Financial Markets and Institutions: Ninth Edition

Financial Markets and Institutions
Ninth Edition
Part 3 Fundamentals of
Financial Institutions
Chapter 7
Why Do Financial Institutions
Exist?
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Chapter Preview (1 of 3)
A vibrant economy requires a financial system that moves
funds from savers to borrowers. But how does it ensure that
your hard-earned dollars are used by those with the best
productive investment opportunities?

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

• The Lemons Problem: How Adverse Selection Influences
Financial Structure
• How Moral Hazard Affects the Choice Between Debt and
Equity Contracts
• How Moral Hazard Influences Financial Structure in Debt
Markets
• Conflicts of Interest

Basic Facts About Financial Structure
Throughout the World (1 of 2)
• The financial system is a complex structure including many
different financial institutions: banks, insurance companies,
mutual funds, stock and bonds markets, etc.

Basic Facts About Financial Structure
Throughout the World (2 of 2)
• The chart on the next slide shows how nonfinancial
business attain 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 debt.

Figure 7.1 Sources of External Funds for Nonfinancial
Businesses: A Comparison of the United States with
Germany, Japan, and Canada
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.

Facts of Financial Structure (1 of 4)
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.
4. Financial intermediaries, particularly banks, are the most
important source of external funds used to finance
businesses.

5. The financial system is among the most heavily regulated
sectors of economy.
6. Only large, well-established corporations have easy
access to securities markets to finance their activities.

7. Collateral is a prevalent feature of debt contracts for both
households and businesses.
8. Debt contracts are typically extremely complicated legal
documents that place substantial restrictions on the
behavior of the borrowers.

Transaction Costs (1 of 2)
• Transactions costs influence financial structure
– E.g., a $5,000 investment only allows you to purchase
100 shares @ $50 / share (equity)
– No diversification
– Bonds even worse—most have a $1,000 size
• In sum, transactions costs can hinder flow of funds to
people with productive investment opportunities

Transaction Costs (2 of 2)
• Financial intermediaries make profits by reducing
transactions costs
1. Take advantage of economies of scale (example:
mutual funds)
2. Develop expertise to lower transactions costs
 Also provides investors with liquidity, which explains
Fact # 3 (slide 7–9)

Asymmetric Information: Adverse
Selection and Moral Hazard (1 of 5)
• In your introductory finance course, you 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.
• In many situations, this is not the case. We refer to this as
asymmetric information.

• Asymmetric information can take on many forms and is
quite complicated. However, to begin to understand the
implications of asymmetric information, we will focus on
two specific forms:
– Adverse selection
– Moral hazard

• Adverse Selection
1. Occurs when one party in a transaction has better
information than the other party
2. Before transaction occurs
3. Potential borrowers most likely to produce adverse
outcome are ones most likely to seek loan and be
selected

• Moral Hazard
1. Occurs when one party has an incentive to behave
differently once an agreement is made between parties
2. After transaction occurs
3. Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won't pay loan back

• The analysis of how asymmetric information problems
affect behavior is known as agency theory.
• We will now use these ideas of adverse selection and
moral hazard to explain how they influence financial
structure.

The Lemons Problem: How Adverse
Selection Influences Financial Structure
(1 of 3)
• Lemons Problem in Used Cars

1. If we can't distinguish between “good” and “bad”
(lemons) used cars, we are willing pay only an average
of good and bad car values
2. Result: Good cars won’t be sold, and the used car
market will function inefficiently.
• What helps us avoid this problem with used cars?

(2 of 3)
• Lemons Problem in Securities Markets

– If we can't distinguish between good and bad
securities, willing to pay only average of good and bad
securities’ value
– Result: Good securities undervalued and firms won't
issue them; bad securities overvalued so too many
issued

(3 of 3)
• Lemons Problem in Securities Markets

3. Investors don't want buy bad securities, so market
don't function well
 Explains Fact # 1 and # 2 (slide 7–8)
 Also explains Fact # 6 (slide 7–10): Less
asymmetric info for well known firms, so smaller
lemons problem

Tools to Help Solve Adverse Selection
(Lemons) Problems (1 of 3)
1. Private Production and Sale of Information
– Free-rider problem interferes with this solution
2. Government Regulation to Increase Information (explains
Fact # 5, slide 7–10)
– For example, annual audits of public corporations
(although Ernon is a shining example of why this does
not eliminate the problem—we’ll discuss that briefly)

3. Financial Intermediation
– Analogy to solution to lemons problem provided by
used car dealers
– Avoid free-rider problem by making private loans
(explains Fact # 3 and # 4, slide 7–9)
– Also explains fact #6—large firms are more likely to
use direct instead of indirect financing

4. Collateral and Net Worth
– Explains Fact # 7, slide 7–11

The Enron Implosion (1 of 2)
• 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 to not report them.
• Even though Enron regularly filed records with the SEC,
the problem was not prevented.

