FINA 2330 Lecture - 2024-2025 PDF

Lecture – 04 1 Why Do Financial Institutions Exist? FINA 2330 2024-2025  2 Reference Financial Markets and Institutions Frederic S. Mishkin and Stanle...

Lecture – 04 1 Why Do Financial Institutions Exist? FINA 2330 2024-2025  2 Reference Financial Markets and Institutions Frederic S. Mishkin and Stanley G. Eakins 9th Edition, Global Edition Pearson Education Chapter 7 : Why Do Financial Institutions Exist? Copyright © 2018 Pearson Education, Ltd. All Rights Reserved  3 Chapter Preview In this chapter, we take a closer look at why financial institutions exist and how they promote economic efficiency. Topics include: Basic Facts About Financial Structure Throughout the World Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard How Adverse Selection (the Lemons Problem) Influences Financial Structure + the Tools to Help? How Moral Hazard Affects the Choice Between Debt and Equity Contracts + the Tools to Help? How Moral Hazard Influences Financial Structure in Debt Markets + the Tools to Help? Conflicts of Interest  4 Basic Facts About Financial Structure Throughout the World (1 of 2) The financial system is a complex structure and function throughout the world, including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc. All of these financial institutions are regulated by government. The chart on the next slide shows how nonfinancial business obtain external funding in the U.S., Germany, Japan, and 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 bonds.  5 Basic Facts About Financial Structure Throughout the World (2 of 2) Figure 7.1 : Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany, Japan, and Canada Bank Loans : primarily of loans from depository institutions. Nonbank Loans : primarily of loans by other financial intermediaries. Bonds : marketable debt securities such as corporate bonds and commercial paper. Stock : new issues of new equity (stock market shares). Sources: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and are gross flows as percentages of the total, not including trade and other credit data, which are not available.  6 Facts of Financial Structure (1 of 5) Eight basic facts (“8-Facts”) are observed from the financial structure all over the world : 1. Stocks are not the most important source of external financing for businesses. 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. ‒ Even for the new corporate bonds, commercial paper and stock issued by corporations through the direct finance channels, the securities have been bought primarily by financial intermediaries such as insurance companies, pension funds, and mutual funds.  7 Facts of Financial Structure (2 of 5) 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. ‒ Industrialized countries: Bank loans are the largest category of sources of external finance. Banks have the most important role in financing business activities. ‒ Developing countries: Banks play an even more important role in the financial system than they do in industrialized countries.  8 Facts of Financial Structure (3 of 5) 5. The financial system is among the most heavily regulated sectors of the economy. ‒ The financial system is heavily regulated. Governments regulate the financial markets primarily to promote provision of information and to ensure the soundness (stability) of the financial system. 6. Only large, well-established corporations have easy access to securities markets to finance their activities. ‒ Individuals and smaller businesses that are not well established are less likely to raise funds by issuing marketable securities. Instead, they most often obtain their financing from banks.  9 Facts of Financial Structure (4 of 5) 7. Collateral is a prevalent feature of debt contracts for both households and businesses. ‒ Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. ‒ Collateralized debt is the predominant form of household debt and is widely used in business borrowing as well. 8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. ‒ Bond or loan contracts typically are long legal documents with provisions (called restrictive covenants) that restrict and specify certain activities that the borrower can engage in.  10 Facts of Financial Structure (5 of 5) Why we have these 8 facts in the financial structure? An important feature of financial markets is that financial markets have substantial amount of transaction costs and information costs. By understanding the influence of these two types of costs to the financial markets, it can help to explain the 8 facts of the financial structure. So, we are going to review an economic analysis to understand how transaction costs and information costs affect financial markets to provide explanations of the 8 facts, which in turn enable a much deeper understanding of how our financial system works.  