Overview of the U.S. Financial System | Investment Banking PDF

2. Overview of the U.S. Financial System This chapter explains how financial markets link the savers to the borrowers. Savers can use two separate channels to lend to borrowers. First, the savers could deposit their funds into a financial institution that in turn, lends to the borrowers. Secon...

2. Overview of the U.S. Financial System This chapter explains how financial markets link the savers to the borrowers. Savers can use two separate channels to lend to borrowers. First, the savers could deposit their funds into a financial institution that in turn, lends to the borrowers. Second, savers could lend directly to the borrowers by directly investing in financial securities. Thus, these two channels create a variety of financial markets, such as the spot and derivative markets, and primary and secondary markets. Furthermore, we examine the impact of financial innovation and government regulation of the financial markets. Finally, we define the common financial instruments at the end of the chapter that we will use for the rest of the book. The U.S. banking system evolved into a complex system. As the United States was forming, the public and the government distrusted large, powerful banks. Consequently, the government passed laws that heavily regulated the banking system, enlarging the number of U.S. banks and shrinking the banks‟ asset size. Moreover, the United States created two layers of commercial banks: national and state banks. Several government agencies at the federal and/or state level regulate these banks. Consequently, banks have used ingenious methods and innovations to circumvent governments‟ regulations. Financial Intermediation A financial system transfers funds from savers to borrowers. Savers and borrowers can be anyone. Some households, businesses, and governments are net savers because they spend less than their income, and they become the source of loans while other households, businesses, and governments are net borrowers. They spend more than their incomes. For example, many college students are net borrowers. Students‟ incomes are usually lower than their yearly expenses, and they use student loans to pay for the difference. After graduation, the students enter the workforce, and they start repaying their student loans. As their incomes continually rise over time, the former students repay their loans and become net savers, saving funds for retirement. Using another example, many local and state governments have laws, requiring them to balance their budgets. This fiscal responsibility forces many local and state governments in the United States to be net savers while the U.S. federal government has been a net borrower for the last 50 years. Transfer of funds from savers to borrowers is vital to an economy. If the borrowers invest the funds by purchasing machines and equipment, the borrowers can produce more goods and services. When businesses produce more goods and services, subsequently, the economy grows, and a growing economy creates jobs and rising incomes. As consumers experience rising incomes, they buy more goods and services, increasing the living standards. Beauty in the U.S. financial system is the financial institutions can collect and concentrate the meager savings of many people and then lend to a large company. For instance, 10,000 savers who have $200 in their savings accounts could allow a financial institution to grant a business loan for $2 million. 18 Kenneth R. Szulczyk Subsequently, the business can invest new machines and equipment, boosting its production level, and creating economic growth. Savers link to the borrowers through two routes: financial intermediaries and direct finance. Common financial intermediaries include banks, mutual funds, and insurance companies. For example, you purchased fire insurance for your home. When you pay your premium, the insurance company invests your payment into the financial markets by investing in financial securities. Financial intermediaries only provide this function for one reason – to earn profits. For instance, banks transfer your funds to borrowers to earn profits. Banks earn profits from the difference between the interest rate paid by the borrowers and the interest rate the bank pays on your accounts. Second route links savers to the borrowers through direct finance. Net savers, like households, can lend directly to businesses through the financial markets. Two broadly defined financial instruments are common stock and bonds. If you buy common stock, you own shares of a corporation that we call equity. We show an example of a stock certificate in Figure 1. Moreover, stockholders have the right to vote on certain corporate policies and elect the Board of Directors. Each share of stock entitles the owner to one vote. For example, if you owned 100 shares of stock, and this corporation issued a million shares, your vote would have a small impact on corporate policy. Finally, the stockholders earn a share of the profits, which we call dividends. Second financial instrument is a bond. A bond consists of a standardized loan to a corporation. A bond is fancy paper giving bondholders legal rights where the corporation promises to repay a long-term loan plus interest to the bondholders. If a corporation bankrupts and is liquidated, bondholders have a higher priority and claim on the corporation‟s assets, while the common stockholders come last. Source: www.oldstockresearch.com/faq.htm Figure 1. An example of a stock certificate Bonds and stocks have two markets: the primary market and second market. A corporation or government issues brand-new securities in the primary market by selling them directly to security dealers. Thus, they sell new securities in the primary market, while investors sell and buy existing securities in the secondary market. Most famous secondary market for stock is the New York Stock Exchange. This exchange allows investors to buy and to sell existing stock for 19  Money, Banking, and International Finance the United States largest corporations. Furthermore, secondary markets are important because these markets increase the liquidity of financial instruments. Investors can easily sell or buy financial securities on secondary markets. Moreover, when government or corporations issue new securities, the prices from the secondary market set the prices for the new securities in the primary market. Why would savers deposit their money into banks, instead of investing directly into the financial markets? Financial intermediaries provide three functions. First, your bank account has liquidity. If an emergency arises, you can easily withdraw funds from your account. If you purchased stock and bonds from the financial markets, you could experience time delays and pay a transaction cost to withdraw yours money. Second, financial intermediaries have specialists who collect information about borrowers. Financial intermediaries lend to borrowers who are not likely to default on their loans. Finally, the financial intermediaries reduce the risk. They lend to a variety of borrowers through a process called diversification. For example, banks will issue credit cards, grant mortgages, lend to a variety of businesses, and buy U.S. government securities. If several credit card holders default, a couple of households stop paying their mortgages, or a business bankrupts and defaults on a bank loan, overall, the banks could still earn profits because the majority of bank customers are repaying their loans. On the other hand, if you directly invested in a company that bankrupts, then you could lose all of your investment. Savers could withdraw their money out of the financial intermediaries and invest directly in the financial markets, such as buying U.S. government securities. We call this process – financial disintermediation. Savers have two reasons to invest directly in government. First, a government may pay a higher interest rate than a bank. For example, your savings account earns 2% interest while a U.S. Treasury bill pays 4% interest. Thus, the investors want to earn the greater interest rate. Second, the U.S. government has a low risk of default because the government has the power to tax and “print” money (i.e. seigniorage). If the government experiences financial trouble, it can raise taxes, issue more government securities, or print money. One problem does occur. If a government accumulates a massive debt, it usually gets money for loans first, while businesses come second. If investors have limited funds, then the businesses might not get the money that they need for investing in machines and equipment. Consequently, a large government debt could impact the financial markets and hamper business investment because a large government debt crowds out private investment. For example, the U.S. government debt has exceeded $17 trillion