The Enron Implosion (2 of 2)
• Even worse, its auditor Arthur Andersen eventually plead
guilty to obstruction of justice charges. With that plea, one
the largest and trusted auditors closed its doors forever.

How Moral Hazard Affects the Choice
Between Debt and Equity Contracts (1 of 4)
• Moral Hazard in Equity Contracts: the Principal-Agent
Problem
1. Result of separation of ownership by stockholders
(principals) from control by managers (agents)
2. Managers act in own rather than stockholders' interest

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

• Tools to Help Solve the Principal-Agent Problem
1. Production of Information: Monitoring
2. Government Regulation to Increase Information
3. Financial Intermediation (e.g., venture capital)
4. Debt Contracts
• Explains Fact # 1, slide 7–8: Why debt is used more than
equity

How Moral Hazard Influences Financial
Structure in Debt Markets (1 of 4)
• Even with the advantages just described, debt is still
subject to moral hazard. In fact, debt may create an
incentive to take on very risky projects. This is important to
understand. Let’s looks at a simple example.

• Most debt contracts require the borrower to pay a fixed
amount (interest) and keep any cash flow above this
amount.
• For example, what if a firm owes $100 in interest, but only
has $90? It is essentially bankrupt. The firm “has nothing
to lose” by looking for “risky” projects to raise the needed
cash.

• Tools to Help Solve Moral Hazard in Debt Contracts
1. Net Worth and Collateral
2. Monitoring and Enforcement of Restrictive Covenants.
Examples are covenants that …
 discourage undesirable behavior
 encourage desirable behavior
 keep collateral valuable
 provide information

• Tools to Help Solve Moral Hazard in Debt Contracts
3. Financial Intermediation—banks and other
intermediaries have special advantages in monitoring
• Explains Facts # 1–4, slides 7–8 & 7–9

Table 7.1 Summary of Asymmetric Information Problems
and Tools to Solve Them (1 of 3)
Asymmetric Tools to Solve It Explains Fact

Information Problem Number
Adverse Selection Private production and sale of 1,2
information
Blank Government regulation to 5
increase information
Blank Financial intermediation 3,4,6
Blank Collateral and net worth 7


Moral hazard in equity contracts Production of information 1
(principal-agent problem) monitoring
Blank Government regulation to 5
increase information
Blank Financial intermediation 3
Blank Debt contracts 6,7


Moral hazard in debt contracts Collateral and net worth 6,7
Blank Monitoring and enforcement 8
of restrictive covenants
Blank Financial intermediation 3,4

Case: Financial Development and
Economic Growth
• Financial repression leads to low growth
• Why?
1. Poor legal system
2. Weak accounting standards
3. Government directs credit (state-owned banks)
4. Financial institutions nationalized
5. Inadequate government regulation
• Financial Crises

Mini-Case: The Tyranny of Collateral
• Legal title to land in foreign countries is much more
complicated than in the U.S.
– Legal title to a dwelling land in the Philippines involves
168 bureaucratic steps
– In Haiti? 176 steps over nineteen years
• Article argues that trillions is held in land not legally titled.
And in that case, land cannot be used as collateral for
loans.
• Adverse selection problem becomes worse.
• Contributes to the problem of the poor.

Financial Crises and Aggregate Economic
Activity
Our analysis of the effects of adverse selection and moral
hazard can also assist us in understanding financial crises,
major disruptions in financial markets. The end result of most
financial crises is the inability of markets to channel funds
from savers to productive investment opportunities.

Is China a Counter-example? (1 of 2)
• Even with its booming economy, China’s financial
development is still in an early stage.
• Per capital income is around $10,000, but savings are
around 40%, allowing China to build up capital stock as
labor moves out of subsistence agriculture.
• However, this is unlikely to work for long.

Is China a Counter-example? (2 of 2)
• Russia in the 1950s had a similar economy, and few would
argue that modern Russia is a success story.
• To continue its growth, China needs to allocate capital
more efficiently. Many of the financial repression problems
we outlined are being addressed by Chinese authorities
today.