11 Transaction Costs (1 of 4) Transaction costs is a major problem in financial markets. Transactions costs influence the financial structure, e.g., – A $5,000 investment can only allow you to purchase 100 shares @ $50/share (equity). There is no diversification. – It is even more restrictive for the investment in bonds as the face value of most bonds are $1,000. – Because the investment amount is so small, ◆ brokerage commission for buying the stock will be a large percentage of the purchase price of the shares. ◆ it can only make a restricted number of investments, have to put all eggs in one basket, and the inability to diversify will be subject to a lot of risk. In sum, transactions costs can hinder flow of funds to people with productive investment opportunities.  12 Transaction Costs (2 of 4) Financial intermediaries make profits by reducing transactions costs 1. Take the advantage of economies of scale ‒ Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. ‒ To bundle the funds of many investors together so that they can take the advantage of economies of scale by reducing the transaction costs per dollar of investment as the size (scale) of the transaction increases.  13 Transaction Costs (3 of 4) Financial intermediaries make profits by reducing transactions costs (Continued) 1. Take the advantage of economies of scale (Continued) ‒ Mutual funds buys large blocks of securities can take the advantage of lower transaction costs, and which is big enough to purchase a widely diversified portfolio of securities to reduce risk. 2. Develop expertise to lower transactions costs (e.g. expertise in information technology) ‒ Lowering costs through information technology and telecommunications system which can be used for a huge number of transactions at a low cost per transaction.  14 Transaction Costs (4 of 4) Financial intermediaries make profits by reducing transactions costs (Continued) 2. Develop expertise to lower transactions costs (e.g. expertise in information technology) (Continued) ‒ Financial intermediary’s low transaction costs enables it to provide its customers with liquidity services, services that make it easier for customers to conduct transactions. Remark: The presence of transaction costs in financial markets explains in part why financial intermediaries and indirect finance play such an important role in financial markets (this explains #3 of the “8 Facts”).  15 Asymmetric Information: Adverse Selection and Moral Hazard (1 of 6) In an introductory finance course, it is probably assumed a world of symmetric information — the case where all parties to a transaction or contract have the same information, be that little or a lot. However, in many situations, this is not the case. We refer to this as asymmetric information. Asymmetric information is the situation arises when one party has insufficient knowledge about the other party in a transaction involved, which causes the first part impossible to make an accurate decision when conducting the transaction. This is an important aspect of financial markets.  16 Asymmetric Information: Adverse Selection and Moral Hazard (2 of 6) Asymmetric information can take on many forms, and is quite complicated. However, to begin understanding the implications of asymmetric information, we will focus on two specific forms: – Adverse selection – Moral hazard  17 Asymmetric Information: Adverse Selection and Moral Hazard (3 of 6) Adverse Selection 1. Occurs when one party in a transaction has better information than the other party. 2. Occurs before the transaction. 3. The parties who most likely produce undesirable outcomes are the ones who most likely want to engage in the transaction. Thus, potential borrowers who most likely produce adverse outcomes are the ones who most likely seek for loans and be selected. 4. Because adverse selection increases the chance that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though good credit risks can be found in the marketplace.  18 Asymmetric Information: Adverse Selection and Moral Hazard (4 of 6) Moral Hazard 1. Occurs when one party has an incentive to behave differently once an agreement is made with another party. 2. Occurs after the transaction. 3. The risk (hazard) that the borrower has an incentive to engage in undesirable (immoral) activities makes it less likely that the loan will be paid back. 4. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not to lend loans.  19 Asymmetric Information: Adverse Selection and Moral Hazard (5 of 6) We will use the ideas of adverse selection and moral hazard to explain how they influence the financial structure. Because of the influences, various tools have been applied and market practices have been developed in the financial structure to solve the problems, and thereby accordingly it resulted in the “8 Facts” as outlined at the beginning of this chapter. We will discuss the following influences and the tools to solve the problems (listed on the next slide): – How Adverse Selection (the Lemons Problem) Influences Financial Structure. – How Moral Hazard Affects the Choice Between Debt and Equity Contracts. – How Moral Hazard Influences Financial Structure in Debt Markets.  