Financial Institutions Lecture 04

Lecture - 04: Why Do Financial Institutions Exist?

• This lecture is about financial institutions and their role in promoting economic efficiency.
• Topics include basic facts about financial structure worldwide, transaction costs, asymmetric information (adverse selection and moral hazard), how adverse selection affects financial structure, influence of moral hazard on the choice between debt and equity contracts, influence of moral hazard in debt markets, and conflicts of interest.
• A key reference for this course is "Financial Markets and Institutions" by Frederic S. Mishkin and Stanley G. Eakins, 9th Edition.

Basic Facts About Financial Structure Throughout the World

• The global financial system is complex, encompassing various institutions like banks, insurance companies, mutual funds, and stock/bond markets.
• All these financial institutions are subject to government regulations.
• A chart (figure 7.1) illustrates how non-financial businesses in the U.S., Germany, Japan, and Canada obtain external funding. Data shows considerable consistency across countries, but the U.S. differs in its emphasis on bonds.

Transaction Costs

• Transaction costs are a significant issue in financial markets. They influence the structure.
• Examples include high brokerage fees for small stock purchases and the need for significant investment amounts for diversification in bonds, making transaction costs a significant portion of the total cost of the transaction.
• Financial intermediaries mitigate costs via economies of scale. They pool funds from many investors to reduce the per-dollar cost of transactions. They diversify and lower risk for the investors.
• Financial intermediaries create expertise to reduce transaction costs in areas like information technology, lowering communication costs through improved systems.

Asymmetric Information: Adverse Selection and Moral Hazard

• Asymmetric information arises when one party in a transaction has better information than the other.
• This primarily occurs before or after the transaction. This makes it hard for one party to make the best decision when conducting the transaction.
• Adverse selection happens before the transaction and refers to the cases where one party in the transaction has better information than the other. In this case, the party with superior information is likely to produce undesirable outcomes from the deal, and this outcome will be the most likely factor affecting the other party.
• Moral hazard happens after the transaction and refers to cases where one party has an incentive to behave differently after an agreement. The probability that a debt will be paid back decreases and lenders likely decide not to lend loans.

How Adverse Selection (The Lemons Problem) Influences Financial Structure

• The "lemons problem" arises because potential buyers cannot distinguish between good and bad securities/products at an average price; this will result in good securities getting undervalued and bad securities becoming overvalued.
• Tools to help overcome this issue include things like producing and selling information, government regulation increasing information, and financial intermediation.

How Moral Hazard Affects the Choice Between Debt and Equity Contracts

• Moral hazard arises after the transaction and refers to cases where one party has an incentive to behave differently after an agreement.
• Equity contracts are subject to the principal-agent problem, where managers (agents) may act in their own interest instead of the stockholders' (principals').
• Tools to reduce moral hazard risks include monitoring and producing financial information to check on the firm's activities and government regulation.

How Moral Hazard Influences Financial Structure in Debt Markets

• Debt contracts are designed to align incentives between lenders and borrowers. This includes things like collateral and net worth, monitoring and enforcement on debt contracts, and financial intermediation.
• The presence of collateral and net worth reduces the risk of adverse selection because in the case of a borrower default, the lender's loss is decreased.
• Tools to reduce moral hazard risk include increased monitoring of borrowers, and enforcing strict rules regarding how the money will be used regarding the debt in question.

Conflicts of Interest

• Financial institutions often develop expertise in interpreting signals to make better decisions, thereby creating economies of scale and providing multiple financial services.
• Conflicts of interest arise when institutions have multiple objectives or competing interests and serving one can damage the others.
• This can lead to concealing information or providing misleading information.
• Specific examples of these conflicts include underwriting and research in investment banks, auditing and consulting in accounting firms, and credit assessment and consulting in rating agencies—with the Enron case in the U.S. as a particular example.
• Remedies to these conflicts in the U.S. include the Sarbanes-Oxley Act of 2002 with changes and global settlements that aimed at correcting the issue.