Successfully reported this slideshow.
GD20503Financial Markets & Institutions
In this chapter, we take a closer look atwhy financial institutions exist:   Basic Facts About Financial Structure    Thr...
 The financial system is a complex structure including many different financial institutions: banks, insurance companies,...
 Thechart on the next slide how nonfinancial business attain external funding in the U.S., Germany, Japan, and Canada. No...
5
   Transactions costs influence financial    structure        E.g., a $5,000 investment only allows you         to purch...
   Financial intermediaries make profits by    reducing transactions costs     1.   Take advantage of economies of scale ...
   In your introductory finance course, you    probably assumed a world of symmetric    information—the case where all pa...
   Asymmetric information can take on many    forms, and is quite complicated.    However, to begin to understand the    ...
   Adverse Selection     1.   Occurs when one party in a transaction has          better information than the other party...
   Moral Hazard     1.   Occurs when one party has an incentive to          behave differently once an agreement is      ...
   The analysis of how asymmetric information    problems affect behavior is known as agency    theory.   We will now us...
   Lemons Problem in Used Cars    1.   If we cant distinguish between ―good‖ and         ―bad‖ (lemons) used cars, we are...
   Lemons Problem in Securities Markets    1.   If we cant distinguish between good and bad         securities, willing p...
    Lemons Problem in Securities Markets    3.   Investors wont want buy bad securities, so         market wont function ...
1.    Private Production and Sale of      Information     – Free-rider problem interferes with this         solution2.    ...
3.   Financial Intermediation        Analogy to solution to lemons         problem provided by used car         dealers  ...
    The Principal-Agent Problem    1.   Result of separation of ownership by         stockholders (principals) from contr...
An example of this problem is useful.Suppose you become a silent partner in anice cream store, providing 90% of theequity ...
However, Steve doesn’t really value the$5,000 (his part), so he goes to thebeach, relaxes, and even spends some ofthe ―pro...
 Tolls      to Help Solve the Principal-Agent Problem  1.Production  of Information: Monitoring  2.Government Regulation ...
 Financial institutions play an important role in  the financial system. Economies of scale:    - their expertise in int...
 What   are conflicts of interest? - a type of moral hazard problem - when a person or institution has multiple objective...
   Why do conflicts of interest arise?1.   Underwriting and Research in Investment     Banking     – a conflict of intere...
2.    Auditing and Consulting in Accounting      Firms     – provide both auditing and non-audit       consulting services...
3.       Credit Assessment and Consulting in Credit         Rating Agencies     – investors and regulators are seeking a w...
 FredericS. Mishkin, Stanley G. Eakins (2012). Financial Markets and Institutions. 7th Edition. Pearson Addison-Wesley.  ...
Upcoming SlideShare
Loading in …5
×

Fundamentals of financial_institutions_powerpoint

525 views

Published on

FMI_Lec4

  • Be the first to comment

  • Be the first to like this

Fundamentals of financial_institutions_powerpoint

  1. 1. GD20503Financial Markets & Institutions
  2. 2. In this chapter, we take a closer look atwhy financial institutions exist: Basic Facts About Financial Structure Throughout the World Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard Conflicts of Interest 2
  3. 3.  The financial system is a complex structure including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc. 3
  4. 4.  Thechart on the next slide 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. 4
  5. 5. 5
  6. 6.  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 6
  7. 7.  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 7
  8. 8.  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. 8
  9. 9.  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 9
  10. 10.  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 10
  11. 11.  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 wont pay loan back 11
  12. 12.  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. 12
  13. 13.  Lemons Problem in Used Cars 1. If we cant 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? 13
  14. 14.  Lemons Problem in Securities Markets 1. If we cant distinguish between good and bad securities, willing pay only average of good and bad securities’ value 2. Result: Good securities undervalued and firms wont issue them; bad securities overvalued so too many issued 14
  15. 15.  Lemons Problem in Securities Markets 3. Investors wont want buy bad securities, so market wont function well 15
  16. 16. 1. Private Production and Sale of Information – Free-rider problem interferes with this solution2. Government Regulation to Increase Information – 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) 16
  17. 17. 3. Financial Intermediation  Analogy to solution to lemons problem provided by used car dealers  Avoid free-rider problem by making private loans  large firms are more likely to use direct instead of indirect financing4. Collateral and Net Worth 17
  18. 18.  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 18
  19. 19. An example of this problem is useful.Suppose you become a silent partner in anice cream store, providing 90% of theequity capital ($9,000). The otherowner, Steve, provides the remaining$1,000 and will act as the manager. IfSteve works hard, the store will make$50,000 after expenses, and you areentitled to $45,000 of it. 19
  20. 20. However, Steve doesn’t really value the$5,000 (his part), so he goes to thebeach, relaxes, and even spends some ofthe ―profit‖ on art for his office. How doyou, as a 90% owner, give Steve the properincentives to work hard? 20
  21. 21.  Tolls 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 21
  22. 22.  Financial institutions play an important role in the financial system. Economies of scale: - their expertise in interpreting signals and collecting information - cost advantage in the production of information - can use the information over and over again Economies of scope: - provide multiple services to their customers - apply one information resource to many different services – can lower the cost of information production 22
  23. 23.  What are conflicts of interest? - a type of moral hazard problem - when a person or institution has multiple objectives (interests) – conflicts between those objectives - a financial institution provides multiple services - the potentially competing interests of those services may lead to individual or firm to conceal information or disseminate misleading information 23
  24. 24.  Why do conflicts of interest arise?1. Underwriting and Research in Investment Banking – a conflict of interest may arise between the brokerage and underwriting services - serve two client groups simultaneously – the security-issuing firms and the security-buying investors - When the potential revenues from underwriting greatly exceed the brokerage commission from selling, the bank will have a strong incentive to alter the information provided to investors to favor the issuing firm’s needs. 24
  25. 25. 2. Auditing and Consulting in Accounting Firms – provide both auditing and non-audit consulting services (i.e advice on taxes, accounting, management information systems and business strategy) to their clients. 25
  26. 26. 3. Credit Assessment and Consulting in Credit Rating Agencies – investors and regulators are seeking a well- researched, impartial assessment of credit quality - Issuer need a favorable rating - The rating may be biased because the issuers are the parties paying the credit rating agency. 26
  27. 27.  FredericS. Mishkin, Stanley G. Eakins (2012). Financial Markets and Institutions. 7th Edition. Pearson Addison-Wesley. 27

×