in 2014. If the U.S. government had a debt of zero dollars, then the investors would invest their funds in the private markets. Financial markets have two methods to complete a transaction. Up to this point, you assumed when a buyer and seller completed a financial transaction, they exchange money for the financial instrument immediately. We call this the cash market or spot market. However, buyers and sellers have another option to complete a transaction. Buyer and seller of a financial instrument can negotiate a price and quantity today, but they exchange money for the financial instrument on a future specific date. These transactions occur in the derivative market. For example, you negotiate a price today to buy 10 Treasury bills from a seller for $9,000 each in six months. You had entered into a contract with the seller for a future transaction. If these 20 Kenneth R. Szulczyk contracts are standardized, investors can buy and sell these contracts on secondary markets. We study the derivatives market in Chapter 18. Financial Instruments Every financial instrument, except stock, has a principal, interest, and maturity. Principal is the loan amount the borrower received from the lender. Then the borrower pays interest as periodic payments to the lender because the lender allows the borrower to use the funds. Interest is a cost to the borrower, but income to the lender. Finally, maturity is the date the security expires, or the final date when the borrower pays the last payment for the principal plus interest. Analysts and economists categorize financial instruments into two broadly defined classes: money market and capital market. Money market comprises of short-term securities with a maturity less than one year. Money market securities are popular and are simply a loan of funds from one party to another. Money market securities are highly liquid and almost as good as money – hence the name money market. Second category, the capital market, includes long- term securities with a maturity greater than a year. Capital market includes common stock because stock has no expiration date because the corporation, in theory, could live forever. Thus, we define stock as a long-term security. You should memorize the following securities because we continually refer to these financial instruments throughout this book. For students to understand these securities, remember who issues the security, and whether it is a money market or capital market security. All these securities have one purpose. One party owes another party money plus interest except stocks. Stocks represent ownership in a corporation and are not loans. Money market securities have maturities less than one year, and we list the common ones:  U.S. Treasury bills or T-bills) are loans to the U.S. government. Maturities range from 15 days to one year. T-bills do not have an interest rate stamped on them, and they start at $10,000. If an investor buys a T-bill for $19,000, and the T-bill has a face value of $20,000 with a maturity of six months. Then six months later, the government will pay $20,000. The $1,000 reflects the interest.  Commercial paper is a loan to a well-known bank or corporation for a short-time period. Corporations use commercial paper to raise funds without issuing new stocks or bonds. Commercial paper is a form of direct finance, and the loan has no collateral.  Banker’s Acceptances are used in international trade. For example, a firm wants to buy from a foreign exporter. Firm deposits money at a bank, and the bank guarantees payment by issuing a banker‟s acceptance. That way, the export accepts the banker‟s acceptance and ships the goods to the firm. If the firm does not deposit money at the bank and the bank guarantees payment, then the bank must pay the foreign exporter, even if the firm bankrupts. These securities are liquid because holders can sell them on a secondary market. 21  Money, Banking, and International Finance  Negotiable Bank Certificates of Deposit (CDs) are loans to banks that banks sell directly to depositors. CDs have a fixed time period. If a depositor withdraws a CD early, then the depositor forfeits the interest. Consequently, CDs usually pay a greater interest rate than a savings account.  Repurchase Agreements (repos) are short-term loans. For example, a bank sells T-bills to a customer and promises to buy it back the next day for a higher price. Greater price reflects interest. Banks used repos to circumvent the law, so banks could pay businesses interest on their checking accounts. Before the 1980s, U.S. banks could not pay interest on checking accounts. For example, IBM has excess funds in their checking account. Bank sells IBM T-bills and uses IBM‟s funds. Next day, the bank returns IBM‟s funds with interest and takes the T-bills back. Consequently, the bank paid interest on a checking account, although the U.S. law prohibited banks to pay interest on checking accounts.  Federal Funds are overnight loans between banks. For example, a bank with excess funds deposited at the Federal Reserve can lend these funds to another bank. Market analysts and the Fed scrutinize the interest rate in this market because monetary policy influences immediately the federal funds interest rate.  Eurodollars are U.S. dollars that people deposit in foreign commercial banks outside the United States and in foreign branches of U.S. banks. Eurodollars are an important source of funds in the international market. Furthermore, the euro has become a popular currency for investors, who have bank accounts denominated in euros that are located outside the Eurozone. The Eurozone comprises of the 17 countries within the European Union that use the euro as its currency. If people and investors have euro denominated accounts outside the Eurozone, then we still call it Eurodollars. Capital market securities have maturities longer than a year, and we list the common ones:  U.S. Treasury securities are loans to the U.S. government. The U.S. government issues Treasury Notes or T-notes from one to 10 years, while Treasury Bonds or T-bonds have maturities greater than 10 years. These Treasury securities have a stated interest rate, and government usually pays interest every six months.  State and local governments can issue bonds, called municipal bonds. The U.S. federal government encourages investors to buy these bonds by exempting investors from U.S. income taxes. Furthermore, municipal bonds fall under two categories: General-obligation bonds and revenue bonds. For general-obligation bonds, a state or local government guarantees the bonds payment with its taxing power. For instance, a city government builds a new firehouse. Then the city government guarantees payment of the bonds with its power to tax. For revenue bonds, local or state government secures the bonds‟ payment by the revenues that the project generates. For example, a college builds a new dormitory, using 22 Kenneth R. Szulczyk revenue bonds. When the students pay to live there, the university pays the bondholders some of the revenue.  We include stocks and bonds that we had defined earlier in this chapter.  Mortgage is a loan on a house or property and the loan duration ranges from 15 to 30 years. Usually, the property becomes the collateral. For instance, if a homeowner loses his job and cannot repay the mortgage, then the bank takes possession of his house. We call this process foreclosure as a bank takes the property and evicts the homeowners. A variety of savings institutions and banks grants mortgages, making mortgages the largest debt market.  Commercial bank loans are banks lending to businesses. These loans do not have well developed secondary markets.  Government agencies can issue securities. For example, Sallie Mae is a quasi-government agency and lends to college students. Then Sallie Mae pools the student loans into a fund and issues bonds, allowing investors to buy into the fund. Subsequently, the investors indirectly earn the interest from the students‟ monthly payments. Thus, Sallie Mae increases the liquidity of student loans. Sallie Mae may experience financial hardship. U.S. economy has been plagued with weak economic growth since the 2007 Great Recession, and many college graduates cannot find jobs and start to default on their student-loan payments. Many call this the College Bubble. As college tuition soars into the stratosphere, many college students accumulate large amounts of debt to pay for their education, and some of these students have slim chances of finding good- paying jobs after they graduate. Consequently, high school graduates may shun college to avoid accumulating debt, sparking a financial crisis for the U.S. colleges and universities. Then the colleges and universities could contract similarly to the U.S. housing market after 2007. The United States Banking System The United States banking system differs from other industrialized countries. For instance, the United States has more banks per capita, and the banks possess fewer assets because the U.S. government imposed strict regulations. Early in the United States history, the public and government feared big banks, so state and federal governments passed regulations that forced banks to be smaller and encouraged a large number of banks to form. The United States, furthermore, has a dual banking system. A bank chooses a charter from a state government or from the U.S. federal government. A charter is a document that legally establishes a corporation and allows a financial institution to participate in banking activities. A national bank receives a charter from the federal government, while a state bank receives a charter from a state government. 