Week 6 Lecture - Financial Intermediation (PDF)

Week 6 Financial intermediation BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Discuss the role of financial intermediaries and how they promote efficiency. 2. Explain asymmetric information, the pro...

Week 6 Financial intermediation BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Discuss the role of financial intermediaries and how they promote efficiency. 2. Explain asymmetric information, the problems it causes, and solutions to these problems. 3. Describe how moral hazard and adverse selection are managed by intermediaries and how they influence business finance. The University of Sydney Page 2  Introduction – Intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities. – Intermediaries increase investment and economic growth while they reduce investment risk and economic volatility. The University of Sydney Page 3  Introduction – Without a stable, smoothly functioning financial system, no country can prosper. – Figure 11.1 plots a commonly used measure of financial activity—the ratio of credit extended to the private sector to gross domestic product—against real GDP per capita. – We can see that there are not any rich countries with very low levels of financial development. The University of Sydney Page 4  Introduction The University of Sydney Page 5  The Role of Financial Intermediaries – Financial markets are important because they price economic resources and allocate them to their most productive uses. – Intermediaries, including banks and securities firms, continue to play a key role in both direct and indirect finance. The University of Sydney Page 6  The Role of Financial Intermediaries The University of Sydney Page 7  The Role of Financial Intermediaries – From the table we can see: – To make comparisons across countries of vastly different size, we measure everything relative to GDP. – There is no reason that the value of a country’s stock market, bonds outstanding, or bank loans cannot be bigger than its GDP. – When you add up all the types of financing, direct and indirect, as a percentage of GDP, the numbers will generally sum to more than 100 in an advanced economy. The University of Sydney Page 8  The Role of Financial Intermediaries – The importance of intermediaries. – Banks are still critical providers of financing around the world. – Intermediaries determine which firms can access the stock and bond markets. – Banks decide the size of a loan and interest rate to be charged. – Securities firms set the volume and price of new stocks and bond issues when they purchase them for sale to investors. The University of Sydney Page 9  The Role of Financial Intermediaries – Financial intermediaries are important because of information. – Lending and borrowing involves both transactions costs and information costs. – Financial institutions exist to reduce these costs. The University of Sydney Page 10  The Role of Financial Intermediaries In their role as financial intermediaries, financial institutions perform five functions: 1. Pooling the resources of small savers, 2. Providing safekeeping and accounting services, as well as access to payments system, 3. Supplying liquidity by converting savers’ balances directly into a means of payment whenever needed, 4. Providing ways to diversify risk, and 5. Collecting and processing information in ways that reduce information costs. The University of Sydney Page 11  The Role of Financial Intermediaries The University of Sydney Page 12  Information Asymmetries and Information Costs Asymmetric information poses two important obstacles to the smooth flow of funds from savers to investors: 1. Adverse selection arises before the transaction occurs. – Lenders need to know how to distinguish good credit risks from bad. 2. Moral hazard occurs after the transaction. – Will borrowers use the money as they claim? The University of Sydney Page 13  Adverse Selection – Used cars and the market for lemons (Akerlof, 1970): – Used car buyers can’t tell good cars from bad. – Buyers will at most pay the expected value of good and bad cars. – Sellers know if they have a good car, so they won’t accept less than the true value. – If buyers are only willing to pay average value, good car sellers will withdraw cars from the market. – Then the market has only the bad cars. The University of Sydney Page 14  Adverse Selection – Some companies have been created to try and solve the asymmetrical information problem. – Consumer Reports has long published information on particular models – More recently CARFAX provides potential buyers with detailed history on any car. – You can also hire a mechanic to look over a car for you before you buy it. – Finally, many car manufacturers are beginning to offer “certified” used cars, which usually come with warranties. The University of Sydney Page 15  Adverse Selection in Financial Markets – If you can’t tell good from bad companies – Stocks of good companies are undervalued, and – Owners will not want to sell them. – If you can’t tell good from bad bonds – Owners of good companies will have to sell bonds for too low a price, so – Good bonds won’t be sold. The University of Sydney Page 16  Solving the Adverse Selection Problem – From a social perspective, the problems of adverse selection are not good. – Some companies will pass up good investments. – Economy will not grow as rapidly as it could. – We must find ways for investors and lenders to distinguish well-run firms from poorly run firms. The University of Sydney Page 17  Disclosure of Information – An obvious way to solve the hidden attributes problem is to provide more information. – In most advanced economies, public companies are required to disclose voluminous amounts of information. – Public companies are those that issue stock and bonds that are bought and sold in public financial markets. – For example, in the U.S., the Securities and Exchange Commission (SEC) requires firms to produce public financial statements that are prepared according to standard accounting practices. The University of Sydney Page 18  Disclosure of Information – With the help of some unethical accountants, company executives found a broad range of ways to manipulate the statements to disguise their firms’ true financial condition. – Although accounting