chapter 9 book: an economic analysis of financial future Flashcards
eight basic facts that we need to explain in order to understand how the financial system works
- Stocks are not the most important source of external financing for businesses
- Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
- Indirect finance is many times more important than direct finance
- Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses
- The financial system is among the most heavily regulated sectors of the economy
- Only large, well-established corporations have easy access to securities markets to finance their activities
- Collateral is a prevalent feature of debt contracts for both households and businesses
- Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower
indirect finance
involves the activities of financial intermediaries
direct finance
businesses raise funds directly from lenders in financial markets
involves the sale to households of marketable securities such as stocks and bonds
the most important source to finance business
Financial intermediaries
particularly banks
the role of financial intermediaries is more important in industrialized or countries industrializing?
countries industrializing
why do governments regulate financial markets?
to promote the provision of information
to ensure the stability of the financial system
collateral
property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments
secured debt
Collateralized debt
predominant form of household debt
is widely used in business borrowing as well
unsecured debt
not collateralized
restrictive covenants
provisions on bond or loan contracts (debt contracts)
restrict and specify certain activities that the borrower can engage in
how transactions costs are wack if you have almost no funds available
Because you have only a small amount of funds available, you can make only a restricted number of investments
a large number of small transactions would result in very high transaction costs.
That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk
solutions to transaction costs
bundle the funds of many investors together so that they can take advantage of economies of scale
expertise
economies of scale
the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases
reduces transaction costs for each individual investor
also important in lowering the costs of things such as computer technology that financial institutions need to accomplish their tasks
The clearest example of a financial intermediary that arose because of economies of scale
A mutual fund
A mutual fund
a financial intermediary that sells shares to individuals
invests the proceeds in bonds or stocks
take advantage of lower transaction costs
benefits of financial intermediaries expertise
expertise lowers transaction costs
provides its customers with liquidity services
liquidity services
services that make it easier for customers to conduct transaction
Asymmetric information
one party s having insufficient knowledge about the other party involved in a transaction to make accurate decisions
Adverse selection
asymmetric information problem that occurs before the transaction occurs
the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction
Moral hazard
arises after the transaction occurs
the lender runs the risk that the borrower will engage in activities that are undesirable from the lender s point of view because they make it less likely that the loan will be paid back
lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan
agency theory
The analysis of how asymmetric information problems affect economic behaviour
why marketable securities are not the primary source of financing for businesses and why are stocks not the most important source of financing for Canadian businesses?
The presence of the lemons problem
stock and bond markets far from being effective in channelling funds from savers to borrower
what makes the lemon problem go away?
the absence of asymmetric information
The solution to the adverse selection problem in financial markets
to eliminate asymmetric information by furnishing people supplying funds with full details about the individuals or firms seeking to finance their investment activities
free-rider problem
occurs when people who do not pay for information take advantage of the information that other people have paid for
suggests that the private sale of information will be only a partial solution to the lemons problem
independent audits
In Canada, government regulation exists that requires firms selling securities to have independent audits
accounting firms certify that the firm adheres to standard accounting principles and discloses information about sales, assets, and earnings
what explains why financial markets are among the most heavily regulated sectors in the economy (fact 5)?
The asymmetric information problem of adverse selection in financial markets
the role of financial intermediaries to combat adverse selection and asymmetric information
financial intermediary such as a bank becomes an expert in producing information about firms
it can sort out good credit risks from bad ones
it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market
facts 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses?
financial intermediary such as a bank becomes an expert in producing information about firms
it can sort out good credit risks from bad ones
it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market
why are large firms more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route? (fact 6)
improvements in information technology
lending role of financial institutions such as banks have declined
The better known a corporation is, the more information about its activities is available in the marketplace
easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one
why is collateral an important feature of debt contracts (fact 7)?
Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults
Collateral reduces the consequences of adverse selection because it reduces the lender s losses in the event of a default
Net worth (also called equity capital)
the difference between a firm’s assets and its liabilities
can perform a similar role to collateral
Equity contracts
such as common stock
claims to a share in the profits and assets of a business
the principal agent problem
moral hazard that affects equity contracts
separation of ownership between stockholders and managers
managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals)
why does the the principal agent problem arise?
because managers have more information about their activities and actual profits than stockholders do
costly state verification
auditing the firm frequently and checking on what the management is doing
goal is to reduce moral hazard problems by engaging in a particular type of information production and monitoring of the firm’s activities
this shit is costly to do and makes the equity contract less desirable
One financial intermediary that helps reduce the moral hazard arising from the principal agent problem
venture capital firm
venture capital firm
pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses
does not allow stock traders to free ride
they let their own people monitor stuff
a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals
debt contract
benefits of a debt contract to the lender when it comes to moral hazard
they don’t really care as long as the firm can make the payments they owe
it is less risky than being a shareholder
they have priority in receiving their share of funds
when is the risk of moral hazard or the temptation of do some dumb shit greatly reduced as a borrower?
When borrowers have more at stake because their net worth in the business or the collateral they have pledged to the lender is high
they have a lot to lose
incentive-compatible debt contract
it aligns the incentives of the borrower with those of the lender
including collaterals
four types of restrictive covenants that achieve moral hazard reduction
Covenants to discourage undesirable behaviour
Covenants to encourage desirable behaviour
Covenants to keep collateral valuable
Covenants to provide information about its activities periodically in the form of quarterly financial statements
problems with restrictive covenants?
they will never be 100% effective
they must be monitored and enforced
which tools solve adverse selection and which fact do they explain?