23  Money, Banking, and International Finance If a bank receives a charter from the federal government, then three government agencies can regulate that bank, which are:  Comptroller of the Currency, an office in the U.S. Treasury Department, regulates national banks. This office also grants charters on behalf of the U.S. federal government, and it requires national banks to be members of the Federal Reserve and Federal Deposit Insurance Corporation. As of 2010, the United States had roughly 1,500 national banks and 50 foreign national banks.  Federal Deposit Insurance Corporation (FDIC) insures deposits at member banks. If this agency insures, then it also regulates. As of 2009, the FDIC had 8,195 member banks.  Federal Reserve System (Fed) is the central bank of the United States and the lender of the last resort. When a bank encounters financial difficulties and cannot receive a loan from other financial institutions, then the bank can ask the Fed for a loan. Moreover, the Fed regulates banks. A state-chartered bank could have fewer regulations. A state government agency regulates its state banks, and many states require their banks to join the Fed and/or FDIC. Therefore, a state bank could have one or more regulatory agencies to deal with. U.S. government imposed another restriction upon the U.S. banking industry – the McFadden Act. The McFadden Act prohibited a commercial bank from opening a branch in another state. This law put national and state banks on equal footing and helped foster competition. However, this law kept small inefficient banks in business, causing the United States to have the largest number of banks in the world. The United States had 14,217 banks in 1986, which fell to 9,459 banks by 2010. Some states imposed more restrictions upon their banks than other states. For example, some states had imposed unit banking that restricted a bank to one geographic location. Unit banking restricts a bank to a single geographical location, such as in one city, and the bank cannot branch to other cities. Currently, no states enforce unit banking. Furthermore, branch banking allows a bank to have two or more banking offices owned by a single banking corporation within a geographical area. Geographic area can be a city, county, or statewide. Currently, 45 states allow statewide branch banking. Different institutions evolved in the United States that differ from commercial banks. They include savings institutions and credit unions, and they are not commercial banks. Thus, they have their own regulatory agencies. These institutions either have a charter from the federal government or a state government. The Federal Home Loan Bank System (FHLBS) is a U.S. government agency similar to the Federal Reserve. The FHLBS regulates nearly 8,000 savings institutions. Moreover, the FDIC insures deposits at savings institutions. Most credit unions have charters from the National Credit Union Administration, which issues charters on the federal government‟s behalf. This agency also insures the deposits at credit unions while the FDIC does not. 24 Kenneth R. Szulczyk Why did U.S. and state government propagate such a complex system? Financial sector is an extremely important sector of the economy, and every country around the world regulates its financial markets. Government uses six reasons to regulate a banking system and its financial markets, which include: Reason 1: Governments want the financial system to be stable. Banks contribute to a nation‟s money supply. A wave of bank failures could trigger a large contraction in the money supply, shrinking the economy and triggering a severe recession. Many economists believe the Great Depression would not be severe if a wave of bank failures had not swept across the country. Reason 2: Money supply and financial markets are intertwined. If the central bank uses the money supply to influence the inflation, business cycle, or interest rates, the central bank also affects the financial markets. Consequently, central banks need government regulations to control monetary policy effectively and help achieve low inflation and low unemployment. Reason 3: The U. S. government wants to promote efficiency in the financial intermediation process. Reason 4: The U.S. government wants to provide low-cost financing for homebuyers. This desire led to the U.S. Housing Bubble that occurred between 1997 and 2007. Reason 5: Financial markets depend on accurate information. Governments ensure borrowers provide accurate information to investors. In the United States, the Securities and Exchange Commission (SEC) requires publicly traded companies (i.e. a company sells stock to the public) to disclose financial information based on acceptable accounting standards. Reason 6: The U.S. government wants to protect consumers. Financial system, such as a bank can be very complicated. Many depositors do not understand the financial instruments, and therefore, they are not able to gauge the soundness of the institution or make rational decisions. In a competitive market like TVs, DVDs, computers, and cell phones, the consumers can easily evaluate and compare different products. The Glass Steagall Banking Act Politicians and the public thought commercial banks should not underwrite new stock and bonds for corporations because they believed banks were underwriting “risky” securities. Furthermore, the banks possess enormous power to create monopolies. Thus, the United States government passed the Glass-Steagall Banking Act in 1933. This law divided the functions of investment banking and commercial banking. A commercial bank is a standard bank while an investment banker markets and sells brand new stocks and bonds. In practice, the Glass-Steagall Banking Act insulated investment banking from the competition. Consequently, borrowers could pay more for issuing new securities than they would pay if commercial banks could underwrite new securities. The United States government repealed pieces of the Glass-Steagall Act in 1999 to allow U.S. investment banks to compete internationally as they moved into commercial banking and insurance. The Glass-Steagall Act also created the Federal Deposit Insurance Corporation (FDIC). The FDIC, a public corporation, insures the deposits of each depositor in commercial banks up to $250,000. For example, if you have $150,000 in your checking account and $150,000 in 25  Money, Banking, and International Finance certificates of deposits, the FDIC would insure a total of $250,000. If your bank fails, you are guaranteed that you will get at least $250,000 from FDIC, potentially losing $50,000. In some cases, the FDIC insured all deposits that exceeded $250,000 per person, while it did not for other bank failures. It depends how FDIC handles the bank failure. FDIC receives its funding from insurance premiums. Every commercial bank that is a member of FDIC must pay approximately $100,000 per year. The FDIC became very successful because bank failures averaged 10 per year between 1934 and 1981. On the other hand, bank failures averaged 2,000 per year during the Great Depression before the U.S. government created the FDIC. The FDIC uses two methods to deal with bank failures. First, the FDIC closes the bank and seizes the bank‟s assets. Then the FDIC sells the bank‟s assets and returns the money to the depositors. If FDIC does not receive enough money to pay all depositors from selling the bank‟s asset, subsequently, the FDIC pays the difference from its own funds. Thus, the FDIC rarely uses the first method because the FDIC could pay out millions or billions in claims. Second, the FDIC purchases and assumes control of the failed bank. Next, the FDIC keeps the bank open and searches for another bank that will buy the failed bank. If the FDIC cannot find a buyer, then FDIC can grant extra incentives, such as low-interest rate loans from the FDIC, or the FDIC buys the problem loans from the failed bank‟s portfolio. The FDIC also allows a bank to cross a state line to buy a failed bank. Although federal law prohibited banks from crossing state lines and opening banks in another state, the federal