Fin 320- Structure Of The Financial System

Front 1

Structure of Interest Rates. Why should we care?

Back 1

- Yields offered by debt securities vary according to a particular structure
- Some debt securities have higher yields than others.
-Investors need to understand why yields vary because they make better investment decisions
-Companies and government agencies need to under why yields vary when deciding how much return (yield) to give when selling new debt securities

Front 2

Characteristics of Debt Securities

Back 2

1. Credit (default) risk
2. Liquidity
3. Tax Status
4. Special Provisions
5. Term to maturity

Front 3

Explain general differences amongst debt securities

Back 3

-Debt securities have different yields because they have different characteristics
-In general, securities with unfavorable characteristics will offer higher yields (rewards) to attract investors

Front 4

What is a default?

Back 4

Failure of the debt security issuer to make the promised payments to the holder of the security

Front 5

Default risk

Back 5

To the investor, default risk is the uncertainty in cash flows arising from possibility that the issuer fails to make promised payments
-With the exception of the U.S. government, all issuers have default risk
-Some issuers have greater default risk than others
-Default risk is an undesirable characteristic

Front 6

Structure of the Financial System Learning objectives

Back 6

List the basic facts about financial structure throughout the world
Explain how transaction costs influence financial structure
Explain how adverse selection influences financial structure
Explain how moral hazard affects the choice between debt and equity contracts
Explain how moral hazard influences financial structure in debt markets
Describe tools used to solve adverse selection, and moral hazard in equity and debt contracts

Front 7

Facts of Financial Structure (1-4)

Back 7

1. Stocks are not the most important source 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, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

Front 8

Facts of Financial Structure (5-8)

Back 8

5. The financial system is among the most heavily regulated sectors of 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 for both households 
and businesses.
8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

Front 9

Which of the following is NOT one of the eight basic facts about financial structure?

A. The financial system is among the most heavily regulated sectors of the economy
B. Issuing marketable securities is the primary way businesses finance their operations
C. Indirect finance is many times more important than direct finance
D. Financial intermediaries are the most important source of external funds to finance businesses

Back 9

B

Front 10

Transaction cost:

Back 10

Time and money spent in carrying out financial transactions

Front 11

For individual investors, transaction costs can easily outweigh return from lending funds. Example?

Back 11

$1000 to lend for 1 year at 10% interest, legal cost of drawing up contract = $500

Front 12

FIs specialize in conducting financial transactions. Specialization allows FIs to:

Back 12

Develop expertise in cost reduction
Reduce cost through large volume transactions (economies of scale)

Front 13

Why is indirect finance is more important than direct finance?

Back 13

Because FIs reduce transaction costs, they are able to channel funds to productive investment opportunities. What does this explain?

Front 14

Adverse Selection

Back 14

-Occurs when potential borrowers (more generally, parties seeking funds) who are most likely to produce adverse outcomes are the ones most likely to seek loans and be selected
-Before transaction occurs

Front 15

Moral Hazard

Back 15

Risk (hazard) that borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because those activities make it more likely that the loan will not be repaid
After transaction occurs

Front 16

If bad credit risks are the ones who most actively seek loans and therefore receive them from financial intermediaries, then financial intermediaries face the problem of ______ .

A. Moral hazard
B. Adverse selection
C. Free-riding
D. Costly state verification

Back 16

B

Front 17

If borrowers take on big risks after obtaining a loan, then lenders face the problem of _______ .

A. Free-riding
B. Adverse selection
C. Moral hazard
D. Costly state verification

Back 17

C

Front 18

How does adverse Selection Influence Financial Structure, using the Lemons Problem in Used Cars example?

