Part 3

Fundamentals of
Financial
Institutions

Chapter 7

Why Do
Financial
Institutions
Exist?

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 Chapter Preview

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?

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Chapter Preview

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

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 Chapter Preview (cont.)

• 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

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Basic Facts About Financial

Structure Throughout the World

• The financial system is a complex structure

including many different financial
institutions: banks, insurance companies,
mutual funds, stock and bonds
markets, etc.

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 Basic Facts About Financial
Structure Throughout the World

• 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.

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

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 Facts of Financial Structure

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.

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Facts of Financial Structure

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.

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 Facts of Financial Structure

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.

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Facts of Financial Structure

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.

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 Transaction Costs

• 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

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Transaction Costs

• 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)

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 Asymmetric Information: Adverse
Selection and Moral Hazard

• 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.

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Asymmetric Information: Adverse

Selection and Moral Hazard

• 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

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 Asymmetric Information: Adverse
Selection and 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

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Asymmetric Information: Adverse

Selection and Moral Hazard

• 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

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 Asymmetric Information: Adverse
Selection and Moral Hazard

• 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.

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The Lemons Problem: How Adverse

Selection Influences Financial Structure

• 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 wonʼt be sold, and the used
car market will function inefficiently.
• What helps us avoid this problem with used
cars?

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 The Lemons Problem: How Adverse
Selection Influences Financial Structure

• 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

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The Lemons Problem: How Adverse

Selection Influences Financial Structure

• 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

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 Tools to Help Solve Adverse
Selection (Lemons) Problems

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)

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Tools to Help Solve Adverse

Selection (Lemons) Problems

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

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 Tools to Help Solve Adverse
Selection (Lemons) Problems

4. Collateral and Net Worth

─ Explains Fact # 7, slide 7-11

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The Enron Implosion

• 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.

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 The Enron Implosion

• 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.

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How Moral Hazard Affects the Choice

Between Debt and Equity Contracts

• 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

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 How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

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.

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How Moral Hazard Affects the Choice

Between Debt and Equity Contracts

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?

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 How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

• 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
• Explains Fact # 1, slide 7–8: Why debt is
used more than equity

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How Moral Hazard Influences

Financial Structure in Debt Markets

• 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.

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 How Moral Hazard Influences
Financial Structure in Debt Markets

• 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.

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How Moral Hazard Influences

Financial Structure in Debt Markets

• 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

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 How Moral Hazard Influences
Financial Structure in Debt Markets

• 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

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Asymmetric Information Problems

and Tools to Solve Them

Table 7.1
Summary
Asymmetric
Information
Problems and
Tools to Solve
Them

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 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

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Mini-Case: Should We Kill All

the Lawyers?

• Lawyers are an easy target as a cause of

problems. Shakespeare’s character Dick the
Butcher quips, “…let’s kill all the lawyers.” Is
he right?
• Most legal work is about contract
enforcement:
1. Establish and maintain important property rights
2. Without such rights, limited investments
3. The US has more lawyers / capita than any
nation. Arguably the richest as well.
Coincidence?
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 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 in the inability of
markets to channel funds from savers to
productive investment opportunities.

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Is China a Counter-example?

• Even with its booming economy, Chinaʼs

financial development is still in an early
stage.
• Per capita 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.

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 Is China a Counter-example?

• 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.

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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.

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 Conflicts of Interest: Underwriting
and Research in Investment Banking
• 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 firmʼs outlook is optimistic.

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Conflicts of Interest: Underwriting

and Research in Investment Banking

• 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 firmʼs 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?

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 Conflicts of Interest: Underwriting
and Research in Investment Banking

• 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.

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Conflicts of Interest: Auditing and

Consulting in Accounting Firms

• 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 firmʼs
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.

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 Conflicts of Interest: Auditing and
Consulting in Accounting Firms

• 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.

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Conflicts of Interest: Credit Assessment

and Consulting in Rating Agencies

§ 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.
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 Conflicts of Interest: Credit Assessment
and Consulting in Rating Agencies

Rating agencies, such as Moodyʼs 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.

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Conflicts of Interest: Credit Assessment

and Consulting in Rating Agencies

• The details of this scandal appear in the

Mini-Case on page 158. In short, the SEC
stepped in and proposed new regulation. For
example, a rating agency can no longer rate
a security that they helped structure. But
the steps go further, creating a real
regulatory reporting hassle for these firms.
• You should read both of these Mini-Cases.
You will see these conflicts arise again as
memory of these conflicts fades with time.

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 Remedies?

• 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

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Remedies?

• 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

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 Remedies?

• 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:

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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, itʼs 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?
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 Chapter Summary

• 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

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Chapter Summary (cont.)

• 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

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 Chapter Summary (cont.)

• 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

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Chapter Summary (cont.)

• 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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