government did not hesitate to violate its own rules when it needed to. The U.S. government established the FDIC to reduce the bank failure rate by preventing bank runs. A bank run is depositors discover their bank has financial trouble, so everyone runs to the bank to withdraw their deposits. Unfortunately, a bank holds only a fraction of the total deposits because a bank grants loans. Thus, a bank will close its doors after the bank has drained all the cash from the vault. Furthermore, if the bank granted many illiquid loans, then the bank must sell these loans at a discount in order to raise more reserves. Selling the illiquid loans at a discount can cause the bank to become insolvent. Insolvent occurs as a bank's total liabilities exceed its total assets. Consequently, any bank on the verge of failing cannot return money to its depositors. Even a financially healthy bank could fail if people spread rumors the bank has financial troubles. Then the rumor triggers a bank run. Bank runs can lead to contagion. Contagion is a bank run on one bank leads to bank runs on other banks. For example, depositors line up at one bank to withdraw their accounts; subsequently, many depositors do not get their money back. Then the depositors tell friends and family, and they begin questioning the health of their banks. Many people cannot gauge the financial health of banks. Friends and family run to their banks to withdraw funds from their accounts, triggering more bank runs. As the contagion spreads, it causes a wave of severe bank runs called financial panics. Financial panics can push the economy into a serious recession. The FDIC charges insurance premiums based on the total amount of deposits at the bank and the risk level the depository institutions pose to the FDIC. Many banks are experiencing financial difficulties that resulted from the 2008 Financial Crisis because the banks approved anyone for a mortgage. As the U.S. entered a recession in 2007, some homeowners started 26 Kenneth R. Szulczyk defaulting on their mortgages. Unfortunately, the housing values were falling since 2007. If a bank foreclosed on a person‟s house, then a bank possesses a home that is losing value. Thus, the financial crisis caused 140 banks to fail during 2009, causing financial difficulties for the FDIC. Then the FDIC requires banks to prepay their deposit insurance for 2010, 2011, and 2012. The FDIC wants banks to prepay $45 billion in deposit insurance after it already doubled the insurance premiums for 2009. Financial Innovation Financial markets and institutions continually change and evolve, and financial innovation can drive this change. If a new financial instrument lowers risk, increases liquidity, or increases information, then investors are attracted to the new security. For example, mutual funds are one financial innovation. A mutual fund pools money from many people together into a fund, and a fund manager invests the fund in a variety of stocks. Consequently, this method lowers investors‟ risk through diversification of stocks. For example, you manage your mutual fund, and you bought 30 different corporate stocks. Your Coca-Cola stock rises one day while the value of your IBM stock declines. Overall, the average of the fund‟s 30 stocks could earn a return for the fund investors. If you bought only Kodak corporate stock, then you would lose your investment when Kodak filed for bankruptcy. Regulations can spur innovation. The U.S. and state governments have always heavily regulated their financial institutions. Consequently, these institutions ingeniously circumvented these regulations by creating new financial instruments or new financial institutions. First method to circumvent banking regulations, bank leaders and owners developed bank holding companies. A bank holding company is one corporation obtains ownership or control of two or more independent banks. A bank holding company can do three things.  Bank holding company can branch within states or across state lines. For example, a corporation buys enough common stock of two banks to become the majority shareholder. Majority shareholder elects the Board of Directors and votes on corporate policy. Therefore, the holding company can control several banks in several states, circumventing the McFadden Act.  Bank holding companies can buy other non-bank companies and enter other spheres of economic activity, such as data processing, investment advice, and insurance. Allowing banks to participate in nonfinancial activities is called universal banking.  Bank holding company can raise non-deposit funds. For example, a bank holding company controls one bank, and this bank needs funds. Holding company issues commercial paper on itself and diverts these funds to the bank, circumventing the interest rate restrictions on bank deposits. Second innovation, nonbank bank, allows banks to circumvent federal and state regulations. Legal definition of a bank is an institution that accepts deposits and makes loans. 27  Money, Banking, and International Finance What would happen if a bank stopped accepting deposits? Legally, the bank is no longer a bank and becomes exempted from the extensive U.S. bank regulations. Nonbank bank is simply a finance company. Third innovation was the creation of money-market mutual funds (MMMF). MMMFs are pools of liquid money-market assets managed by investment companies. The MMMF is identical to a mutual fund. Investment companies sell shares to the public in small denominations, and the fund managers invest in money market instruments. Consequently, MMMF became very successful. MMMF grew from $3.3 billion in 1997 into $186.9 billion in 1981 and 959.8 billion by 2010. The MMMFs began hurting the banks financially as people started withdrawing money from their bank accounts and investing them into MMMFs. MMMFs paid a higher interest rate, and they allow check-writing privileges. Accordingly, banks began losing customers, and they place pressure the regulatory agencies that, in turn, placed pressure on Congress and the President to change the laws. Since 1982, banks began offering money market deposit accounts (MMDA) that are similar to a MMMF with only one difference. The FDIC considers a MMDA to be a bank account and thus, it insures them, while it does not insure MMMFs. Finally, MMDAs have no reserve requirements, and they have grown rapidly as people started to invest in them. Last innovation, automated teller machine (ATM), allowed banks to circumvent regulations. Modern computer technology allows a bank's customers to receive banking services through computer terminals located at banks, stores, and shopping malls. Customers can make deposits, withdrawals, and credit-card transactions. Technically, ATMs are not bank branches, and are not subjected to branch banking restrictions. Therefore, ATMs are located some distance away from the main bank. Furthermore, many banks created networks, so customers could access their accounts from any place within the United States and across the world. Moreover, banks offer debit cards. For example, a customer uses a debit card to pay for goods and services by electronically transferring funds from his checking account to a store's bank account. Thus, the debit card has replaced checks. Some businesses do not accept checks, but take debit cards because the merchants know they will receive money from the customer's bank. Political climate was changing in the United States before the 2008 Financial Crisis. Innovation, rising interest rates, and deregulation were eroding the regulatory structure set up in the 1930s. Banks can cross state lines, open branches in other states, offer investment advice and brokerage services. Thus, the banking industry experienced two trends. First, banks can acquire other banks, reducing the number of banks in the United States. Second, as banks merge, they become bigger as their assets grow. U.S. banks were approaching the size of Japanese and German banks, which traditionally were larger in asset size. Then the 2008 Financial Crisis struck the U.S. economy, causing many commercial and investment banks to teeter on bankruptcy. The U.S. federal government came to the rescue and purchased stock of many financial corporations. Taxpayers indirectly helped the corporations. Subsequently, the U.S. government helped and approved many bank mergers, including mergers between commercial and investment banks. Consequently, the U.S. government bailed out these banks because they were too big to fail. A wave of large bank failures would implode the whole 28 Kenneth R. Szulczyk U.S. financial system. Thus, the U.S. banks will become larger with partial government ownership (or interference depending on your viewpoint). Many critics of financial deregulation demand the U.S. government to re-enact the Glass– Steagall Act that would separate commercial and investment banking activities. Many leaders around the world are debating whether to pass new laws to separate commercial and investment banking in their countries because the 2008 Financial Crisis forced governments to spend billions in bailing out their large banks. The Common Financial Instruments common stock bond U.S. Treasury bill (T-bill) Treasury Note (T-note) commercial paper Treasury Bond (T-bond) banker‟s acceptance general-obligation bond negotiable bank certificate of deposit revenue bond repurchase agreement mortgage Federal Funds mutual fund Eurodollars money-market mutual fund (MMMF) money market deposit account (MMDA) 29 Chapter Questions 1. Why would people deposit their savings into financial intermediaries, instead of directly investing in the financial markets? 