20 Asymmetric Information: Adverse Selection and Moral Hazard (6 of 6) Asymmetric Tools to Solve It Information Problem How Adverse Selection Private production and sale of information (the Lemons Problem) Government regulation to increase information Influences Financial Structure Financial intermediation Collateral and net worth How Moral Hazard Production of information: Monitoring Affects the Choice Government regulation to increase information Between Debt and Equity Contracts Financial intermediation Debt contracts (vs. Equity contracts) How Moral Hazard Collateral and net worth Influences Financial Monitoring and enforcement of restrictive covenants Structure in Debt Markets Financial intermediation  21 How Adverse Selection (the Lemons Problem) Influences Financial Structure (1 of 10) Adverse selection problem interferes with the efficient functioning of a market, was outlined by George Akerlof in the “Lemons Problem” of used cars market. 1. Potential buyers: They are usually unable to assess the quality of the used cars. If they can't distinguish between “good” and “bad” (lemons) used cars, they are willing to pay only an average price of good and bad car values. 2. Owners of used cars: It is more likely that they should know well whether their cars are peaches (undervalued) or lemons (overvalued). 3. Result: Good cars won’t be sold, and the used car market cannot function efficiently. What can help us to avoid this problem with used cars?  22 How Adverse Selection (the Lemons Problem) Influences Financial Structure (2 of 10) Lemons Problem in Securities Markets – If investors cannot distinguish between good and bad securities, they are willing to pay only an average price of good and bad securities values. – If purchasers of securities can distinguish good firms from bad firms, they will be willing to pay the full value of the securities issued by good firms. – Result: Good securities are undervalued and firms will not issue the instruments. Bad securities are overvalued and too many of them are issued.  23 How Adverse Selection (the Lemons Problem) Influences Financial Structure (3 of 10) Lemons Problem in Securities Markets (Continued) ‒ Investors do not want to buy bad securities, so the markets do not function well. ▪ It explains # 1 and # 2 of the “8 Facts”: The presence of the lemons problem keeps securities markets, such as the stock and bond markets, from being effective in channeling funds from savers to borrowers. ▪ It also explains # 6 of the “8 Facts”: Less information asymmetry for well known firms, so a smaller lemons problem. The more famous is the firm, the more information about its activities is available in the marketplace. Thus, it is easier for investors to evaluate the quality of the firm and determine whether it is a good one or a bad one.  24 How Adverse Selection (the Lemons Problem) Influences Financial Structure (4 of 10) Tools to Help Solve Adverse Selection Problems In the absence of asymmetric information, the lemons problem goes away. 1. Private Production and Sale of Information – To eliminate asymmetric information by furnishing the parties who supply funds with the full details about the parties who are seeking for funds to finance their investment activities. – One way is to have private companies collect and produce information that distinguishes firms and then sell it. For example, S&P, Moody’s, and Value Line gather the financial information of different firms, publish and sell them to subscribers.  25 How Adverse Selection (the Lemons Problem) Influences Financial Structure (5 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 1. Private Production and Sale of Information (Continued) – However, free-rider problem interferes with this solution which occurs if some people do not pay but take the advantage of using the information paid by other people. – Free-rider problem: ◆ Purchasers of information expect that the information is worthwhile for identifying and buying the securities of good firms that are undervalued. ◆ If many free-riding investors, without paying for the information, simply follow the actions of the information purchasers, this will immediately remove the investment opportunities. ◆ As a result, no one is willing to pay for the information in the first place and the private companies may not be able to sell enough of this information to make it worth their while to gather and produce it. ⇒ Less information is produced in the marketplace.  26 How Adverse Selection (the Lemons Problem) Influences Financial Structure (6 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 2. Government Regulation to Increase Information ‒ The government regulates the securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are. ‒ Government agency requires independent audits, in which accounting firms certify that the firm is adhering to the standard accounting principles and disclosing accurate information about sales, assets, and earnings (Although the Enron case is a shining example of why this does not eliminate the problem. Refer to next slide.) ‒ It explains # 5 of the “8 Facts”.  