Conflicts of Interest
• Conflicts of interest are a type of moral hazard that occurs
when a person or institution has multiple interests, and
serving one interest is detrimental to the other.
• Three classic conflicts developed in financial institutions.
Looking at these closely offers insight in avoiding these
conflicts in the future.

Conflicts of Interest: Underwriting and
Research in Investment Banking (1 of 3)
• Investment banks may both research companies with
public securities, as well as underwrite securities for
companies for sale to the public.
• Research is expected to be unbiased and accurate,
reflecting the facts about the firm. It is used by the public to
form investment choices.
• Underwriters will have an easier time if research is
positive. Underwriters can better serve the firm going
public if the firm’s outlook is optimistic.

• Research is expected to be unbiased and accurate,
reflecting facts about the firm. It is used by the public to
form investment choices.
• Underwriters can command a better price for securities
issued by a firm if the firm’s outlook is optimistic.
• An investment bank acting as both a researcher and
underwriter of securities for companies clearly has a
conflict—serve the interest of the issuing firm or the
public?

• During the tech boom, research reports were clearly
distorted to please issuers. Firms with no hope of ever
earning a profit received favorable research.
• This also lead to spinning, where underpriced equity was
allocated to executives who would promise future business
to the investment bank.

Conflicts of Interest: Auditing and
Consulting in Accounting Firms (1 of 2)
• Auditors check the assets and books of a firm for the
quality and accuracy of the information. The objective in an
unbiased opinion of the firm’s financial health.
• Consultants, for a fee, help firms with variety of
managerial, strategic, and operational projects.
• An auditor acting as both an auditor and consultant for a
firm clearly is not objective, especially if the consulting fees
exceed the auditing fees.

Conflicts of Interest: Auditing and
Consulting in Accounting Firms (2 of 2)
• The case of Arthur Andersen, of course, epitomizes this
conflict. A myriad of conflicts with its client Enron resulted
in the eventual demise of Arthur Andersen when Enron
collapsed. You can read further about that incident in the
Mini-case box on page 157.

Conflicts of Interest: Credit Assessment
and Consulting in Rating Agencies (1 of 3)
• Rating agencies assign a credit rating to a security
issuance of a firm based on projected cash flow, assets
pledged, etc. The rating helps determine the riskiness of a
security.
• Consultants, for a fee, help firms with variety of
managerial, strategic, and operational projects.
• An rating agency acting as both a rater and consultant for
a firm clearly is not objective, especially if the consulting
fees exceed the rating fees.

Rating agencies, such as Moody’s and Standard and Poor,
were caught in this game during the housing bubble. Firms
asked the rater to help structure debt offerings to attain the
highest rating possible. When the debt subsequently
defaulted, it was difficult for the agency to justify the original
high rating. Perhaps it was just error. But few believe that—
most see the rating agencies as being blinded by high
consulting fees.

• The details of this scandal appear in the Mini-Case on
page 160. In short, the SEC stepped in and proposed new
regulation.
• You should read both of these Mini-Cases. You will see
these conflicts arise again as memory of these conflicts
fades with time.

Remedies? (1 of 3)
• Aside from the two Mini-Cases, has much been done to
remedy conflicts? Yes.
• Sarbanes-Oxley Act of 2002
– 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
Remedies? (2 of 3)
• Aside from the two Mini-Cases, has much been done to
remedy conflicts? Yes.
• Global Legal Settlement of 2002
– Required investment banks to sever 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

Remedies? (3 of 3)
• Will these work?
– It’s too early to determine yet.
– However, there is much criticism over the cost involved
with these separations. In other words, financial
institutions can no longer take advantage of the
economies of scope gained from relationships.
– Some have argued that Sarbanes-Oxley has negatively
impacted the value of U.S. Capital Markets. The details
of that follow:

Mini-Case: Has SOX Led to a Decline in
U.S. Capital Markets?
• The cost of implementing Sarbanes-Oxley is not trivial. For
companies with less than $100 million in sales, it’s
estimated to be around 1% of sales.
• During the same period, 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. Is it time to revisit
this bill to determine if the benefits outweigh the costs?

Chapter Summary (1 of 4)
• 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

• 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?

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Financial Markets and Institutions

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

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• Lemons Problem in Used Cars

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• Lemons Problem in Securities Markets

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• Lemons Problem in Securities Markets

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Asymmetric Tools to Solve It Explains Fact

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Asymmetric Tools to Solve It Explains Fact

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Asymmetric Tools to Solve It Explains Fact

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