2. Distinguish between stocks and bonds. 3. Distinguish between the primary and secondary markets. 4. Appraise the importance of the secondary markets. 5. Define financial disintermediation, and why it occurs? 6. Identify the money market instruments and capital market instruments. 7. Distinguish between a money market and capital market. 8. Do common stocks have a maturity date? 9. Appraise the difference between a state bank and a national bank. 10. Which government agencies regulate the commercial banks? 11. Explain why the government regulates the banking sector. 12. Explain the role of the Federal Deposits Insurance Corporation (FDIC). 13. Identify the two methods the FDIC uses to handle a bank failure. 14. Please define bank runs, contagion, and financial panics. 15. Why did the financial markets in the modern world become international? 16. Why do governments regulate the financial markets? 17. Identify methods a bank holding company uses to circumvent government regulations. 18. How does a nonbank bank and automated teller machines circumvent bank regulations? 19. Distinguish between a money-market mutual fund and a money-market deposit account. 30  3. Multinational Enterprises This chapter defines and distinguishes the three business forms: proprietorships, partnerships, and corporations. Then students study the corporations extensively because they have many advantages over proprietorships and partnerships, as well as different management structures. Although corporations roughly comprise 20% of U.S. businesses, they dominate the business and financial markets. Unfortunately, the corporate structure has several disadvantages with the main one being susceptible to corporate fraud. Thus, students study the disadvantages and ways to minimize them. Finally, corporations dominate international trade and finance, which is why we study them in this book. Towards the end of the chapter, we explain the Law of Comparative Advantage, and why businesses engage and profit from free trade. Forms of Business Organizations Goal of a business is to earn profits. Alfred P. Sloan stated, “General Motors is not in the business of making automobiles. General Motors is in the business of making money.” All business owners seek profit, and we classify them as a sole proprietorship, partnership, and corporations. Sole proprietorship is one person owns the business. That one person becomes liable for all the business‟s debts, and the business is dissolved legally, when the owner dies. Sole proprietors are the most numerous businesses in the United States, and they usually own farms, grocery stores, hotels, and restaurants. A partnership is a business owned and managed by two or more people. Partnership is defined as general or limited liability. Under a general partnership, all partners become liable for the partnership‟s debts and obligations. If one partner applies for a bank loan, steals the money, and flees the country, the remaining partners become liable for the bank loan. A limited liability partnership restricts liability and helps protect the partners‟ assets that he or she does not use directly in the business. Thus, a partner can only lose assets invested in the partnership while his or her other assets are protected from creditors. On the other hand, general partnerships do not have this protection. If a general partnership bankrupts, then creditors can go after a partners‟ assets such as the partners‟ house, car, personal bank accounts, and other assets. Usual partnerships are accounting and law firms. A corporation becomes the last form, and the focus of this chapter. Although corporations comprise approximately 20% of businesses in the United States, they dominate domestic and international markets because they enter into all spheres of business activity. Unfortunately, corporations can become so complex; the management loses sight on its goal of earning profits. For instance, shareholders represent the owners of the corporation, and they should benefit. Sometimes corporate managers lose sight of earning profits. Unfortunately, the managers do not maximize the shareholders‟ wealth, maximize share price, or maximize a firm‟s value. However, if a corporation continually earns losses year after year, then the business would fail, similarly to a proprietorship and partnership. 31 Kenneth R. Szulczyk Corporations Corporations start as private companies that transform into a corporation. They have an Initial Public Offer (IPO), the day the corporation begins selling stock to the public. Usually, the corporation‟s founder holds large shares in the company‟s stock and becomes a millionaire or billionaire over night from the market value of his or her stock holdings. A charter is a legal document from government that creates the corporation. By law, the corporation becomes an independent legal entity with rights similar to a person. A state government approves corporate charters in the United States. For example, several corporations choose the State of Delaware because the state charges the lowest fees to incorporate. A corporation has three parties: stockholders, board of directors, and executive officers. Stockholders own the corporation, and they usually meet once a year to vote for the board of directors, and one share equals one vote. Consequently, the majority shareholder dominates the board of directors, and therefore, controls the corporation. Of course, a majority shareholder could be another corporation. Next, the board of directors sets corporate policy, declares dividends, and selects the president and executive officers. Executive officers operate the daily business of the corporation. We show two corporate forms in Figure 1. For both forms, the stockholders are the owners and elect the board of directors. They differ who becomes the president of the corporation. In the first form, the board chairman is also the chief executive officer and president of the corporation. For the second form, the board appoints a chief operating officer to be president of the corporation. Figure 1. Two forms of corporate management Corporations are large organizations that can raise a substantial amount of financial capital. Consequently, a corporation has financial resources to enter foreign countries and dominate international trade. Furthermore, it creates special departments that employ specialists in law, 32  Money, Banking, and International Finance taxes, finance, and accounting, who handle operations for foreign countries. Advantages of the corporate form include:  A corporation has limited liability. Stockholders own the corporation, and they are not liable for a corporation's debt. If a corporation fails, subsequently, the stockholders only lose their investment, the amount of common stock that they had purchased.  Stockholders can easily transfer corporate ownership. Stocks are certificates that represent ownership in a corporation, and stockholders can freely buy or sell stock to other investors through the stock market.  Corporations have continuity of life. Theoretically, a corporation could live forever.  Stockholders do not have a mutual agency relationship, where the stockholders cannot bind a corporation to contracts. Stockholders have no say in the daily operation of the corporation even though they own the corporation. Corporations have two disadvantages. First, government heavily regulates corporations. Corporations file many reports with government because corporations can expand into many countries, markets, and industries. Corporations may encourage regulations because bureaucratic red tape creates barriers to entry. Thus, new companies experience troubles entering the market with complex and arduous regulations. Second, government imposes taxes twice on corporations. Corporations pay taxes from their profits. Then stockholders receive profit from the corporation as dividends, and the dividends become income to the stockholder that a government also taxes. Corporations could issue two different classes of stock: common stock and preferred stock. Common stock allows stockholders to vote at stockholder meetings, while preferred stock does not have any voting rights. For stockholders to give up their voting right, they will receive their dividends before the common stockholders. Consequently, a corporation could issue preferred stock to expand operations and not share control of the corporation with the new preferred stockholders. Moreover, corporations can pay different dividends, paying a higher dividend to the common shareholders. We define preferred stock by the following categories:  Cumulative Preferred Stock – a corporation must pay past-due dividends to cumulative preferred stockholders before it pays dividends to common stockholders. Stockholders only receive dividends, when the board of directors declares them.  