27 How Adverse Selection (the Lemons Problem) Influences Financial Structure (7 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 2. Government Regulation to Increase Information (Continued) – Case : The Enron Implosion ◆ Up to 2001, Enron appeared to be a very successful firm engaged in energy trading. ◆ However, that the firm had severe financial problems, and hid many of its problems in complex financial structures that allowed Enron not to report them. ◆ Even though Enron regularly filed records with the SEC, the problems were not discovered. ◆ Its auditor Arthur Andersen didn’t do the audit job faithfully and eventually plead guilty to obstruction of justice charges. With such plea, one of the largest audit firms in the world closed its doors forever.  28 How Adverse Selection (the Lemons Problem) Influences Financial Structure (8 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 3. Financial Intermediation – Private production of information and government regulation to encourage provision of information can lessen, but do not eliminate, adverse selection problems in financial markets. – The “lemon problem” of used car market is tackled by having dealers as intermediaries who purchases used cars from individuals and resells them to other individuals. Used- car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee. – If dealers purchase and then resell cars on which they have produced information, they can avoid the problem of other people free-riding on the information they produced.  29 How Adverse Selection (the Lemons Problem) Influences Financial Structure (9 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 3. Financial Intermediation (Continued) – Analogy to the solution of having used car dealers to tackle the lemons problem, financial intermediaries, such as banks, become experts in producing information about firms, so that they can sort out good and bad credit risks. – An important element in the banks’ ability to profit from the information they produce is that they can avoid free-rider problems by primarily making private loans (other investors cannot watch what they do) rather than by purchasing securities that are traded in the open market. – The importance of financial intermediaries explains # 3 and # 4 of the “8 Facts”. – It also explains #6 of the “8 Facts” that large firms are more likely to use direct instead of indirect financing.  30 How Adverse Selection (the Lemons Problem) Influences Financial Structure (10 of 10) Tools to Help Solve Adverse Selection Problems (Continued) 4. Collateral and Net Worth – Collateral, the property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s loss in the event of a default. – The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts. It explains # 7 of the “8 Facts”.  31 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (1 of 7) Moral hazard is the problem when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. The important consequence of moral hazard is that it explains why a firm finds it easier to raise funds with debt than with equity contracts. Moral Hazard Problem in Equity Contracts : the Principal- Agent Problem 1. Equity contracts are subject to a particular type of moral hazard called the principal–agent problem. It is the result of separation of ownership by stockholders (principals) from control by managers (agents). 2. Managers act in own rather than stockholders' interest.  32 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (2 of 7) Moral Hazard Problem in Equity Contracts : the Principal- Agent Problem (Continued) 3. The principal–agent problem, which is an example of moral hazard, arises only because the managers have more information about their activities than the stockholders do — that is, information is asymmetric. 4. The principal–agent problem would not arise if the owners of a firm would have complete information about what the managers were up to, so that they could prevent wasteful expenditures or frauds. 5. The principal–agent problem would not occur if ownership and control were not separated.  33 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (3 of 7) Example of Principal-Agent Problem: ‒ Suppose you become a silent partner in an ice cream store, providing 90% of the equity capital ($9,000). The other owner, Steve, provides the remaining $1,000 and will act as the manager. If Steve works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it. ‒ However, Steve 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 you, as a 90% owner, give Steve the proper incentives to work hard?  34 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (4 of 7) Example of Principal-Agent Problem: (Continued) ‒ The moral hazard arising from the principal–agent problem might be even worse if Steve were not totally honest. ‒ Besides pursuing personal benefits, managers might also pursue corporate strategies (such as the acquisition of other firms) that enhance their personal power but do not increase the corporation’s profitability.  