Back 18

If we can't distinguish between “good” and “bad” (lemons) used cars, we are willing to pay only an average of good and bad car values
Result: Good cars won’t be sold, and the used car market will not function efficiently

Front 19

Lemons problem in the securities market

Back 19

If investors can't distinguish between good and bad securities, will pay only average of good and bad securities’ values
Result:
Good securities undervalued and good firms won't issue them
Bad securities overvalued so many bad firms issue them
Investors won't want buy bad securities, so market won't function well
Lemons problem keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers
Partly explains Facts # 1 and # 2

Front 20

Tools to Help Solve Adverse Selection

Back 20

1. Private Production and Sale of Information
2. Government Regulation to Increase Information
3. Financial Intermediation
4. Collateral and Net Worth

Front 21

Private companies collect and produce information that distinguishes good from bad firms and then sell it to investors. What are some names?

Back 21

E.g., Standard and Poor’s, Moody’s, Value Line

Front 22

Free-rider problem:

Back 22

People who do not pay for the information take advantage of the information that other people have paid for
Because of free-riding, less investor demand for information. Less information is produced

Front 23

Free Riding Humor

Back 23

This is a story about four people: Everybody, Somebody, Anybody, and Nobody.
There was an important job to be done and Everybody was asked to do it.
Everybody was sure Somebody would do it.
Anybody could have done it, but Nobody did it.
Somebody got angry about that because it was Everybody's job.
Everybody thought Anybody could do it, 
but Nobody realized that Everybody 
wouldn't do it.
It ended up that Everybody blamed 
Somebody when actually Nobody asked 
Anybody.

Front 24

Government Regulation to Increase Information- Explain how this can be used as a tool to Help Solve Adverse Selection?

Back 24

Explains Fact # 5
E.g., Securities and Exchange Commission (SEC) require annual audits of public corporations
Does not always work. E.g., Enron

Front 25

How can Financial Intermediation be used as a tool to Help Solve Adverse Selection?

Back 25

Solves adverse selection in a manner similar to how used car dealers solve lemons problem in used car market
FIs like banks produce information about firms. Acquire funds from deposits and lend the funds to good firms at higher rate
FIs avoid free-rider problem by primarily making private loans
Explains Facts # 3 and # 4
Explains fact #6 – large firms are more likely to use direct financing

Front 26

Collateral and Net Worth- Explain how this can be a tool used to solve adverse selection.

Back 26

Address the consequence of adverse selection: if borrower defaults, lender suffers a loss
Collateral: property that is pledged to a lender to guarantee payment in case the borrower fails to make debt payments
Net worth (equity) = assets – liabilities
Collateral and net worth help to reduce lender’s loss if a default occurs. Lender is more willing to lend if there is collateral or high net worth
Explains fact # 7

Front 27

Adverse selection helps to explain _____ .

A. Why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets
B. Why collateral is an important feature of consumer, but not business, debt contracts
C. Why direct finance is more important than indirect finance as a source of business finance
D. Only A and B

Back 27

D

Front 28

Financial intermediaries and, particularly, banks have the ability to avoid the free-rider problem as long as they primarily ____.

A. Make private loans
B. Acquire a diversified portfolio of stocks
C. Buy junk bonds
D. Do a combination of A and B

Back 28

D

Front 29

Moral Hazard in Equity Contracts: 
the Principal-Agent Problem. Please explain further.

Back 29

In modern corporations, there is a separation of ownership by stockholders (principals) from control by managers (agents)
Stockholders do not have complete information about what managers are doing (information asymmetry)
Leads to moral hazard because managers act in their own interest (e.g., huge salary, big office, private jet) rather than in stockholders' interest (maximize profits)

Front 30

How Moral Hazard Affects the Choice Between Debt and Equity Contracts. Please give an example.

Back 30

Suppose you become a silent partner in an ice cream store, providing 90% of the equity capital ($9,000). The other owner, Steve, provides the remaining $1,000 and will act as the manager. If Steve works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it.

However, Steve might decide that $5,000 is not enough to make him expend the effort to be a good manager.
Instead he goes to the beach, 
relaxes, and even spends 
company resources to buy 
artwork for his office.
In the end, the store has zero profits.
Steve’s decision to act in his interest (but not yours) will cost you $45,000

Front 31

Tools to Help Solve the 
Principal-Agent Problem

Back 31

1. Production of Information: Monitoring
2. Government regulation to increase information
3. Financial Intermediation
4. Debt Contracts

Front 32

Production of Information: Monitoring-- How can this be used as a tool to Help Solve the 
Principal-Agent Problem?