Protected Preferred Stock – a corporation must deposit part of its profits into a fund, and, thus, the corporation can guarantee dividend payments to preferred stockholders.  Redeemable Stock – a corporation has the right to repurchase the preferred stock in the future. 33 Kenneth R. Szulczyk  Convertible Stock – a stockholder can convert preferred stock into common stock on a specific date in the future. Issuing of stock allows corporations to garner large amounts of financial capital. Furthermore, a corporation can raise capital by issuing bonds. A bond is a loan. However, a bond is standardized, allowing investors to buy or sell bonds on the financial markets. Moreover, a bondholder has two rights. First, a corporation pays interest on the bond, regardless of a corporation‟s financial position. Second, a corporation pays the face value of the bond on a specific date in the future. If a corporation bankrupts or it is dissolved, subsequently, the corporate debts are paid first that include bonds, bank loans, and taxes. If any assets remain, then the preferred stock holders are paid, and finally, the common stockholders are last. Corporations can buy other corporations. For instance, a parent corporation can have many subsidiaries, and the parent company does not fully integrate the subsidiaries into the parent corporation. Corporations develop these complex structures because of lawsuits, taxes, and regulations. Unfortunately, lawsuits are common and excessive in the U.S. If a successful lawsuit bankrupts a subsidiary, only that subsidiary is impacted. For example, a judge sued a dry cleaner for $65 million because the dry cleaner lost his pants. Although the dry cleaner found the judge‟s pants a week later, the lawsuit bankrupted the dry cleaner. In another example, a corporation owns 10 different apartment complexes. A corporation establishes each apartment complex as a separate, legal entity. If a tenant is injured on one property, he or she can sue the complex that limits the lawsuit to one subsidiary. Stockholders, of course, want a good return for their investment. A return reflects an investor‟s profit stated in annual percentage terms, and it has two sources: Dividend yield and capital gains. A dividend yield converts the dividend into a percentage. For example, you received $1 per share on your Facebook stock with a value of $20 per share. Dividend equals D; the stock price is P, and t indicates today‟s time. We calculate your dividend yield as 5% in Equation 1. Dt $1 dividend yield = 100  100  5% (1) Pt $20 Investors could earn a capital gain, which means they can sell their stock for a greater price than the amount they paid for it. For example, you bought your Facebook stock for $18 per share last year and sold it this year for $20. We compute a capital gain of 11.1% in Equation 2. Notice the subscripts; t represents today while t-1 represents last year. If the investment does not exactly equal one year, then we must adjust the capital gain. For instance, if your investment lasted for two years, subsequently, you would divide the capital gain by 2, converting it into an annual return. Pt  Pt 1 $20  $18 capital gain= 100  100  11.1% (2) Pt1 $18 34  Money, Banking, and International Finance Your return from your Facebook investment is the dividend yield plus the capital gain, or 16.1%. Corporate managers can influence the dividend yield that ranges approximately 2% per year while they have little influence on the capital gains that could range as high as 12% per year. Unfortunately, investors could face catastrophic losses if a stock market quickly plummets during a downturn in an economy. For example, the U.S. stock markets dropped half in value during 2008, and many internet stocks became worthless during 2000 as the stock from internet companies plummeted. Consequently, investors could earn capital losses if they sell their stock as it falls in value, or the corporation bankrupts. Corporations can use subsidiaries to avoid regulations or avoid taxes. For instance, a parent corporation could relocate to the Bahamas or Cayman Islands. These countries are tax havens with low taxes, little regulations, and strong confidentiality laws. Consequently, corporations can shift assets and liabilities among subsidiaries to decrease their overall tax burden. At this point, we clarify some tax terminology. Tax evasion is a person or corporation owes a government for taxes, but refuses to pay it. Some activity created the tax liability, and the law requires them to pay taxes. Otherwise, government can assess fines or send the tax evaders to prison. However, corporations can use tax avoidance because they can afford to hire specialists. Tax avoidance is the managers careful plan the corporate activities and prevent the creation of tax liabilities. Dividing line between tax evasion and avoidance can be a thin one. Since the 2007 Great Recession is still impacting the world economy in 2013, some tax authorities penalize and fine companies that use tax avoidance. Unfortunately, tax collections are down, and many governments are becoming aggressive in tax collections. For example, Italian tax inspectors board yachts as they dock in Italian ports. Italian yacht owners registered their yachts in the Cayman Islands, avoiding registration fees and avoiding the VAT fuel taxes. Consequently, the Italian ports reported 40% declines in yacht docking as the yacht owners avoid Italy‟s ports. Unfortunately, the economies around the ports suffer from fewer customers, who shop and eat in the local communities, which could further depress tax revenues. Corporate Fraud The Enron Corporation declared bankruptcy in 2001 and became the universal symbol for corporate fraud. Enron managers created Special Purpose Entities (SPE) with the sole purpose to wipe debt and liabilities from Enron‟s financial statements. A Special Purpose Entity consists of a company or subsidiary of the corporation. A SPE could be a shell company, where the company does not physically exist, except on paper. The Enron managers invested in many power plants around the world, and some of its investments soured and failed. Then, they created off-balance sheet companies, and they sold its bad investments to its SPEs. Afterwards, their balance sheet appeared financially strong, and Enron applied for more bank loans, gaining more cash. Next, the Enron management bought more companies, and they repeated the process. At the end, Enron hid $25 billion in debt from its investors. 35 Kenneth R. Szulczyk Enron‟s managers invested Enron stock in the SPEs. As Enron‟s stock price soared, the SPE's finances remained healthy until Enron‟s stock price peaked at $90 per share. Once Enron‟s stock price began plummeting until it fell below one dollar per share in 2000, the SPEs earned substantial losses. Enron hid the losses and asked banks for more loans that would keep the company afloat, but Enron failed to obtain new loans. The U.S. economy entered a recession in 2001 after many internet companies bankrupted in 2000. A recession always exposes an organization‟s weakness. Unfortunately, Enron employees‟ pension funds were invested in Enron stock, and many employees lost their pension funds and became unemployed. Almost everyone in the financial world overlooked the SPEs, including Enron‟s auditor, Arthur Anderson, Enron‟s law firm, and the regulators from the Securities and Exchange Commission (SEC). Then the U.S. government passed the Sarbanes-Oxley Act in 2002, which required CFOs and CEOs to sign their company‟s financial statements. Law‟s goal was to increase transparency. Transparency means outsiders can look at an organization, and know the rules and can accurately assess a firm's true finances. Unfortunately, Enron was “a black box,” and only a few insiders knew Enron‟s genuine financial picture. On the other hand, a non- transparent government tends to be corrupt. For example, if government officials do not write down the laws and rules, or the laws and rules are vague, subsequently, the bureaucrats have wide discretion whether to approve a business license or activity, fueling corruption. The U.S. economy rebounded from the strong, overly optimistic real estate market. Everyone