35 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (5 of 7) Tools to Help Solve the Principal-Agent Problem 1. Production of Information: Monitoring ‒ To reduce the moral hazard problem by producing information to monitor of the firm’s activities such as auditing the firm frequently and checking on what the managers are doing. ‒ As the monitoring process is costly, it makes equity contracts less desirable. It explains why equity is a less important element in the financial structure. 2. Government Regulation to Increase Information ‒ Same as adverse selection, government has the incentives to reduce the moral hazard problem. That explains why the financial system is so heavily regulated (it explains #5 of the “8 Facts).  36 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (6 of 7) Tools to Help Solve the Principal-Agent Problem (Continued) 3. Financial Intermediation ‒ Financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard. ‒ Venture capital firm particularly can reduce the moral hazard arising from the principal–agent problem. The venture capital firm pools the resources of its partners together and uses the funds to help budding entrepreneurs to start new businesses. In exchange for the use of the venture capital, the firm receives equity shares in the new business. The venture capital firm usually insists on having several of its own people to participate as members of the board of directors in order to keep a close watch on the new business. As the equity is private and not marketable to anyone except the venture capital firm, other investors are unable to take a free ride on the venture capital firm’s verification activities.  37 How Moral Hazard Affects the Choice Between Debt and Equity Contracts (7 of 7) Tools to Help Solve the Principal-Agent Problem (Continued) 4. Debt Contracts (vs. Equity Contracts) ‒ Debt contracts are structured in the way to limit moral hazard so that it would only exist in certain situations, and hence it could reduce the need to monitor the managers. ‒ The debt contract has exactly these characteristics because it is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. ‒ The less frequent is the need to monitor the firm, the lower is the cost of verification. It helps explain why debt contracts are used more frequently than equity contracts to raise capital. ‒ It explains why debt is used more than equity, #1 of the “8 Facts”.  38 How Moral Hazard Influences Financial Structure in Debt Markets (1 of 5) Even with the above advantages just described, debts are still subject to moral hazard. The requirement of periodic fixed payments specified in the debt contracts may create incentives to the borrowers to take on very risky projects. Let’s looks at an 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. To address this problem, most debt contracts require the borrower not only to make a regular fixed payment amount (interest), but also must always keep the cash flow to be above this amount.  39 How Moral Hazard Influences Financial Structure in Debt Markets (2 of 5) Tools to Help Solve Moral Hazard in Debt Contracts 1. Collateral and Net Worth ‒ When a borrower would have more at stake, such as his net worth (net between his assets and liabilities) is high or the collateral that he has pledged to the lender is valuable, the risk of moral hazard will be greatly reduced because the borrower himself has a lot to lose (more “skin in the game”). ‒ The solution of high net worth and collateral is to make the debt contract to be incentive compatible, that is, to align the incentives of the borrower with those of the lender.  40 How Moral Hazard Influences Financial Structure in Debt Markets (3 of 5) Tools to Help Solve Moral Hazard in Debt Contracts (Continued) 2. Monitoring and Enforcement of Restrictive Covenants ‒ To ensure the borrower will use the money for the purpose as the lender wants, this can be achieved by writing provisions (restrictive covenants) into the debt contract to restrict the borrower’s activities. ‒ By monitoring the borrower’s activities to see whether he is complying with the restrictive covenants and enforcing the covenants if not, this can make sure that the borrower will not take on risks at the lender’s expense.  41 How Moral Hazard Influences Financial Structure in Debt Markets (4 of 5) Tools to Help Solve Moral Hazard in Debt Contracts (Continued) 2. Monitoring and Enforcement of Restrictive Covenants (Continued) ‒ There are 4 types of restrictive covenants: ▪ Covenants to discourage undesirable behavior ▪ Covenants to encourage desirable behavior ▪ Covenants to keep collateral valuable ▪ Covenants to provide information – It explains #8 of the “8 Facts”, debt contracts are often complicated.  42 How Moral Hazard Influences Financial Structure in Debt Markets (5 of 5) Tools to Help Solve Moral Hazard in Debt Contracts (Continued) 3. Financial Intermediation ‒ Although restrictive covenants help reduce moral hazard problem, they do not eliminate it. It is almost impossible to write covenants that can rule out every risky activity. ‒ Monitoring and enforcement of restrictive covenants are costly. Moreover, the free-rider problem also arises in the debt securities (bond) markets just as it does in the stock markets. ‒ Financial intermediaries, particularly banks, have the ability to avoid the free-rider problem as long as they primarily make private loans. – It explains # 3 and #4 of the “8 Facts”.  