#3 Why Do FIs Exist

Financial Markets & Institutions (Term IV) 2012

#3Why Do Financial Financial Institutions Exist?

Lecture Objectives

ü Why financial institutions exist and how they promote economic efficiency.

ü Why financial markets have a given financial Structure in every economy in the World

ü How & Why transaction costs influences the financial

Dr. Kulbir Singh (IMT-Nagpur)

ü How & Why transaction costs influences the financial structure

ü How & Why information costs influences the financial structure

ü What is Asymmetric Information and related concepts of Adverse Selection and Moral Hazard

Lecture Objectives (cont.)

ü What is Lemons Problem: How Adverse Selection Influences Financial Structure

ü How Moral Hazard Affects the Choice Between Debt and Equity Contracts

ü How Moral Hazard Influences Financial

ü How Moral Hazard Influences Financial Structure in Debt Markets

ü Importance of FIs through case of China & Soviet Union

ü To understand another type of MH: CoI

Basic Facts About Financial Structure Throughout the World

• The financial system is a complex structure including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds

mutual funds, stock and bonds markets, etc.

Basic Facts About Financial Structure Throughout the World

• The chart on the next slide how nonfinancial business attain external funding in the U.S., Germany, Japan, and Canada.

Canada.

• Notice that, although many aspects of these countries are quite different, the sources of financing are somewhat consistent, with the U.S. being different in its focus on debt.

Sources of Foreign External Finance

Dr. Kulbir Singh (IMT-Nagpur)15-6

Facts of Financial Structure

1. Stocks are not the most important source of external financing for businesses.

q In case of India… equity market is much larger than corporate bond market… yet stocks are not important source of external finance….why????

(see Slide 8 & 10)q Why debt market in India underdeveloped…

§ Predominance of bank loans

§ FII’s participation is limited

§ Pension, Insurance, Households limited participation…lacks confidence

§ Crowding out by Govt. bonds

Resource Raised: India

MODE 2007-08 2008-09 2009-10 2010-11*

1 Debt - 1,500 2,500 2,197

2 Equity 54,511 2,082 46,737 46,701

- of which IPOs 42,595 2,082 24,696 33,068

- No. of IPOs 85 21 39 40

RESOURCE MOBILIZATION THROUGH THE PRIMARY MARKET

Dr. Kulbir Singh (IMT-Nagpur) 3-8

- No. of IPOs 85 21 39 40

- Mean IPO Size 501 99 633 827

3 Private Placements 118,485 173,281 212,635 147,400

4 Euro Issues (GDR/ADR) NA NA NA NA

TOTAL 172,996 176,863 261,872 196,298

Non-Equity Resources 118,485 174,781 215,135 149,597

Non-Equity Resources(%) 68% 99% 82% 76%

2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. (see Slide 10 & 12)

Resource Raised: India…

Source: RBI Annual Report 2010-11 (pp. 41)

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. (see Slide 10 & 12)

4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. (see Slide 12 & 13)

Source: RBI Annual Report 2010-11 (pp. 51)

Source: A Hundred Small Steps (Planning Commission), pp. 81)

5. The financial system is among the most heavily regulated sectors of economy. (see Slide 15)

6. Only large, well-established corporations have easy access to securities markets to finance their activities. (see Slide 16)

Source: A Hundred Small Steps (Planning Commission), pp. 126)

Dr. Kulbir Singh (IMT-Nagpur)3-16Source: Handbook of Statistics on Indian Securities Market 2010(SEBI), pp. 20)

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.

Transactions Costs

• Transactions costs influence financial structure– E.g., a Rs. 5,000 investment only allows you to

purchase 100 shares @ Rs.50 / share (equity)

– No diversification

– Bonds even worse—most have a Rs1,000 size

• In sum, transactions costs can hinder flow of funds to people with productive investment opportunities

• Percentage of Indian Households own any securities are small (see slide 19 & 20)

Source: RBI Annual Report 2010-11 pp. 173

Dr. Kulbir Singh (IMT-Nagpur)3-20Source: A Hundred Small Steps (Planning Commission), pp. 52)

Transactions Costs

• Financial intermediaries make profits by reducing transactions costs

1. Take advantage of economies of scale(example: mutual funds)

(example: mutual funds)

