8 Flashcards
What is the most important source of external financing for businesses?
Financial intermediaries (like banks), not stocks or bonds
Do businesses primarily finance operations by issuing debt and equity securities?
No, issuing marketable securities (like stocks and bonds) is not the primary method of financing operations.
Which is more important: direct finance or indirect finance?
Indirect finance (through financial intermediaries) is many times more important than direct finance (through stocks or bonds).
How regulated is the financial system?
The financial system is one of the most heavily regulated sectors of the economy.
What is the most important source of external funds for businesses?
Banks and other financial intermediaries are the most important sources of external funding
Who has easy access to securities markets to finance their activities?
Only large, well-established corporations have easy access to securities markets.
What is collateral in a debt contract?
Collateral is property pledged to a lender to guarantee repayment of a loan.
What is the difference between secured and unsecured debt?
Secured debt: Backed by collateral (e.g., mortgage).
Unsecured debt: No collateral (e.g., credit card debt).
Why are debt contracts highly complex?
Debt contracts are long and detailed legal documents with restrictive covenants to regulate borrower activities.
Why do financial intermediaries exist?
To reduce transaction costs and provide efficient services for borrowing and lending.
How do financial intermediaries reduce transaction costs?
Economies of scale: Pool large funds to reduce per dollar cost.
Expertise: Provide financial advice and services.
Liquidity services: Make transactions easier (e.g., money market funds).
Why do transaction costs affect direct finance?
High brokerage fees and large denominations of stocks/bonds make it costly for individuals to participate in direct finance.
What is asymmetric information?
It occurs when one party (borrower) has more information than the other (lender), creating risk in lending.
Why do banks exist in the presence of asymmetric information?
Banks reduce asymmetric information by:
Screening borrowers before lending.
Monitoring borrower activities after lending.
How do financial intermediaries protect themselves from asymmetric information?
Require collateral.
Include restrictive covenants in loan agreements.
Perform credit checks.
Why do small businesses rely heavily on banks?
Small businesses lack access to securities markets and rely on bank loans for funding.
What is the role of economies of scale in finance?
It allows financial intermediaries to bundle funds, reducing per-unit transaction costs.
Why is the financial system heavily regulated?
protect consumers
reduce risk
prevent financial crises.
What are the two problems caused by asymmetric information?
Adverse selection (before the transaction)
Moral hazard (after the transaction)
What is adverse selection?
Adverse selection occurs before the transaction when:
Riskier borrowers are more likely to apply for loans.
Lenders may unknowingly give loans to high-risk borrowers.
What is moral hazard?
Moral hazard occurs after the transaction when:
The borrower may engage in risky activities that reduce the likelihood of repayment.
Lenders face the risk of default.
What does agency theory analyze?
Agency theory analyzes how asymmetric information impacts economic behavior between two parties (borrowers and lenders).
What is Akerlof’s “lemons problem” in adverse selection?
In a used car market:
Buyers can’t determine car quality.
Sellers of good cars leave the market.
Only low-quality cars (lemons) remain.
This leads to market failure.
How does Akerlof’s lemons problem relate to financial markets?
Borrowers with high risk are more likely to seek loans.
Lenders cannot easily identify good borrowers.
Good borrowers may leave the market, reducing overall loan quality.
What are four solutions to adverse selection in financial markets?
Private production and sale of information (e.g., credit rating agencies).
Government regulation to improve information flow.
Financial intermediation (banks) to screen borrowers.
Collateral and net worth to secure loans.
What is the free-rider problem in adverse selection?
Investors avoid paying for information but still benefit from it.
This reduces the incentive to produce information.
How does government regulation reduce adverse selection?
Mandatory disclosure of financial information.
Audits to ensure accurate reporting.
Protects lenders by increasing transparency
Why do banks help reduce adverse selection?
Banks conduct private screening and loan evaluation.
They avoid the free-rider problem by keeping loans private.
This explains why indirect finance is more common
How does collateral solve adverse selection?
Collateral is pledged property that guarantees loan repayment.
High-risk borrowers are less likely to apply if collateral is required.
How does net worth reduce adverse selection?
Net worth = Assets - Liabilities.
High net worth firms are less likely to default, reducing lender risk.
Which facts do the solutions to adverse selection explain?
Fact 3, 4, 6: Banks dominate finance due to private screening.
Fact 5: Government regulations improve information flow.
Fact 7: Collateral reduces lender risk.
Why do large, well-established firms have easier access to finance?
They have higher net worth and better credit history.