43 Table 7.1 : Summary of Asymmetric Information Problems and Tools to Solve Them (1 of 3) Asymmetric Explains Fact Tools to Solve It Information Problem Number How Adverse Selection (the Private production and sale 1,2 Lemons Problem) Influences of information Financial Structure Government regulation to 5 increase information Financial intermediation 3,4,6 Collateral and net worth 7  44 Table 7.1 : Summary of Asymmetric Information Problems and Tools to Solve Them (2 of 3) Asymmetric Explains Fact Tools to Solve It Information Problem Number How Moral Hazard Affects the Production of information: 1 Choice Between Debt and Equity Monitoring Contracts Government regulation to 5 increase information Financial intermediation 3 Debt contracts (vs. Equity 1 contracts)  45 Table 7.1 : Summary of Asymmetric Information Problems and Tools to Solve Them (3 of 3) Asymmetric Explains Fact Tools to Solve It Information Problem Number How Moral Hazard Influences Collateral and net worth 6,7 Financial Structure in Debt Monitoring and enforcement 8 Markets of restrictive covenants Financial intermediation 3,4 List of “8 Facts”: 1. Stocks are not the most important source of external financing. 2. Marketable securities are not the primary source of finance. 3. Indirect finance is more important than direct finance. 4. Banks are the most important source of external funds. 5. The financial system is heavily regulated. 6. Only large, well-established firms have access to securities markets. 7. Collateral is prevalent in debt contracts. 8. Debt contracts have numerous restrictive covenants.  46 Conflicts of Interest (1 of 2) Financial institutions develop their expertise in interpreting signals and collecting information from their customers. This gives them cost advantage in producing the information that can be used over and over again in many ways they like, and also allow them to provide multiple financial services to their customers, thereby realizing economies of scale. Conflicts of interest is a type of moral hazard problem that occurs when a person or institution has multiple objectives (interests). Because of the conflicts among these interests, serving one interest may be detrimental to the others. ‒ The problem would likely occur when a financial institution provides multiple services. ‒ The potentially competing interests of those services may make the individuals working in the financial institution to conceal information or disseminate misleading information.  47 Conflicts of Interest (2 of 2) The following three types of financial service activities have led to prominent conflicts-of-interest problems in the financial markets. They are, – underwriting and research in investment banks – auditing and consulting in accounting firms – credit assessment and consulting in credit-rating agencies We will particularly refer to the incidents in the U.S. that were caused by the conflicts. Looking at these closely can offer insights in avoiding conflicts in the future. Even though the issues happened in the past were noted and addressed, as time moves on, the conflicts arise again as memory of the conflicts fades with time.  48 Conflicts of Interest: Underwriting and Research in Investment Banking (1 of 3) Investment banks perform two tasks: (1) perform research for the companies which issue public securities, and (2) underwrite these securities for sale to the public on behalf of the issuing companies.  49 Conflicts of Interest: Underwriting and Research in Investment Banking (2 of 3) Research is expected to be unbiased and accurate, reflecting the facts about a company. It is used by the public to form investment choices. Underwriters will have an easier time if the research result is positive. Underwriters can better serve the company going public and command a better price for the securities issued by the company if the company’s outlook is optimistic. An investment bank acting as both the researcher and the underwriter of the securities issued by a company clearly has a conflict — serves the interest of the issuing company or the public?  50 Conflicts of Interest: Underwriting and Research in Investment Banking (3 of 3) During the tech boom of the 1990s in the U.S., research reports were clearly distorted to please issuers. Companies with no hope of ever earning profits could still receive favorable research reports. Another common practice that exploits conflicts of interest is spinning. Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business with the investment banks.  