The Structure of Finance

How Things Work in Banking

Flow of Funds
Largest lender Households Largest borrower Governments and Businesses Indirect Finance Saver to Bank (or other intermediate) to Borrower. Ex. Car Loan Direct Finance Saver to Borrower Ex. Buying bonds from GE

Flow of Funds
Direct Finance Borrower sells securities.
Securities become liabilities for seller Assets for buyer. Asset because someone owes you money. Liability because you have to pay someone money.

Structure of Financial Markets

Debt and Equity Markets

Primary and Secondary Markets

Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary markets

Exchanges and Over-the-Counter (OTC) Markets Money and Capital Markets

Money markets deal in short-term debt instruments Capital markets deal in longer-term debt and equity instruments (mortgages are longer-term debut)

Structure of Financial Markets

Debt Instruments Bond or mortgage, contractual agreement, pays fixed amount for a given period
Maturity is term of contract until expiration Less than year Short-term More than 10 years Long-term In between length Intermediate-term

Structure of Financial Markets

Equities Common Stock, claim to share of net income, and to assets of business (owner)
Some pay dividends Considered to have no maturity Allows right to vote in company issues (mainly management)

Structure of Financial Markets

Primary Market new securities are sold, not usually sold to the public, going public
Investment Banks guarantees a price then they sell to the public.

Secondary Market NYSE, NASDAQ Brokers agents of investors Dealers buy and sell securities at given prices

Structure of Financial Markets

Corporations only acquire new funds selling securities the first time
Not on sales in secondary market.

Secondary markets increase securities liquidity.

Provides info about market price in primary market.

Structure of Financial Markets

Exchanges Centralized in one location, ex. NYSE, CBT Over-the-Counter (OTC) Markets Different locations with inventory of securities, but connected online so not much different than exchanges in difference of prices by location.

Money Market Instruments

Think short-term borrowing and lending, less than a year. U.S. T-Bills Initially sell at discount of
maturity price, no interest payments.
Most liquid instrument No possibility of default, govt can print money to meet obligations

Negotiable Bank CDs Debt sold by banks,

CDs are short term, different than a savings account because of time period restraint.

Money Market Instruments

Commercial Paper Short-term debt issued by large banks and corporations, ex. Microsoft and GM Bankers Acceptances Issued by firm and back by a bank for a fee. International Check Repurchase Agreements short term loan using T-Bill as collateral

Money Market Instruments

Federal Funds usually overnight loans between banks of deposits at the FED Eurodollars Dollar help outside U.S which mean less oversight

Capital Market Instruments

Maturity of more than 1 year
Stocks Equity claims on net income and assets
Owned by individuals, pensions, mutual funds, and insurance companies

Mortgages Loans to purchase homes, lands or other structures.

Collateral is object of purchase.

Corporate Bonds Long term bonds issued by companies with strong credit ratings

Capital Market Instruments

U.S. Govt Securities Long term bonds
Most widely accepted world wide.

U.S. Govt Agency Securities Ex. Ginnie Mae, Federal Farm Credit Bank
Backed by government

State and Local Govt Bonds Municipal bonds, have tax advantages Consumer & Bank Commercial Loans Car loans, home loans, etc. mostly by banks

Internationalization of Financial Markets

Foreign Bonds: sold in a foreign country and denominated in that countrys currency Eurobond: bond denominated in a currency other than that of the country in which it is sold Eurocurrencies: foreign currencies deposited in banks outside the home country World Stock Markets

Basics Truths of Financing

o Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations o Indirect finance is many times more important than direct finance

Basics Truths of Financing

o o Financial intermediaries are the most important source of external funds The financial system is a heavily regulated sector of the economy (a lot effective)

Basics Truths of Financing

o o Collateral is a prevalent feature of debt contracts
o Your house for the mortgage, car for auto loan

Debt contracts are complicated legal documents that place substantial restrictive covenants on borrowers
o What you can and cant do with the money.

