Chapter 8 Mishkin Notes

An Economic Analysis of financial coordinate wherefore do Financial Institutions Exist? (Why is Indirect bear so Important? ) Chapter 8 Chapter Preview W e take a c fall asleepr look at why financial institutions exist and how they advertise economic efficiency. Topics include A Few Basic accompaniments About Financial Structure Transaction cost asymmetrical Information obstinate selection and incorrupt risk of infection Chapter Preview (cont. ) The Lemons Problem How ominous option Influences Financial Structure How Moral Hazard Affects the Choice Between Debt and Equity Contracts How Moral Hazard Influences Financial Structure in Debt Markets 1Basic Facts About Financial Structure Throughout the World The chart on the coterminous slide shows how non-financial business get external funding in the U. S. , Germany, Japan, and Canada. Notice that, although many aspects of these countries ar quite different, the sources of financing are somewhat consistent, with the U. S. being different in its focus on debt. Sources of External Finance Copyright 2007 Pearson Addison-Wesley. All rights reserved. 8-5 Eight Basic Facts of Financial Structure 1. Stocks are not the most serious source of external financing for businesses Direct Finance 2. Issuing marketable debt and equity ecurities is not the primary way in which businesses finance their operations Direct Finance 2 Eight Basic Facts of Financial Structure 3. Indirect finance, which involves the activities of financial intermediaries, is m any times more important than direct finance, in which businesses raise pecuniary resource directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds employ to finance businesses. Eight Basic Facts of Financial Structure 5. The financial system is among the most heavily adjust sectors of economy. 6. Only large, well -established corporations ave easy access to securities ma rkets to finance their activities. Eight Basic Facts of Financial Structure 7. validatory is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents that role substantial restrictions on the behavior of the borrowers. 3 W hy is Indirect Finance so Important? proceedings Cost Information Cost Transaction Costs Financial intermediaries to reduce transaction cost (and pip profits) through Economies of scale Expertise Read the municipal bond article. Transaction Costs Transactions costs ? ? ? E. g. a $5,000 investment exclusively allows you to purchase 100 shares $50 / share (equity) No diversification Bonds purge worsemost put on a $1,000 size 4 Transaction Costs Financial intermediaries recognise profits by reducing transactions costs Take advantage of economies of scale (example mutual funds) engender expertise to lower transactions costs provide investors with liquidity and diversification Information Costs asymmetric Information symmetric tuitionthe font where all parties to a transaction or contract have the same information. In many situations, this is not the case. We refer to this as asymmetric information.Asymmetric Information Adverse infusion and Moral Hazard We will focus on two specific forms of asymmetric information ? Adverse selection ? Moral hazard 5 Asymmetric Information Adverse Selection and Moral Hazard Adverse Selection 1. Occurs when one party in a transaction has better information than the other(a) party 2. Before transaction occurs 3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan The Lemons Problem How Adverse Selection Influences Financial Structure If musical note cannot be assessed, the buyer is willing to pay at m ost a price that reflects the average step Sellers of well(p) case items will not want to sell at the price for average quality The buyer will decide no t to buy at all because all that is left in the market is poor quality items This result, when large(p) quality pushes good quality from the m arket because of an information gap, is cognise as adverse selection This problem explains fact 2 and partially explains fact 1 Asymmetric Information Adverse Selection and Moral Hazard Moral Hazard 1. Occurs when one party has an inducement to behave differently once an agreement is made between parties 2. After transaction occurs 3. Hazard that borrower has incentives to ngage in undesirable (immoral) activities making it more likely that wont pay loan back 6 Health redress radial Information think, if you get sick, drugs cost $10,000/year Everyone has a 1/10 get of acquiring sick Solution Insurance will be offered at $1,000 per year Health Insurance Symmetric Information continued Suppose 10% of the population (2 out of 20) is sickly and has a 50%(1/2) chance of getting sick independent. Other 90% (18 people) only has 1/1 8 chance of getting sick. This information in known to everyone. How do you price the insurance? Health Insurance Symmetric Information ontinued poorly(p) types pay? Healthy types pay? 7 Health Insurance Asymmetric Information Adverse Selection Same as previous example, but ones type (sick or well-grounded) is private information. Suppose insurance company offers policy at $1,000 per year? Suppose insurance company offers policy at $1,000 per year? Sickly type happy to save $4,000. Healthy drop out and go without insurance. Adverse selection Bad quality pushes good quality from the market because of an information gap. 8 How about charging little say $555. 56 to everyone? How about charging less say $555. 56 to everyone? Break even on the healthy type, but lose on sickly type. Only way for insurance company in this case to break even is to charge $5,000 ? Healthy will go without insurance. Adverse Selection and Financial Structure Lemons Problem in Securities Markets Suppose investors cannot distinguish between good and bad securities, willing to pay only the average of the good and bad securities values. Result Good securities undervalued and firms wont issue them bad securities overvalued, so in like manner many issued. 9 Lemons Problem in Securities Markets Investors wont want to buy bad securities, so m arket wont function well. ?Explains Facts 1 and 2 ? Also explains Fact 6 only large well established firms have access to securities m arkets Bad quality pushes good quality from the m arket because of an information gap. Tools to Help decide Adverse Selection Problems Private Production and sales agreement of Information ? Free-rider problem interferes with this solution Government Regulation to Increase Information (explains Fact 5) Tools to Help Solve Adverse Selection Problems Financial Intermediation ? Analogy to solution to lemons problem provided by used railroad car dealers ? Avoid free-rider problem by making private loans (explains Fact 3 and 4) ?Also explains fact 6large firms are more likely to use direct instead of indirect financing 10 Tools to Help Solve Adverse Selection Problems Collateral and Net Worth ? Explains Fact 7 How Moral Hazard Affects the Choice Between Debt and Equity Contracts Called the Principal - mover Problem ? Principal less information (stockholder) ? Agent more information (manager) Separation of ownership and control of the firm ? Managers pursue personal benefits and power kind of than the profitability of the firm Tools to help solve the Principal-Agent Problem Monitoring ? Expensive Government regulation to amplification information Fact 5 Financial Intermediation ? Venture capital firms provides the equity and place on that point own people in management Debt Contracts ? Reduces the need to monitor as long as borrower is performing. Explains Fact 1, why debt is used more than equity 11 How Moral Hazard Influences Financial Structure in Debt Markets Even with the advantages just described, debt is still subject to moral hazard. ? Debt may create an incentive to take on very risky projects. How Moral Hazard Influences Financial Structure in Debt Markets Most debt contracts require the borrower to pay a fixed amount (interest) and keep any ash flow above this amount. For example, suppose 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 Lenders need to find ways ensure that borrowers do not take on too much risk. ? A good legal contract ? Bonds and loans often carry restrictive covenants Restrict how funds are used Require minimum net worth, collateral, bank balance, credit rating. Financial Intermediaries have particular advantages in monitoringFacts 3 and 4 ? 12 STOP HERE 13