51 Conflicts of Interest: Auditing and Consulting in Accounting Firms (1 of 2) An accounting firm may provide two services to the same company: (1) auditing, and (2) consultancy. Auditors check the assets and books of a company for the quality and accuracy of the information. The objective is to provide an unbiased opinion for the company’s financial health. Consultancy services, for a fee, help the company with variety of managerial, strategic, and operational projects. An accounting firm acting as both an auditor and consultant for the same company clearly is not objective, especially if the consulting fees exceed the auditing fees.  52 Conflicts of Interest: Auditing and Consulting in Accounting Firms (2 of 2) In the Enron case of the U.S., Arthur Andersen is a typical example of the conflicts between auditing services and consulting services. A lot of conflicts with its client Enron resulted in the eventual demise of Arthur Andersen when Enron collapsed.  53 Conflicts of Interest: Credit Assessment and Consulting in Rating Agencies (1 of 2) A security issuing company may procure from the same rating agency for the following two services : (1) credit rating of a security issuance, and (2) consulting services. A rating agency assign a credit rating to a security issuance of a company based on projected cash flow, assets pledged, etc. The rating helps determine the riskiness of a security. Consultants, for a fee, help companies with variety of managerial, strategic, and operational projects. A rating agency acting both as the rater and the consultant for a company clearly is not objective, especially if the consulting fees exceed the rating fees.  54 Conflicts of Interest: Credit Assessment and Consulting in Rating Agencies (2 of 2) Rating agencies, such as Moody’s and Standard and Poor, were caught in this game during the 2007-2008 housing bubble in the U.S.. Some companies asked the raters to help structuring debt offerings that could attain the highest possible ratings. When the debts issued by those companies subsequently defaulted, it was difficult for the agencies to justify the original high ratings offered by them. Perhaps it was just an error. But few believe that — most see the rating agencies as being blinded by high consulting fees. Finally, the SEC stepped in and proposed new regulation.  55 Conflicts of Interest: Remedies in the U.S. (1 of 3) In the U.S., a lot of works have been done to remedy the conflicts. The Sarbanes-Oxley Act was enacted in 2002. The bill, – Established an oversight board to supervise accounting firms. – Increased the SEC’s budget for supervisory activities. – Limited consulting relationships between auditors and firms. – Enhanced criminal charges for obstruction. – Improved the quality of the financial statements and board.  56 Conflicts of Interest: Remedies in the U.S. (2 of 3) The Global Legal Settlement in 2002 – Required investment banks to separate links between research and underwriting. – Spinning is explicitly banned. – Imposed a $1.4 billion fine on accused investment banks. – Added additional requirements to ensure independence and objectivity of research reports to improve the quality of information in financial markets.  57 Conflicts of Interest: Remedies in the U.S. (3 of 3) Concerns: – However, there is much criticism over the cost involved with these separations of functions In other words, financial institutions can no longer take the advantage of economies of scale gained from relationships. Although such a separation of functions may reduce conflicts of interest, it may also diminish economies of scale and thus potentially lead to a reduction of information in financial markets. – Some have argued that Sarbanes-Oxley has negatively impacted the value of U.S. capital markets.  58 Case: Has SOX Led to a Decline in the U.S. Capital Markets? The cost of implementing Sarbanes-Oxley is not trivial. For companies with less than $100 million in sales, it is estimated to be around 1% of sales. During the same period after implementing Sarbanes- Oxley, European countries have made it easier for firms to go public. Both equity issuances and bond issuances are growing faster now in Europe than in the U.S.  59 Summary (1 of 2) Basic Facts About Financial Structure Throughout the World: we reviewed eight basic facts concerning the structure of the financial system. Transaction Costs: we examined how transaction costs can hinder capital flow and the role financial institutions play in reducing transaction costs. Asymmetric Information: Adverse Selection and Moral Hazard: we defined asymmetric information along with two categories of asymmetric information — adverse selection and moral hazard. The Lemons Problem: How Adverse Selection Influences Financial Structure: we discussed how adverse selection effects the flow of capital and tools to reduce this problem.  60 Summary (2 of 2) How Moral Hazard Affects the Choice Between Debt and Equity Contracts: we reviewed the principal-agent problem and how moral hazard influences the use of more debt than equity. How Moral Hazard Influences Financial Structure in Debt Markets: we discussed how moral hazard and debt may lead to increased risk-taking, and tools to reduce this problem. Conflicts of Interest: we reviewed several examples of conflicts in our economy, many of which ended badly. Can we address these in the future before they lead to severe problems?