practices have changed, information problems persist. – In a limited sense, there is private information collected and sold to investors. – Research services like Moody’s, Value Line, and Dun and Bradstreet collect information directly from firms and produce evaluations. – To be credible, companies cannot pay for this research, so investors have to. The University of Sydney Page 19  Disclosure of Information – Private information services face a free-rider problem. – A free-rider is someone who doesn’t pay the cost to get the benefit of a good or service. The University of Sydney Page 20  Collateral and Net Worth – Collateral is something of value pledged by a borrower to the lender in the event of the borrower’s default. – It is said to back or secure a loan. – Unsecured loans, like credit cards, are loans made without collateral. – Because of this they generally have very high interest rates. The University of Sydney Page 21  Collateral and Net Worth – The net worth is the owner’s stake in a firm - the value of the firm’s assets minus the value of its liabilities. – Net worth serves the same purpose as collateral – If a firm defaults on a loan, the lender can make a claim against the firm’s net worth. – From the perspective of the mortgage lender, the homeowner’s equity serves exactly the same function as net worth in a business loan. The University of Sydney Page 22  Collateral and Net Worth – The importance of net worth in reducing adverse selection is the reason owners of new businesses have so much difficulty borrowing money. – Most small business owners must put up their homes and other property as collateral for their business loans. – Only after establishing a successful business and building up net worth, can they borrow without personal property. The University of Sydney Page 23  Moral Hazard: Problem and Solutions – The phrase moral hazard originated when economists who were studying insurance noted that an insurance policy changes the behaviour of the person who is insured. – Moral hazard arises when we cannot observe people’s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck. The University of Sydney Page 24  Moral Hazard: Problem and Solutions – A second information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project. – Moral hazard affects both equity and bond financing. The University of Sydney Page 25  Moral Hazard in Equity Finance – If you buy stock in a company, how do you know your money will be used in the way that is best for you, the stockholder? – It is more likely that the manager will use the funds in a way that is most advantageous to them, not you. – The separation of your ownership from their control creates what is called a principal-agent problem. The University of Sydney Page 26  Solving the Moral Hazard Problem in Equity Financing – During the 1990’s, a concerted attempt was made to align managers’ interests with those of stockholders. – Executives were given stock options that provided lucrative payoffs if a firm’s stock price rose above a certain level. This gave managers incentives to misrepresent companies’ profits. – At this time, there is no foolproof way of ensuring managers will behave in the owner’s best interest. The University of Sydney Page 27  Moral Hazard in Debt Finance – When the managers are the owners, moral hazard in equity finance disappears. – Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking. – Lenders need to find ways to make sure borrowers don’t take too many risks. – People with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their collateral. The University of Sydney Page 28  Solving the Moral Hazard Problem in Debt Finance – Legal contracts can solve the moral hazard problem inherent in debt finance. – Bonds and loans carry restrictive covenants that limit the amount of risk a borrower can assume. – The firm may have to maintain a certain level of net worth, a minimum credit rating, or a minimum bank balance. – For example: home mortgages require home insurance, fire insurance, etc. The University of Sydney Page 29  Negative Consequences of Information Costs The University of Sydney Page 30  Financial Intermediaries and Information Costs – Much of the information that financial intermediaries collect is used to: – Reduce information costs, and – Minimise the effects of adverse selection and moral hazard. – To do this, intermediaries: – Screen loan applicants, – Monitor borrowers, and – Penalise borrowers by enforcing contracts. The University of Sydney Page 31  Screening and Certifying to Reduce Adverse Selection – To get a loan, whether from a bank, a mortgage company, or a finance company, you must fill out an application. – The lender uses a company that collects and analyses credit information, summarising it for potential lenders in a credit score. – Every time someone requests a credit score, they have to pay, eliminating the free rider problem. – Banks can collect information on a borrower that goes beyond their credit report and loan application. The University of Sydney Page 32  Screening and Certifying to Reduce Adverse Selection – Underwriters screen and certify firms seeking to raise funds directly in the financial markets. – Underwriters are large investment banks like Goldman Sachs, JPMorgan Chase, and Morgan Stanley. – Without certification by one of these firms, companies would find it difficult to raise funds. The University of Sydney Page 33  Monitoring to Reduce Moral Hazard – Intermediaries monitor both the firms that issue bonds and those that issue stocks to reduce moral hazard. – Many hold significant number of shares in individual firms. – They may place a representative on the company’s board of directors. The University of Sydney Page 34  Monitoring to Reduce Moral Hazard – For new companies, a financial intermediary called a venture capital firm does the monitoring. – They specialise in investing in risky new ventures in return for a stake in the ownership and a share of the profits. – They keep a close watch on the managers’ actions. – The threat of a takeover helps to persuade managers to act in the interest of the stock and bondholders. The University of Sydney Page 35  Homework problems – CS chapter 11 – Problems 8, 9, 11, 13-16 – Data exploration problems 1, 4 The University of Sydney Page 36