2. Develop expertise to lower transactions costs• Also provides investors with liquidity, which explains Fact # 3

Asymmetric Information: Adverse Selection and Moral Hazard

• Role of information in financial markets…. Information markets

• In CF course, assumed a world of symmetricinformation

information

• In real market, there is asymmetric information-a situation when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction

• Asymmetric information can take on many forms, and is quite complicated. However, to begin to understand the implications of asymmetric information, we will focus on

asymmetric information, we will focus on two specific forms:

– Adverse selection

– Moral hazard

• Adverse Selection

1. Occurs when one party in a transaction has better information than the other party

2. Before transaction occurs

3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected

• Moral Hazard1. Occurs when one party has an incentive to behave differently once an agreement is made between parties

made between parties

2. After transaction occurs

3. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

• The analysis of how asymmetric information problems affect economic behavior is known as agency theory.

• We will now use these ideas of adverse selection and moral hazard to explain how they influence financial structure.

The Lemons Problem: How Adverse Selection Influences Financial Structure

• Lemons Problem in Used Cars

1. If we can't distinguish between “good” and “bad” (lemons) used cars, we are willing pay only an average of good and bad car values

only an average of good and bad car values

2. Result: Good cars won’t be sold, and the used car market will function inefficiently.

• What helps us avoid this problem with used cars?

• Lemons Problem in Securities Markets

1. If we can't distinguish between good and bad securities, willing pay only average of good and bad securities’ value

and bad securities’ value

2. Result: Good securities undervalued and firms won't issue them; bad securities overvalued so too many issued

• Lemons Problem in Securities Markets

3. Investors won't want buy bad securities, so market won't function well

– Explains Fact # 1 and # 2

– Also explains Fact # 6: Less asymmetric inform. for well known firms, so smaller lemons problem

Tools to Help Solve Adverse Selection (Lemons) Problems

1. Private Production and Sale of Information

– Free-rider problem interferes with this solution

– Can govt. disseminate such information to public?

– Then what’s the solution???

2. Government Regulation to Increase Information

2. Government Regulation to Increase Information(explains Fact # 5 – why financial mkts. are among the most heavily regulated sectors in the economy)

– ….does it work???

– For example, annual audits of public corporations (although collapse of Enron & accounting scandal at Satyam Computers are shining examples of why this does not eliminate the problem

3. Financial Intermediation– Analogy to solution to lemons problem provided by used car dealers

– Avoid free-rider problem by making private loans (explains Fact # 3-why indirect finance is so much more

(explains Fact # 3-why indirect finance is so much more impt. than direct finance and # 4- why banks are the most impt. source of external funds for financing businesses.)

– Greater role of banks in develop’g countries… inform about private firms harder to get…greater role of fin. Intermed.

– Also explains fact #6 – large firms are more likely to use direct instead of indirect financing – pecking order hypothesis

4. Collateral and Net Worth – Explains Fact # 7

How Moral Hazard Affects the Choice Between Debt and Equity Contracts

• Moral Hazard in Equity Contracts: the Principal-Agent Problem

1. Result of separation of ownership by stockholders (principals) from control by

stockholders (principals) from control by managers (agents)

2. Managers act in own rather than stockholders' interest

An example of this problem is useful. Suppose you become a silent partner in an ice cream store, providing 90% of the equity capital ($9,000). The other owner,

equity capital ($9,000). The other owner, Ravi, provides the remaining $1,000 and will act as the manager. If Ravi works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it.

However, Ravi doesn’t really value the $5,000 (his part), so he goes to the beach, relaxes, and even spends some of the “profit” on art for his office. How do

the “profit” on art for his office. How do you, as a 90% owner, give Ravi the proper incentives to work hard?

• Tools to Help Solve the Principal-Agent Problem

1.Production of Information: Monitoring• Costly state verification…. Makes equity contracts less desirable, so,……fact #1explained

• Free-rider problem decreases monitoring…..additional explanation for fact #1.

for fact #1.