This reduces adverse selection risk for lenders.
What happened in the Enron Implosion?
Enron Corporation (energy trading company) was the 7th largest in the U.S. in Aug 2000.
Filed bankruptcy in Dec 2001 due to accounting fraud (hiding debt).
Several executives were jailed.
Largest bankruptcy in U.S. history at that time.
What lesson did the Enron scandal teach?
Government regulation can reduce asymmetric information problems but cannot eliminate them.
Managers can hide financial problems, making it hard for investors to know a company’s true value.
What is the Principal-Agent Problem in equity contracts?
Principal (stockholders) = Own the company but have less information.
Agent (managers) = Control the company and have more information.
Conflict: Managers may pursue personal benefits instead of maximizing shareholder value.
Why does the Principal-Agent Problem occur?
Separation of ownership and control.
Stockholders want profits;
Managers may prioritize personal benefits and power.
What is costly state verification in solving the Principal-Agent Problem?
Monitoring managers through frequent audits, management checks, etc.
It is costly and leads to a free-rider problem.
Free-riders benefit without paying for monitoring.
How does the free-rider problem affect monitoring?
Some shareholders pay for audits/monitoring.
Others benefit from the audit without contributing.
This reduces the incentive to monitor.
How does government regulation help solve the Principal-Agent Problem?
Government regulation increases information transparency.
Punishes fraudulent behavior (like Enron).
However, catching fraud is still challenging.
How does financial intermediation reduce the Principal-Agent Problem?
Example: Venture capital firms invest directly in startups.
They monitor activities closely because they own a stake.
Reduces the free-rider problem.
How do debt contracts reduce the Principal-Agent Problem?
Debt contracts require fixed repayments regardless of performance.
If the firm performs well -> no monitoring.
If the firm underperforms -> lender increases monitoring.
Why do debt contracts still have moral hazard issues?
Borrowers may take on riskier projects than lenders would like.
This increases the chance of default.
Lenders still face moral hazard despite fixed payments.
How does the Enron scandal relate to moral hazard?
Managers hid the company’s true financial status.
This is an example of moral hazard in equity contracts.
Investors suffered major losses.
Which fact does the Principal-Agent Problem relate to most?
Fact 1: Stocks are not the most important source of external financing.
Fact 5: Government regulation is heavily involved in financial markets.
How does net worth and collateral reduce moral hazard in debt contracts?
Involves the borrower in losses, reducing the incentive for risky investments.
Aligns the interests of lender and borrower.
This is called incentive-compatible behavior.
What are the four types of restrictive covenants in debt contracts?
Discourage undesirable behavior (e.g. high-risk investments).
Encourage desirable behavior (e.g. maintaining positive cash flow).
Keep collateral valuable (e.g. maintaining assets).
Provide information (e.g. regular financial reports).
Why is monitoring and enforcing restrictive covenants important?
Prevents borrowers from engaging in risky activities.
Ensures collateral value is maintained.
Reduces free-rider problems by requiring constant monitoring.
How does financial intermediation solve moral hazard in debt contracts?
Banks provide private loans that are not publicly traded.
This eliminates free-riding because no third party can benefit from monitoring without contributing.
Direct loans => better monitoring.
Relates to Facts 3 and 4 (importance of intermediaries).
What is a conflict of interest in financial markets?
When financial institutions provide multiple services (auditing, consulting, underwriting), their objectives may conflict.
This can result in misleading information to the public.
Increases asymmetric information in the market.
Why are conflicts of interest harmful in financial markets?
Reduces the quality of information in the market.
Financial markets may fail to allocate funds to productive investments.
Decreases efficiency in the economy.
What is the conflict of interest in investment banks?
Investment banks perform two conflicting roles:
- Research companies issuing securities.
- Underwrite securities and sell them to the public.
The bank may bias information to secure higher underwriting revenues.
What is “spinning” in investment banking?
Spinning occurs when banks allocate under-priced IPO shares to third-party companies in exchange for future business.
This biases the market and misleads investors.
What conflict of interest exists in auditing and consulting firms?
Auditors may skew their judgments to secure consulting business.
They may provide favorable audits to retain clients.
This leads to misleading financial information.
How do credit rating agencies face conflicts of interest?
Issuers of securities pay credit agencies to get a credit rating.
Agencies may provide favorable ratings to keep business.
This reduces the reliability of credit ratings.
How do conflicts of interest increase asymmetric information?
Misleading information causes investors to make poor investment decisions.
Funds may be misallocated, reducing economic efficiency.
Markets become less reliable.