Back 32

Stockholders monitor firm’s activities
Audit the firm frequently, verify profits
Check what management is doing
Limitations
Monitoring is costly in terms of time and money
Free-rider problem
Every stockholder wants to benefit from monitoring but no one wants to do it
Explains Fact #1

Front 33

Government regulation to increase information-- How can this be used as a tool to Help Solve the 
Principal-Agent Problem?

Back 33

Explains fact #5
Examples:
Require firms to adhere to standard accounting principles to make auditing easier
Impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits
However regulation is only partly effective. Detecting fraud is not easy.

Front 34

Financial intermediation-- How can this be used as a tool to Help Solve the 
Principal-Agent Problem?

Back 34

Venture Capital (VC) firm
Provides equity funds to start new businesses
Information production: VC firm monitors the business closely, e.g., VC representatives are directors
No free-riding problem: Equity is not marketable to anyone except the VC firm
Explains Fact #3

Front 35

Debt Contracts-- How can this be used as a tool to Help Solve the 
Principal-Agent Problem?

Back 35

Reduce need to monitor managers
If cash flows are enough to make debt payments, lender gets paid. No monitoring needed; no need to verify cash flows
Lender only needs to monitor if firm is in default
Explains Fact #1

Front 36

Moral hazard in equity contracts is known as the ______ problem because the manager has fewer incentives to maximize profits than the stockholders might ideally prefer.

A. Principal-agent
B. Adverse selection
C. Free-rider
D. Debt deflation

Back 36

A

Front 37

One financial intermediary that helps to reduce the moral hazard arising from the principal-agent problem is the _____ .

A. Venture capital firm
B. Money market mutual fund
C. Pawn broker
D. Savings and loan association

Back 37

A

Front 38

How Moral Hazard Influences Financial Structure in Debt Markets. Even with the advantages just described, debt is still subject to moral hazard. Why?

Back 38

Debt contract:
- Borrower pays fixed amount to lender
- Borrower keeps whatever remains (residual cash flow)
To maximize residual cash flow, borrower has incentive to take on investment projects that are riskier than the lender would like – moral hazard

Front 39

How Moral Hazard Influences Financial Structure in Debt Markets--Example?

Back 39

Back to the ice cream store example:
Suppose you lend $9,000 to Steve at 10% interest
Instead of setting up the ice cream store, Steve might use the money to invent a diet ice cream. If successful, Steve will become a millionaire, but the idea only has a 1-in-10 chance of success
If Steve pursues diet ice cream idea, default is very likely – you may lose all your money

Front 40

Tools to Help Solve Moral Hazard in 
Debt Contracts

Back 40

1. Net worth and collateral
2. Monitoring and enforcement of restrictive covenants
3. Financial Intermediation

Front 41

Net worth and Collateral

Back 41

If value of net worth or collateral is high, borrower has more to lose in the event of default. Less likely to act against the interest of lender
Ice cream store example: Suppose start up requires $100k. You lend $9k and Steve puts in $91k. If diet ice cream idea fails, Steve can lose up to $91k.
Explains Fact # 6: large firms tend to have more assets that can be pledged as collateral. Bonds backed by collateral are easier to sell.
Explains Fact # 7

Front 42

"Restrictive covenants" include..