Transaction Costs
Acquiring resources can be expensive There are benefits to volume Financial intermediaries have evolved to reduce transaction costs
Economies of scale Expertise

Transaction Costs
Economies of scale
Transaction costs decrease as costs spread across more transactions grow (size or number)
Ex. Mutual Funds buy large number of shares

Transaction Costs
Expertise
Same idea as specialization in that they can focus on improving services while lowering costs
Ex. Online services and advice vs. postal mail

Asymmetric Information
Adverse selection occurs before the transaction

Moral hazard arises after the transaction

Agency theory analyses how asymmetric information problems affect economic behavior

Adverse Selection: The Lemons Problem

If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality Sellers of good quality items will not want to sell at the price for average quality

The buyer will decide not to buy at all because all that is left in the market is poor quality items
It leads to a market not functioning properly

Adverse Selection: The Lemons Problem

George Akerlof: Nobel prize winner, lemons problems and Used Cars
Used car buyers have little information. Pay average of value of lemons and peaches Sellers know the quality of there care Average price for sellers of peaches is to low and will not sell car Average price for sellers of lemons is high and will want to sell car. Result few quality cars sold, value of used cars declines

Adverse Selection: Solutions

Private production and sale of information
Free-rider problem

Government regulation to increase information

Reduces uncertainty from withholding information

Financial intermediation
Banks specialize in assessing risk

Collateral and net worth

Skin in the game

Moral Hazard in Equity Contracts

Called the Principal-Agent Problem
Principal stockholders Agent - managers

Separation of ownership and control of the firm

Managers pursue personal benefits and power rather than the profitability of the firm

Principal-Agent Problem: Solutions

Monitoring (Costly State Verification) Free-rider problem One party can take advantage of costly actions without paying Government regulation to increase information Limits ability to hide behavior

Principal-Agent Problem: Solutions

Financial Intermediation
Venture capital firms: add resources but become very involved in decision making

Debt Contracts
Return is fixed

Moral Hazard in Debt Markets

Borrowers have incentives to take on projects that are riskier than the lenders would like
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 $100m in interest, next quarter, but only has $90? It is essentially bankrupt. The firm has nothing to lose by looking for risky projects to raise the needed cash.

Moral Hazard: Solutions

Net worth and collateral
Incentive compatible

Monitoring and Enforcement of Restrictive Covenants

Discourage undesirable behavior Encourage desirable behavior Keep collateral valuable Provide information

Financial Intermediation
Banks provide the above

Conflicts of Interest in Financing

Moral hazard problem caused by economies of scope
Economies of scope: lower costs by offering more services.
An institution has multiple objectives and, as a result, has conflicts between those objectives A reduction in the quality of information in financial markets increases asymmetric information problems

Ex: Certifying and sales

Conflicts of Interest in Financing

Problem buyers assume information is accurate
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be

Why Do Conflicts of Interest Arise?

Underwriting and Research in Investment Banking
Information produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ. Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies future business

Why Do Conflicts of Interest Arise?

Morgan Stanley memo 1992: Our objective. . . Is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.

Why Do Conflicts of Interest Arise?

Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and opinions to win consulting business
Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts Auditors may provide an overly favorable audit to solicit or retain audit business Nothing wrong here, everythings fine

Conflicts of Interest: Remedies

Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act)
Increases supervisory oversight to monitor and prevent conflicts of interest Establishes a Public Company Accounting Oversight Board Increases the SECs budget Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit

Conflicts of Interest: Remedies

Sarbanes-Oxley Act of 2002
Beefs up criminal charges for white-collar crime and obstruction of official investigations
Requires the CEO and CFO to certify that financial statements and disclosures are accurate Requires members of the audit committee to be independent

However, very expensive for small firms ($100 mil or less) to comply $824,000

Conflicts of Interest: Remedies

Global Legal Settlement of 2002
Requires investment banks to sever the link between research and securities underwriting Bans spinning Imposes $1.4 billion in fines on accused investment banks Requires investment banks to make their analysts recommendations public Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that would provide research to their brokerage customers

Financial Crises and Aggregate Economic Activity

Look back in history, crises can be caused by:
Increases in interest rates Increases in uncertainty Asset market effects on balance sheets Problems in the banking sector Government fiscal imbalances

http://www.nytimes.com/2007/06/13/opinion/13carlat.html

Look online for a web chapter on Conflict of Interest