2.Government Regulation to Increase Information

3.Financial Intermediation (e.g, venture capital)• Eliminates moral hazard pbm…..VC members on BoD

• No free-ride on VC’s verification activities

4.Debt Contracts• Contract structure allows reduced need to monitor managers…… explains fact #1

How Moral Hazard Influences Financial Structure in Debt Markets

• Debt contracts are better than equity contracts… as debt reduces moral hazard problem…– ……but does it ELIMINATES nearly/ completely????

• In fact, debt may create an incentive to take on very risky projects. This is important to understand.

risky projects. This is important to understand. Let’s looks at a simple example.

• Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount.

• For example, what if a firm owes $100 in interest,

• For example, what if a firm owes $100 in interest, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash.

• Tools to Help Solve Moral Hazard in Debt Contracts1. Net Worth & Collateral

• Incentive compatible – greater the borrower’s net worth and collateral pledged, the greater the borrowers incentive to behave in the way the lender expects and desires, the smaller the moral –hazard problem in the debt contract, and easier it is for the firm or

hazard problem in the debt contract, and easier it is for the firm or household to borrow.

2. Monitoring and Enforcement of Restrictive Covenants. Examples are covenants that …1.discourage undesirable behavior….loan to finance specific activities

2.encourage desirable behavior….. Home loan owner’s life insurance

3.keep collateral valuable……keep in good condition & in possession

4.provide information…..periodic reports….right to audit & inspect firm’s books anytime

• Tools to Help Solve Moral Hazard in Debt Contracts– Explains the fact #8 : Why debt contracts are often

complicated legal documents with numerous restrictions on borrower’s behavior

• Tools to Help Solve Moral Hazard in Debt Contracts

3. Does restrictive covenants completely eliminate moral pbm. in debt contracts? NO. Why????

– Impossible to write covenants that rule out every risky activities

– Borrowers will still find out loopholes in covenants to circumvent

– Covenants need to be monitored and enforced

– Monitoring and enforcement of covenants lead to free-rider pbm.

4. Financial Intermediation - banks & other intermediaries have special advantages in monitoring due their private loans and also eliminates free-rider pbm.

• Explains Facts # 3 & #43-41

Asymmetric Information Problems and Tools to Solve Them

Case: Financial Development and Economic Growth

• In transition/developing economies, financial systems are repressed……financial systems are underdeveloped.

• Financial repression leads to low growth. Why?• Two important tools to help solve AS and MH in

• Two important tools to help solve AS and MH in credit market are: Collateral & restrictive covenants

• Repressed system are marked with1. Poor legal system……AS pbm arises… lenders seek

more information about borrowers2. Weak accounting standards…..poorly developed &

corrupt legal system makes enforcement of Restr. Coven. difficult

Case: Financial Development and Economic Growth

• Private FIs have an incentive to solve AS & MH pbms. & lend to borrowers with most productive investment opportunities. However…….

• Repressed financial system are marked with3. Government directs credit ..themselves or favored

sectors…….thru state-owned development institutions …..@ below market rate Irs…….O/C: less efficient investment and slower economic growth

4. Financial institutions nationalized…….no incentive to allocate their capital to most productive uses..

5. Inadequate government regulation…..retards provision of adequate information to the market place

• These factors explain why some nation poor or rich.3-44

Is China a Counter-example?

• Even with its booming economy, China’s financial development is still in an early stage.– Legal systems are weak…financial contracts difficult to enforce

– Accounting standards are lax… no high-quality inform. About creditors

About creditors– Regulation of banks in formative stages– Banking sector is dominated by state-owned banks

• Yet Chinese economy has enjoyed one of the highest growth rates in world in last 20 years?

• How has China been able to grow so rapidly given its low level of financial development?

• ANSWER– Highest savings rate……averaging 40%

– Shifted underutilized labor from subsistence agriculture to productive industry sector

• RESULT…..high growth…due to

• RESULT…..high growth…due to– Huge increase in capital

– Gains in productivity

• But this will not run for a long-time. Why? – Soviet Union……1950s & 1960s shared same situation as China today….but ignored development of FIs during high-growth periods of 1950s and 1960s

• MORAL FOR CHINA– Allocate capital more efficiently which requires to improve its financial system. Chinese govt. has announced that

– State-owned banks will be privatized

– Legal reforms in contracts & bankruptcy

• MORAL FOR YOU….– Financial Institutions are important for the development of an economy….