forgot Enron‟s misdeeds until the 2007 Great Recession, when the scale of fraud became much larger. For example, Lehman Brothers used exotic securities such as credit default swaps and collateralized debt obligations to buy real estate (Discussed in Chapter 18). After the recession had struck, unemployment doubled, and many households started defaulting on their mortgages. Commercial and investment banks stopped lending overnight, and real estate prices began tumbling. Unfortunately, Lehman Brothers went on a spending spree, buying real estate toward the peak of the housing bubble. It held $768 billion in bank and bond debt while it had $639 billion in assets that dropped rapidly as real estate prices fell. Lehman Brothers filed for bankruptcy in 2008 and had closed its doors after 158 years of business. Countries differ in corporate structure and planning. The U.S. corporations usually focus on short-term profits, and thus, they have problems with corporate fraud. On the other hand, the Japanese plan long term and they form a Keiretsu, a conglomerate of many companies with a bank member. Consequently, the bank could grant low-interest loans to its partner companies, and the Keiretsu usually focuses on long-term profits and market shares. Furthermore, corporations in South Korea, Germany, and Russia also established conglomerates, which are similar to a Keiretsu. Some governments become a shareholder in a company, which the former communistic countries often use. Government retains control over the company, and it attracts partners who bring technology and efficient management practices. Unfortunately, government as a shareholder becomes susceptible to corruption because a government can use its authority to protect the company and isolate it from competition. Some corporations suffer from the principal-agent problem, when two related parties have different incentives, creating conflicts and odds with each other. For example, the corporate 36  Money, Banking, and International Finance structure separates the managers from the owners (i.e. stockholders). Stockholders select managers, who maximize profits, maximize the return to the shareholders and/or increase shareholder value. However, managers may not act in the best interest to the owners. They want high salaries, generous benefits, luxurious offices, and access to private planes and Limousines, reducing the return to the stockholders. The U.S. investment banks, for example, were partnerships before the 1990s, and the managers handled money carefully. They were both the principal and agent. Then the managers converted the investment banks to corporations during the 1990s, and the managers gambled and took high risks while the shareholders owned the corporations. Investment banks became involved in the mortgage market in the early 2000s and were caught in the mania of the U.S. housing bubble. When the bubble deflated, the shareholders lost their stock value during the 2008 Financial Crisis. Finally, for one perverse example, GM cancelled its stock, and the shareholders lost everything during 2008. Remember, the corporate managers represent the shareholders and run the corporation on their behalf. A family who dominates a corporation could reduce the principal-agent problem. For example, the Walton family is the majority shareholders who actively manage the Wal-Mart Corporation. Microsoft was similar, when Bill Gates was both the CEO and majority shareholder. Consequently, they become both the agent and principal, and they have one united interest - to earn profits. Thus, these companies earned high returns, and managers have better vision and oversight over their corporations. Expanding into Foreign Countries A multinational corporation is a company incorporates itself in one country and operates in one or more foreign countries. For example, British Petroleum, General Electric, Toshiba, and Wal-Mart are multinational corporations with extensive business activities that span across the globe. Sometimes financial analysts use the term, multinational enterprise because a government could form a joint venture with a corporation, and the definition of an enterprise implies a broader meaning. A multinational enterprise‟s goal is to earn profits. Therefore, they enter the international markets and foreign countries in the pursuit of profits. Every international enterprise has a choice. It could export to another country or relocate production outside their home country. For instance, many U.S. corporations relocated manufacturing outside the United States, although the U.S. suffers from a high unemployment rate since the beginning of the Great Recession. Financial analysts and economists divide the world‟s markets into mature economies and emerging markets. Mature economies are competitive, and a company entering this market would face narrow profit margins. Some examples include the United States and Europe. On the other hand, the emerging-market economies are countries that recently opened their markets to international trade and finance. They can be very profitable but entail greater risk. For example, China, India, and Mexico are removing their government controls of their markets, and they allow international investors and corporations to invest in their economies. A government that attracts foreign investment must change its laws to reflect three requirements. First, a government establishes an open-market place that means a government 37 Kenneth R. Szulczyk allows free markets and allows the free movement of capital, labor, and technology. Thus, a government relaxes its control over its market. Second, a government allows strategic management. Thus, companies can develop new products and services, and compete with other companies. Furthermore, a multinational enterprise could tailor its goods and services to accommodate different cultures and tastes. Finally, multinational corporations need access to capital because international activities require financing. Hence, a country must allow the free movement of money, and corporations are free to issue more stock, bonds, or receive bank loans without government interference. Consequently, a firm has twelve reasons to relocate production to another country, rather than to export. Reason 1: A foreign government offers subsidies and tax breaks to a company. Some countries such as Dubai (United Arab Emirates) and China have free-trade zones, where companies pay little or no taxes, experience few regulations, and can freely export their products and services to the international markets. Consequently, some governments offer incentives to companies because they want to create jobs and reduce unemployment and poverty rates. Reason 2: A company gains access to technology from another country. For example, India has talented computer programmers and engineers, who work for relatively lower wages than their counterparts in the United States and Europe. Consequently, a company could relocate to India to tap into their skilled workforce. Reason 3: An enterprise that moves its factories to a foreign country automatically avoids trade restrictions, like tariffs and import quotas. Government does not apply trade restrictions to products and services produced within a country. Reason 4: A company relocates its manufacturing facilities to reduce transportation costs. For example, sugarcane is bulky and expensive to transport. Consequently, sugar producers locate the sugar mills close to the sugarcane fields. Then they extract and purify the sugar and ship it to distant markets. Reason 5: A business gains access to new markets and more consumers. For instance, the Coca-Cola Corporation produces and sells its carbonated soda products in most countries around the world, boosting its consumers. Reason 6: A company could diversify its business and manufacturing by expanding into foreign markets. Some foreign markets grow quickly, while other markets experience weak growth. Consequently, the business could earn a return on its investments. Reason 7: A company needs an important raw material for production. For example, battery manufacturers need lithium to produce laptop batteries. They started mining and refining facilities in Bolivia because Bolivia possesses half the world‟s reserves for lithium. Reason 8: Businesses and companies reduce their production costs. Consequently, many U.S. manufacturing companies moved to China and Mexico to take advantage of the lower wages and comparable productivity. Reason 9: A company outsources its production to another company, usually located outside the country. For example, Microsoft outsourced its production of X-box consoles to Flextronics, a Singaporean company. Then Flextronics outsourced the production to a Chinese manufacturing plant. Consequently, outsourcing can lower a company‟s cost, granting it a cost advantage over its competitors. 