6p the structure of finance-2

7/31/2019 6p the Structure of Finance-2

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The Structure of Finance

How Things Work in Banking


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Flow of Funds

Largest lender Households

Largest borrower Governments andBusinesses

Indirect Finance Saver to Bank (or otherintermediate) to Borrower. Ex. Car Loan

Direct Finance Saver to Borrower Ex.Buying bonds from GE


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Flow of Funds

Direct Finance

Borrower sells securities.

Securities become liabilities for seller Assets for buyer.

Asset because someone owes you money.

Liability because you have to pay someonemoney.


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Structure of Financial Markets

Debt and Equity Markets

Primary and Secondary Markets Investment Banks underwritesecurities 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 (mortgages are longer-term debut)


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Debt Instruments Bond or mortgage,contractual agreement, pays fixed amount for agiven period

Maturity is term of contract until expiration Less than year Short-term

More than 10 years Long-term

In between length Intermediate-term


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Primary Market new securities are sold, notusually sold to the public, going public

Investment Banks guarantees a price then they sell to

the public.Secondary Market NYSE, NASDAQ

Brokers agents of investors

Dealers buy and sell securities at given prices


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Corporations only acquire new fundsselling securities the first time

Not on sales in secondary market.

Secondary markets increase securitiesliquidity.

Provides info about market price in primary

market.


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Exchanges Centralized in one location, ex.NYSE, CBT

Over-the-Counter (OTC) Markets Different

locations with inventory of securities, butconnected online so not much different thanexchanges in difference of prices by location.


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Money Market Instruments

Think short-term borrowing and lending,less than a year.

U.S. T-BillsInitially sell at discount ofmaturity price, no interest payments.

Most liquid instrument

No possibility of default, govt can print money to

meet obligations Negotiable Bank CDsDebt sold by banks,

CDs are short term, different than a savingsaccount because of time period restraint.


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Commercial Paper Short-term debtissued by large banks and corporations,ex. Microsoft and GM

Bankers Acceptances Issued by firmand back by a bank for a fee.International Check

Repurchase Agreements short term loanusing T-Bill as collateral


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Federal Funds usually overnight loansbetween banks of deposits at the FED

Eurodollars Dollar help outside U.S which

mean less oversight


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Capital Market Instruments

U.S. Govt Securities Long term bonds Most widely accepted world wide.

U.S. Govt Agency Securities Ex. Ginnie Mae,

Federal Farm Credit Bank Backed by government

State and Local Govt Bonds Municipal bonds,have tax advantages

Consumer & Bank Commercial Loans Carloans, home loans, etc. mostly by banks


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Internationalization of Financial Markets

Foreign Bonds: sold in a foreign countryand denominated in that countrys currency

Eurobond: bond denominated in a currency

other than that of the country in which it issold

Eurocurrencies: foreign currencies

deposited in banks outside the homecountry

World Stock Markets


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Basics Truths of Financing

o Issuing marketable debt and equity securities isnot the primary way in which businesses financetheir operations

o Indirect finance is many times more importantthan direct finance


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o Financial intermediaries are the most importantsource of external funds

o The financial system is a heavily regulated sectorof the economy (a lot effective)


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o Collateral is a prevalent feature of debt contracts

o Your house for the mortgage, car for auto loan

o Debt contracts are complicated legal documentsthat place substantial restrictive covenants onborrowers

o What you can and cant do with the money.


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Transaction Costs

Acquiring resources can be expensive

There are benefits to volume

Financial intermediaries have evolved toreduce transaction costs

Economies of scale

Expertise


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Transaction Costs

Economies of scale

Transaction costs decrease as costs spreadacross more transactions grow (size or number)

Ex. Mutual Funds buy large number of shares


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Asymmetric Information

Adverse selection occurs before the transaction

Moral hazard arises after the transaction

Agency theory analyses how asymmetricinformation problems affect economic behavior


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Adverse Selection:The Lemons Problem

If quality cannot be assessed, the buyer is willing topay 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 allthat is left in the market is poor quality items

It leads to a market not functioning properly


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Adverse Selection:The Lemons Problem

George Akerlof: Nobel prize winner, lemonsproblems and Used Cars

Used car buyers have little information. Pay averageof value of lemons and peaches

Sellers know the quality of there care

Average price for sellers of peaches is to low and willnot sell car

Average price for sellers of lemons is high and willwant to sell car.

Result few quality cars sold, value of used carsdeclines


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Adverse Selection: Solutions

Private production and sale of information Free-rider problem

Government regulation to increase

information Reduces uncertainty from withholdinginformation

Financial intermediation Banks specialize in assessing risk

Collateral and net worth Skin in the game


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Moral Hazard in Equity Contracts

Called the Principal-Agent Problem

Principal stockholders

Agent - managers

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 One party can takeadvantage of costly actions without paying

Government regulation to increase information

Limits ability to hide behavior


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Moral Hazard in Debt Markets

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

Most debt contracts require the borrower to pay a fixed

amount (interest) and keep any cash flow above thisamount.

For example, what if a firm owes $100m in interest, nextquarter, but only has $90? It is essentially bankrupt. The

firm has nothing to lose by looking for risky projects toraise the needed cash.


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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

Banks provide the above


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Conflicts of Interest in Financing

Moral hazard problem caused by economies ofscope

Economies of scope: lower costs by offering more

services. 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 Ex: Certifying and sales


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Conflicts of Interest in Financing

Problem buyers assume information is accurate

Financial markets do not channel funds into productiveinvestment 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 InvestmentBanking

Information produced by researching companies is

used to underwrite the securities. The bank isattempting to simultaneously serve two client groupswhose information needs differ.

Spinning occurs when an investment bank allocates

hot, but underpriced, IPOs to executives of othercompanies in return for their companies future

business


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Morgan Stanley memo 1992: Our objective. . . Is

to adopt a policy, fully understood by the entirefirm, including the Research Department, that we

do not make negative or controversial commentsabout our clients as a matter of sound businesspractice.


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Auditing and Consulting in Accounting Firms

Auditors may be willing to skew their judgments andopinions to win consulting business

Auditors may be auditing information systems or taxand financial plans put in place by their nonauditcounterparts

Auditors may provide an overly favorable audit tosolicit or retain audit business

Nothing wrong here, everythings fine


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Conflicts of Interest: Remedies

Sarbanes-Oxley Act of 2002 (Public AccountingReturn and Investor Protection Act)

Increases supervisory oversight to monitor and prevent

conflicts of interest Establishes a Public Company Accounting Oversight

Board

Increases the SECs budget

Makes it illegal for a registered public accounting firm toprovide any nonaudit service to a clientcontemporaneously with an impermissible audit


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Sarbanes-Oxley Act of 2002

Beefs up criminal charges for white-collar crime andobstruction of official investigations

Requires the CEO and CFO to certify that financialstatements and disclosures are accurate

Requires members of the audit committee to beindependent

However, very expensive for small firms ($100mil or less) to comply $824,000


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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 tocontract with at least 3 independent research firms thatwould provide research to their brokerage customers


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Financial Crises andAggregate Economic Activity

Look back in history, crises can be causedby:

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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Look online for a web chapter on Conflictof Interest

http://www.nytimes.com/2007/06/13/opinion/13carlat.html

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