(Monitoring and enforcement of restrictive covenants)

Back 42

Provisions in the debt contract that restricts the borrower’s activities
Reduce moral hazard by (a) ruling out undesirable behavior or (b) encouraging desirable behavior

Explains Fact #8 – why debt contracts are often complicated legal documents

Front 43

4 types of restrictive covenants:

(Monitoring and enforcement of restrictive covenants)

Back 43

1. Covenants to discourage undesirable behavior
E.g., Loan can only be used to finance specific activities, such as buying particular equipment
2. Covenants to encourage desirable behavior
E.g., borrower must make sure that equity/asset ratio is at least 50% (keep net worth high)
3. Covenants to keep collateral valuable
E.g., auto loan contract requires borrower to maintain minimum amount of collision and theft insurance
4. Covenants to provide information
E.g., borrower has to report on its activities regularly – facilitates monitoring by lender

Front 44

Restrictive covenants cannot rule out every risky activity. Why?

(Limitations of restrictive covenants)

Back 44

- Borrowers can find loop holes to make covenants ineffective
Restrictive covenants must be monitored and enforced to be effective.
- Free-riding problem if restrictive covenants are attached to marketable debt (bonds)

Front 45

FIs, particularly banks, avoid free-rider problem as long as they make primarily private loans. Why?

(Financial Intermediation)

Back 45

Private loans are not traded
No one can free-ride on the intermediary’s monitoring and enforcement of covenants.
By making private loans, FI fully captures benefit of such activities and will work to shrink moral hazard problem in debt contracts
Explains Facts #3, #4

Front 46

Structure of the Financial System Chapter Summary:

Back 46

There are 8 basic facts about financial structure throughout the world:
1. Stocks are not the most important source of external financing
2. Marketable securities are not the primary source of finance
3. Indirect finance is more important than direct finance
4. Banks are the most important source of external funds
5. The financial system is heavily regulated
6. Only large, well-established firms can access securities markets
7. Collateral is prevalent in debt contracts
8. Debt contracts have numerous restrictive covenants

Collectively, transaction cost, adverse selection and moral hazard can explain these 8 facts.

Front 47

Private production and sale of information explains which fact #?

(Tools to Solve Adverse Selection)

Back 47

1, 2

Front 48

Government regulation to increase information explains which fact #?

(Tools to Solve Adverse Selection)

Back 48

5

Front 49

Financial Intermediation explains which fact #?

(Tools to Solve Adverse Selection)

Back 49

3, 4, 6

Front 50

Collateral and net worth explains which fact #?

(Tools to Solve Adverse Selection)

Back 50

7

Front 51

Production of Information: Monitoring
(Tools to Solve Moral hazard in equity contracts[principal-agent problem])

Back 51

1

Front 52

Government regulation to increase information explains which fact #?
(Tools to Solve Moral hazard in equity contracts[principal-agent problem])

Back 52

5

Front 53

Financial Intermediation explains which fact #?
(Tools to Solve Moral hazard in equity contracts[principal-agent problem])

Back 53

3

Front 54

Debt Contracts explains which fact #?
(Tools to Solve Moral hazard in equity contracts[principal-agent problem])

Back 54

1

Front 55

Collateral and Net Worth
(Tools to Solve Moral hazard in debt contract)

Back 55

6, 7

Front 56

Monitoring and enforcement of restrictive covenants helps to explain which fact #?
(Tools to Solve Moral hazard in debt contract)

Back 56

8

Front 57

Financial Intermediation helps to explain which fact #?
(Tools to Solve Moral hazard in debt contract)

Back 57

3, 4

Front 58

Asymmetric Info Fact # 1

Back 58

Stocks are not the most important source of external financing.

Front 59

Asymmetric Info Fact # 2

Back 59

Marketable securities are not the primary source of finance.

Front 60

Asymmetric Info Fact # 3

Back 60

Indirect finance is more important than direct finance.

Front 61

Asymmetric Info Fact # 4

Back 61

Banks are the most important source of external funds.

Front 62

Asymmetric Info Fact # 5

Back 62

The financial system is heavily regulated.

Front 63

Asymmetric Info Fact # 6

Back 63

Only large, well-established firms have access to securities markets.

Front 64

Asymmetric Info Fact # 7

Back 64

Collateral is prevalent in debt contracts.

Front 65

Asymmetric Info Fact # 8

Back 65

Debt contacts have numerous restrictive covenants.