• So, we have understood…..– WHY FINANCIAL INSTITUTIONS EXIST?!?!

What Are Conflicts of Interest and Why Are They Important?

• Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies

services, they realize economies of scope.

• However, these services may be competing with one another, and this creates the potential for a conflict of interest.

What Are Conflicts of Interest and Why Are They Important?

• The conflicts of interest may arise as the concealment of information for the dissemination of misleading information.

• Why should we care this CoI?

• Because a reduction in the quality of information increases the presence of symmetric information.

Ethics and Conflicts of Interest

• Conflicts of interest generate incentives to provide false or misleading information. This behavior is considered unethical.

• One way to limit these conflicts is to make workers aware of the ethics issues at stake, so that they are less likely to engage in unethical behavior.

Types of Conflicts of Interest

Three areas of financial service activities that harbor the greatest potential for generating conflicts of interest.

These are:

– Underwriting and research in investment banking

– Auditing and consulting in accounting firms

– Credit assessment and consulting in credit-rating agencies

Underwriting and Research in Investment Banking

• Some investment banks both underwritenew securities sold the public, and provide research (buy/sell recommendations) to the investing public

the investing public

• When revenues from underwriting exceed brokerage commissions, favorableresearch will attract more business, at the expense of unbiased recommendations to the investing public.

• In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients.

potential new clients.

• Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning). This immediate “profit” may appear as nothing more than payment for future business.

• Refer such two cases in the book:

– “The King, Queen, and Jack of the Internet” &

– “Frank Quattrone and Spinning”

Auditing and Consulting in Accounting Firms

• Role of auditors in public firms – to provide an unbiased view of the financial reports to reduce asymmetric information between the firm’s management and the investing public.

• By also providing management advisory services (such as systems support), the auditor has an incentive to fudge the audit if the fees from other services are substantial.

Auditing and Consulting in Accounting Firms

• Auditors also have a conflict of interest since they are paid by the firm they audit. If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well.

business as well.

• A well known case of the failure of auditors to provide unbiased reports was Arthur Andersen’s audit of Enron.

• In case of Satyam Computers, PricewaterhouseCoopers (PwC)….action?

Credit Assessment and Consulting in Credit-Rating Agencies

• Bond investors rely on credit-rating agency assessment of firm’s debt (debt ratings).

• However, ratings are only provided when the firm pays the agency. Agencies, then, have

firm pays the agency. Agencies, then, have an incentive provide “better” ratings to attract business.

• Rating agencies have also started providing firms with other services, and have the same conflicts as auditors in this regard

What Has Been Done to Remedy Conflicts of Interest?

Two major policies were implemented following the scandals of the late 1990s and early 2000s. These are:

– Sarbanes-Oxley Act of 2002 (USA)

– Global Legal Settlement of 2002 (USA)

Sarbanes-Oxley Act of 2002

Passed following the public outcry over corporate scandals. The act, in summary, has the following six major components:

1. Established the Public Company Accounting

1. Established the Public Company Accounting Oversight Board to supervise accounting firms.

2. Prohibited public accounting firms from engaging in nonaudit services to a client it is also auditing.

3. Members of the board’s audit committee must be independent.

Sarbanes-Oxley Act of 2002

Passed following the public outcry over corporate scandals. The act, in summary, has the following six major components:4. Required the reporting of off-balance sheet

4. Required the reporting of off-balance sheet activities.

5. Appropriated additional funding for the SEC.

6. Increased the charges for white-collar crimes and obstruction.

Global Legal Settlement of 2002

• This was a settlement reached between the New York Attorney General and several of the largest U.S. investment banks - Bear Stearns, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, & UBS Warburg

Warburg• The key terms of the agreement included:

1. Firms must severe the link between underwriting and research activities.

2. Spinning is banned.3. Firms must make public analyst recommendations and

target prices.

Global Legal Settlement of 2002

The key terms of the agreement included:

4. Brokerage firms required to obtain third-party, independent research for their clients.

5. $1.4 billion in fines.

#3 Why Do FIs Exist

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