38  Money, Banking, and International Finance Reason 10: A company investing in a foreign market today may lead to future investments. For example, a company opens a subsidiary in Moscow, Russia. After establishing the subsidiary, the company can open branches in other Russian cities or enter other Russian speaking countries. Reason 11: A company that produces in a foreign market reduces economic exposure. Economic exposure is changes in economic factors, such as inflation, interest rates, and exchange rates affect a company's profits. One important factor is fluctuating exchange rates. A company could experience wide swings in profits if it produces in one country and exports to another. However, if the company produces and sells within the same country, fluctuating exchange rates would impact less because the company‟s revenues and costs are denominated in the same currency. Thus, a company's profit could remain stable in a foreign market. Reason 12: Many companies relocate subsidiaries to politically safe and business-friendly countries, such as the Bahamas, Dubai, and Singapore. These countries have low taxes and few regulations. Multinational enterprises are more complicated than businesses that remain in their home country. First, the businesses transfer resources, such as machines, equipment, and labor between different countries. Next, they ship products and services to other countries. Consequently, companies need excellent management in logistics, and specialists who monitors a country‟s different laws and regulations. Second, international enterprises are exposed to exchange rate risks and credit risks. Thus, a company‟s profit can quickly change due to fluctuations in currency exchange rates, or a company cannot get credit to finance operations in a specific country. Finally, enterprises have other exposures, such as country risk. For example, when Hugo Chavez became president of Venezuela, his government began nationalizing companies. Any international enterprise in Venezuela can experience the seizure of its assets without compensation. A country risk is the risk of investing in a particular country as political conditions rapidly change. For example, the Republic of Kazakhstan was a former state of the Soviet Union that became an independent country in 1991. Country‟s president, Nursultan Nazarbayev, opened its economy to free markets in early 1990s. Consequently, Kazakhstan made great strides towards a market economy and attracted billions in international investment because the country contains vast petroleum and mineral wealth. After the 2008 Financial Crisis, the Kazakh government is gradually reviving the Soviet rules, practices, and regulations. Unfortunately, the Soviet legal system is very bureaucratic, slow, and arbitrary, and suffers from corruption and political favoritism. Moreover, the Kazakh government nationalized several foreign-owned companies, and international investment began plummeting in 2012. The Law of Comparative Advantage Law of Comparative Advantage forms the basis of free trade. David Ricardo, a British political economist, formulated the law in the 19 century. It states two countries can benefit from trade by specializing in the production of goods where a country has a relatively cheaper cost. Thus, governments that instituted free trade between themselves help fuel the rapid growth of globalization and the rise of the multinational enterprises. Political leaders reduced their 39 Kenneth R. Szulczyk tariffs and trade barriers to allow money, products, and services to cross borders. Finally, the Law of Comparative Advantage still works for a large country that can produce everything. Economists use a production possibilities curve (PPC) to show how two countries benefit from free trade. A PPC represents graphically a country‟s maximum production level for two goods given its endowment of resources. Resources include labor, machines, equipment, land, and entrepreneurs. The PPC has three assumptions:  Both countries produce at full employment, which means a country produces on the boundary of the production possibilities curve. Thus, society employs its entire labor force, and entrepreneurs use all their machines, equipment, and land to produce goods and services.  The PPCs are straight lines. Consequently, an industry experiences no losses when entrepreneurs move resources from industry to another. Although this analysis works with curved PPCs, the straight-line PPCs simplify the analysis.  Two countries, the United States and Mexico, produce only tomatoes and cars. We begin the analysis with no trade between Mexico and the United States. United States produces 50 units while Mexico produces 60 if they shift the entire country‟s resources to produce tomatoes. If entrepreneurs shift all the resources into car manufacturing, then the United States produces 100 cars while Mexico produces 30. The intercepts indicate the maximum production levels for the PPC curves, which we show in Figure 2. Figure 2. The Production Possibilities Curves for Mexico and the United States We set each country‟s production level at the half-way point. Thus, the United States produces 25 tomatoes and 50 cars while Mexico produces 30 tomatoes and 15 cars. Consequently, the total production for both countries equals 55 tomatoes and 65 cars. 40  Money, Banking, and International Finance If Mexico and the United States engage in free trade, subsequently, the countries specialize in producing products where they have low opportunity costs. Opportunity cost reflects the slopes of the PPCs. Slope for the United States equals 0.5, which means the U.S. must give up the production of one car to produce 0.5 tomatoes. On the other hand, Mexico has a slope of 2. It can produce two tomatoes by giving up one car. Consequently, the United States specializes in car manufacturing while Mexico specializes in growing tomatoes. Straight-line PPCs lead to complete specialization, whereas curved PPCs have partial specialization because curved PPCs experience increasing opportunity costs as an industry expands. With complete specialization, the United States produces all cars while Mexico produces all tomatoes because the opportunity costs do not change. U.S. entrepreneurs continually shift resources from the tomato industry into the car industry until they reach the maximum car production. On the other hand, the Mexico entrepreneurs do the exact opposite. Consequently, the United States produces 100 cars and grows zero tomatoes while Mexico grows 60 tomatoes and produces zero cars. Gain in world production equals 35 cars and 5 tomatoes. Unfortunately, we need more trade theory to predict how the countries would divide this extra production between themselves. This simple analysis of free trade has limitations. First, this analysis does not include the role of technology, or the flow of resources from one country to another. Second, this analysis does not include outsourcing. Outsourcing is a firm contracts part of its production to another firm in another country, and it has become very popular. Finally, the communication and transportation costs are decreasing, which strengthens outsourcing and the flow of resources. Chapter Questions 1. Explain why sole proprietorships are usually small businesses. 2. Identify the benefits of incorporating a business. 3. Board of directors of a corporation needs more funding to invest in a new factory. However, they do not want to issue more common stock because it would weaken the majority shareholders' position. Identify the board‟s options. 4. Could a corporation use a subsidiary to hide debt or manipulate its financial statements? 5. You bought stock for a new internet company for $25 per share last year and paid a $0.50 dividend per share. Unfortunately, the company faces bankruptcy, and you quickly sell your shares for $15. Calculate your rate of return for this investment. 6. Did the U.S. federal government fix corporate fraud after passing the Sarbanes-Oxley Act in 2002? 7. Could a bank that becomes a member of a Keiretsu create problems for the entire company? 41 8. Does the principal-agent problem exist if a university pays a commission to an enrollment counselor who enrolls students in the university? 9. Distinguish between a third-world country and an emerging economy. 10. Could a country produce within the interior of a production possibilities curve? 11. Identify the benefits for a business to expand into a growing country like China. 12. Is outsourcing a form of free trade? 13. You have two countries: Bosnia and Herzegovina and Colombia. Both countries grow tobacco and coffee. Two countries can produce a maximum with their resources in the table. Production Tobacco Coffee Bosnia and Herzegovina 1,000 500 Colombia 500 1,000 Please draw the two PPCs with the production set at the half-way point. Identify the gain of production if the two countries engage in free trade. 42