List of facts:
- Stocks are not the most important source of external financing.
- Marketable securities are not the primary source of finance.
- Indirect finance is more important than direct finance.
- Banks are the most important source of external funds.
- The financial system is heavily regulated.
- Only large, well-established firms have easy access to securities markets.
- Collateral is prevalent in debt contracts.
- Debt contracts have numerous restrictive covenants.
Private production and sale of information (facts 1 and 2)
Government regulation to increase information (fact 5)
Financial intermediation (facts 3,4 and 6)
Collateral and net worth (fact 7)
which tools solve Moral hazard in equity contracts (principal agent problem) and which fact do they explain?
List of facts:
- Stocks are not the most important source of external financing.
- Marketable securities are not the primary source of finance.
- Indirect finance is more important than direct finance.
- Banks are the most important source of external funds.
- The financial system is heavily regulated.
- Only large, well-established firms have easy access to securities markets.
- Collateral is prevalent in debt contracts.
- Debt contracts have numerous restrictive covenants.
Production of information: monitoring (fact 1)
Government regulation to increase information (fact 5)
Financial intermediation (fact 3)
Debt contracts (fact 1)
which tools solve Moral hazard in debt contracts and which fact do they explain?
List of facts
- Stocks are not the most important source of external financing.
- Marketable securities are not the primary source of finance.
- Indirect finance is more important than direct finance.
- Banks are the most important source of external funds.
- The financial system is heavily regulated.
- Only large, well-established firms have easy access to securities markets.
- Collateral is prevalent in debt contracts.
- Debt contracts have numerous restrictive covenants.
Net worth and collateral (fact 7
Monitoring and enforcement of restrictive covenants (fact 8)
Financial intermediation (facts 3 and 4)
financial repression
many developing countries or ex-communist countries experiencing very low rates of growth because their financial systems are underdeveloped
state owned banks
bank owned by their government
in many developing and transition countries, there is absence of profit motive
how can financial institutions obtain economies of scope? how will it be beneficial to these institutions?
By providing multiple financial services to their customers
they can lower the cost of information production for each service by applying one information resource to many different services
downsides of economies of scope made from financial institutions
it also creates potential costs in terms of conflicts of interests
The potentially competing interests of those services may lead an individual or firm to conceal information or disseminate misleading information
Why Do We Care About Conflicts of Interest?
because a substantial reduction in the quality of information in financial markets increases asymmetric information problems
prevents financial markets from channelling funds into productive investment opportunities
financial markets and the economy become less efficient
which types of financial service activities have led to prominent conflict-of-interest problems in financial markets in recent years
underwriting and research in investment banks
auditing and consulting in accounting firms
credit assessment and consulting in credit-rating agencies
the two tasks performed by investment banks
They research companies issuing securities
they underwrite these securities by selling them to the public on behalf of the issuing corporations
why does underwriting and research in investment banks lead to conflicts of interest?
A conflict of interest arises between the brokerage and underwriting services the banks want serve the security-issuing firms and the security-buying investors at the same time
these have difference information needs but often get the same info
Issuers benefit from optimistic research, whereas investors desire unbiased research
also, there is Spinning
Spinning
occurs when an investment bank allocates hot, but underpriced, initial public offerings (IPOs) to executives of other companies in return for their companies future business with the investment bank
is a form of kickback meant to persuade executives to use that investment bank because hot IPOs typically immediately rise in price after they are first purchased
initial public offerings (IPOs)
shares of newly issued stock
when does auditing arise in conflicts of interest? why?
when an accounting firm provides its client with both auditing services and non-audit consulting services
auditors may be willing to skew their judgements and opinions to win consulting business from these same clients
auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts within the firm,
these may be not down to criticize the systems or advice
how can credit ratings give rise to conflicts of interests?
when multiple users with divergent interests depend on the credit ratings
investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer
how can credit ratings AGENCIES give rise to conflicts of interests?
conflict of interest may arise when credit-rating agencies also provide ancillary consulting services
if debt issuers often ask rating agencies to advise them on how to structure their debt issues, the credit-rating agencies would experience a conflict of interest similar to the one found in accounting firms that provide both auditing and consulting services
the credit-rating agencies would be audit- ing their own work
Two major policy measures implemented in the United States to deal with conflicts of interest
the Sarbanes-Oxley Act
the Global Legal Settlement
the Sarbanes-Oxley Act
This act increased supervisory oversight to monitor and prevent conflicts of interest
established a Public Company Accounting Oversight Board (PCAOB) to supervise accounting firms and ensure that audits are independent and controlled for quality
increased the SEC s budget to supervise securities markets
beefed up criminal charges for white-collar crime and obstruction of official investigations
CEOs, CFOs, and auditors must certify the accuracy of periodic financial statements and disclosures of the firm
members of the audit committee cannot be managers in the company or receive any consulting or advisory fee from the company
GLOBAL LEGAL SETTLEMENT OF 2002
this settlement directly reduced conflicts of interest
It required investment banks to sever the links between research and securities underwriting
It banned spinning
It required investment banks to make their analysts recommendations public
