy
What are the three main financial markets?
- Bond market: where interest rates are determined
- Stock market: has a major effect on people’s wealth and on firm’s investment decisions.
- Foreign Exchange Market: fluctuations in FX rate have major consequences on economy in question.
Why do banks and other FIs play crucial role in improving the efficiency of the economy?
- They channel funds from people who may not put them to productive use to people who can do so (financial intermediary)
What does money and monetary policy have an influence on?
- Inflation, business cycles and interest rates.
Definition of a Security
- A claim on the issuer’s future income or assets.
Definition of an Asset
- Any financial claim or piece of property that is subject to ownership.
Definition of a Bond
- A debt security that promises to make periodic payments for a specific amount of time.
Interest Rate Definition
- The cost of borrowing or the price paid for the rental of funds.
Definition of a Stock
- Represents a share of ownership in a corporation
Definition of a Financial Intermediaries
- Institutions that borrow funds from people who have saved and in turn make loans to people who need funds.
- FIs that acquire funds by issuing liabilities and use the funds to acquire assets by purchasing securities or making loans.
Definition of Aggregate Output
- Measure of this is GDP
- The market value of all final goods and services produced in a country during the course of the year.
Definition of Aggregate Income
- Total income of factors of production (land, labour, capital) from producing goods and services in the economy during year.
- Best thought to equal Aggregate Output
Basic Function of Financial Markets
- To channel funds from savers who have an excess of funds to spenders who have a shortage of funds.
- Achieved by either direct or indirect finance
Direct Finance
- Borrowers borrow funds directly from lenders by selling them securities.
Indirect Finance
- Involves a financial intermediary that stands between the lender-savers and borrow-spenders and helps channel funds from one to the other.
How does indirect finance impact the economy and society?
- Improves the economic welfare in society.
- Allow funds to move from people who have no productive investment opportunities to those who have these opportunities, thus financial markets contribute to economic efficiency.
What can financial markets be classified as?
- Debt and Equity Markets
- Primary and Secondary Markets
- Exchanges and OTC Markets
- Money and Capital Markets
What are the principal money market instruments?
- Debt instruments with maturities of less than a year.
- US Treasury Bills, Negotiable bank certificates of deposit, commercial paper, repurchase agreements, federal funds.
What are the principal capital market instruments?
- Debt and equity instruments with maturities greater than one year.
- Stocks, mortgages, corporate bonds, US govt securities, state and local govt bonds and consumer and bank commercial loans.
How do F Intermediaries play an important role in the financial system?
- Reduce transaction costs.
- Allow risk sharing
- Solve problems created by adverse selection and moral hazard.
- Thus increasing economic efficiency
Evaluation to the point of F intermediaries play important role in financial system
- Economies of scope created can lead to a conflict of interest causing less efficiency.
What are the three principal categories for financial intermediaries?
- Banks, contractual savings institutions, investment intermediaries
Who fall into banks?
- Commercial banks, saving and loan associations, mutual savings banks, credit unions.
Who fall into contractual savings institutions?
- Life insurance companies, fire and casualty insurance companies, pension funds
Who fall into investment intermediaries?
- Finance companies, mutual funds, money market mutual funds, hedge funds and investment banks.
Why do governments regulate financial markets and financial intermediaries?
- Increase information available to investors and to ensure soundness of financial system.
What regulation is In place to help tackle thus?
- Disclosure of information to the public.
- Restrictions on who can set up a financial intermediary
- Restrictions on what assets financial intermediaries can hold
- Provision of deposit insurance
- Limits on competition
- Restrictions on interest rates
What are banks’ primary liabilities?
- Source of funds
- Deposits
What are banks’ primary assets?
- Uses of funds
- Business and consumer loans, mortgages, government securities, municipal bonds.
What are contractual savings institutions primary liabilities?
- Premiums from policies
What are contractual savings institutions primary assets?
Corporate bonds and mortgages, municipal bonds, stock, government securities
What are investment intermediaries primary liabilities?
- Commercial paper, stocks, bonds, shares, partnership participation
What are investment intermediaries primary assets?
- Consumer and business loans, stocks, bonds, money market instruments, loans, FX
Conflict of Interest
A moral hazard problem which occurs when someone has multiple objectives which may conflict each other.
Moral Hazard Definition
- Problem created by asymmetric information after the transaction has occurred.
- Risk that the borrower may engage in hidden activities that are undesirable from a lenders perspective. Therefore loan less likely to be paid back.
Adverse Selection Definition
- Problem created by asymmetric information before the transaction occurs.
- When potential borrowers who are most likely to produce an undesirable outcome actively seek a loan and thus more likely to be selected.
Diversification Definition
- Investing in a portfolio of assets whose returns of not always move together, with result that overall risk is lower than for individual assets.
- Explains risk sharing
- Risk averse, risk loving
Transaction Costs
- The time and money spent in carrying out financial transactions.
Capital Defintion
- Wealth, either financial or physical, employed to produce more wealth.
Primary Market
- Where new issues of a security, such as bond or stock, are sold to initial buyers by corp or govt borrowing the funds.
Secondary Market
- Where securities can be resold.
- FTSE 100, NYSE
How can adverse selection be solved?
- Private production and sale of information.
- Govt regs to increase information.
- Financial intermediation
- Collateral and net worth
How can moral hazard in equity contracts be solved?
- Can be seen as the principal agent problem.
- Production of information: monitoring
- Govt regs to increase information
- FI
- Debt Contracts
How can moral hazard be solved in debt contracts?
- Collateral and net worth
- FI
- Monitoring and enforcement of restrictive covenants
Enron 2001 Issue
- Engaged in transactions, keeping debt and financial contracts off its balance sheet to hide financial difficulty.
- Govt regulation can lessen information asymmetry but not eliminate it.
- Adverse Selection Problem: secured $1.5b of funding.
How do Transaction Costs impact direct involvement in financial markets?
- They freeze many small savers and borrowers out of the market.
How can F intermediaries take advantage in reducing TC’s?
- Economies of scale and are better able to develop expertise, leading to lower TC’s and enabling savers and borrowers to benefits from the existence of financial markets.
Free-Rider Problem in Adverse Selection
- Occurs when people who do not pay for the information take advantage of information that other people have paid for.
- Explains why FIs, particularly banks, play a more important role in financing activities of businesses than do security markets.
Moral Hazard/Principal-Agent Problem in Equity Contracts
- Occurs because managers (agents) have less incentive to maximise profits than stockholders (principals).
- Explains why debt contracts are more prevalent in FMs
Tyranny of Collateral
- Explains why poor countries can’t access financial markets.
- People in developing countries are bound by corruption and lack of collateral and therefore cannot start businesses or afford to take out a mortgage for a house.
