Lecture one

• The financial system is complex in structure and includes many different types of institutions all regulated by government: banks, insurance companies, mutual funds, stock and bond markets
• The financial system channels amounts from savers to people with productive investment opportunities
• Finance


  Internal vs. external
• External finance


  Direct vs. indirect
• Types of external finance

  • Direct finance
  • Indirect finance
• Stocks are not the most important source of external financing for businesses
• Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
• Indirect finance is many times more important than direct finance
• Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses
• The financial system is among the most heavily regulated sectors of the economy
• Only large, well-established corporations have easy access to securities markets to finance their activities
• Collateral is a prevalent feature of debt contracts for both households and businesses
• Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
• Imperfect capital markets


  Lenders are concerned with risk, transaction costs, liquidity

  Borrowers are concerned with access to funds at particular dates and for specific periods of time, and obtaining funds at the lowest possible cost
• Financial intermediaries


  Can bridge the gap between borrowers and lenders and reconcile their (often) incompatible needs and objectives

  Through transaction costs reduction, maturity transformation, risk sharing, asymmetric information
• Transaction costs


  The costs of a trade or exchange (e.g., brokerage commission)

  They influence financial structure by making small investments uneconomical and increasing risk
• Economies of scale


  The reduction in average cost that results from an increase in the volume of a good or service produced
• Maturity transformation


  Financial intermediaries transform longer-term assets into shorter-term liabilities, providing investors with more choices concerning maturity for their investments and borrowers with more choices for the length of their obligations
• Risk sharing


  Financial intermediaries help reduce the exposure of investors to risk through asset transformation and diversification
• Asymmetric information


  The situation in which one party in an economic transaction has better information than does the other party

  It leads to adverse selection and moral hazard
• Adverse selection


  The problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment

  It increases the chances that loans might be made to high-risk borrowers
• Moral hazard


  The risk that people will take actions after they have entered into a transaction that will make the other party worse off

  It increases the probability of default
• Lemons problem


  In the used-car market, the seller has more information than the buyer regarding the quality of the product

  The prices that potential buyers are willing to pay reflect their lack of information on the true condition of the car
• Financial system


  The network of institutions and markets that facilitate the flow of funds between individuals, businesses, and governments.
• The lemons problem prevents securities markets from operating effectively in channelling funds from savers to borrowers
• Tools to solve adverse selection in financial markets

  • Private production and sale of information

  Government regulation to increase information

  Net worth and collateral

  Financial intermediation
• Banks succeed in reducing asymmetric information in financial markets mostly by holding non-traded loans
• Principal-agent problem


  The moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals)
• Tools to solve the principal-agent problem

  • Monitoring

  Incentive compensation

  Bonding

  Reputation

  Regulation
• Banks are the most important source of external funds used to finance businesses, especially in developing countries
• The larger and more established a corporation is, the more likely it will be to issue securities to raise funds
• Moral hazard in the stock market

  Separation of ownership from control - Firms are owned by shareholders but run by top management. The principal-agent problem is the moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals)
• Managers have an incentive to

  • Under-report profits, so that they can reduce dividends and retain the use of the funds
  • Use corporate funds for their own personal use
  • Pursue corporate strategies that enhance their own personal power but do not increase the corporation's profitability
• Equity is not a more important element in the financial structure
• Financial markets are among the most heavily-regulated, partially due to the difficulty in finding or proving fraud
• Financial intermediation (venture-capital / private-equity firms)


  • Pool their partners' resources and use the funds to help (new) businesses
  • Participate on the board of directors
  • Equity in the new firm is private (non-marketable)
  • No free-riding
• Indirect finance is important
• Stocks are not the most important source of financing
• Moral hazard in the bond market

  Borrowers have incentives to take on projects that are riskier than the lenders would like, preventing the borrower from paying back the loan
• Tools to solve moral hazard in debt contracts

  Net worth and collateral - The greater the borrower's net worth and collateral pledged, the higher the borrower's incentive to behave in the way that the lender expects, the lower the moral hazard problem in the debt contract, and the easier it is for a firm to borrow