Chapter 8 Mishkin Notes

An Economic Analysis of pecuniary Structure Why do pecuniary Institutions Exist? (Why is Indirect Finance so important? ) Chapter 8 Chapter Preview W e take a closer t angiotensin-converting enzyme at why financial institutions exist and how they promote economic efficiency. Topics take A Few Basic incidents About financial Structure consummation Costs A even tuition inauspicious weft and righteous jeopardize Chapter Preview (cont. ) The Lemons difficulty How obstinate Selection Influences fiscal Structure How Moral embark Affects the Choice Between Debt and candour Contracts How Moral jeopardy Influences financial Structure in Debt Markets 1Basic incidents About financial Structure Throughout the orb The chart on the next slide shows how non-financial business get outer funding in the U. S. , Germany, Japan, and Canada. Notice that, although many aspects of these countries be quite different, the characters 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 important source of external financing for businesses Direct Finance 2. Issuing marketable debt and equity ecurities is not the primary counseling 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 to a greater extent 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 use to finance businesses. Eight Basic Facts of Financial Structure 5. The financial system is among the most heavily regulated sectors of economy. 6. still large, well - accomplished corporations ave easy access to securities markets to finance their activities. Eight Basic Facts of Financial Structure 7. Collateral is a prevalent feature of debt squinchs for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents that transport substantial restrictions on the behavior of the borrowers. 3 W hy is Indirect Finance so Important? Transactions Cost Information Cost Transaction Costs Financial intermediaries to reduce transaction cost (and make mesh) through Economies of scale of measurement expertness Read the municipal bond article. Transaction Costs Transactions costs ? ? ? E. g. a $5,000 investment wholly allows you to purchase 100 make dos $50 / share (equity) No diversification Bonds even worsemost have a $1,000 size 4 Transaction Costs Financial intermediaries make profits by reducing transactions costs Take advantage of economies of scale (example mutual funds) Develop expertise to lower transactions costs abide investors wi th liquidity and diversification Information Costs Asymmetric Information symmetric datathe case 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 unfavorable Selection and Moral Hazard We get out 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 society in a transaction has better information than the other party 2. Before transaction occurs 3. Potential borrowers most likely to produce wayward outcome are ones most likely to seek loan The Lemons job How Adverse Selection Influences Financial Structure If property cannot be assessed, the buyer is allowing to succumb at m ost a price that reflects the just fiber Sellers of ripe(p) quality items will not want to shit at the price for average quality The buyer will ascertain not to buy at all because all that is left in the market is poor quality items This result, when sorry quality pushes good quality from the m arket because of an information gap, is known as adverse selection This business explains fact 2 and partially explains fact 1 Asymmetric Information Adverse Selection and Moral Hazard Moral Hazard 1. Occurs when one party has an incentive to behave differently once an agreement is make between parties 2. After transaction occurs 3. Hazard that borrower has incentives to ngage in undesirable (immoral) activities make it to a greater extent than likely that wont pay loan back 6 health insurance policy regular Information ideate, if you get sick, drugs cost $10,000/year Everyone has a 1/10 chance of getting sick Solution Insurance will be offered at $1,000 per year wellness Insurance harmonious Information continued Suppose 10% of the population (2 out of 20) is unwell and has a 50%(1/2) chance of get ting sick independent. Other 90% (18 people) only has 1/18 chance of getting sick. This information in known to everyone. How do you price the insurance? Health Insurance Symmetric Information ontinued Sickly parts pay? Healthy types pay? 7 Health Insurance Asymmetric Information Adverse Selection Same as previous example, scarce ones type (sick or healthy) is mystic information. Suppose insurance caller 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 less(prenominal) 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 too 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 Solve Adverse Selection Problems snobby Production and Sale of Information ? Free-rider problem interferes with this solution Government enactment to Increase Information (explains Fact 5) Tools to Help Solve Adverse Selection Problems Financial Intermediation ? Analogy to solution to lemons problem provided by used car dealers ? Avoid free-rider probl em by making private loans (explains Fact 3 and 4) ?Also explains fact 6large firms are more(prenominal) likely to use direct instead of indirect financing 10 Tools to Help Solve Adverse Selection Problems Collateral and Net worth(predicate) ? Explains Fact 7 How Moral Hazard Affects the Choice Between Debt and Equity Contracts Called the Principal -Agent Problem ? Principal less information (stockholder) ? Agent more information (manager) Separation of ownership and control of the firm ? Managers pursue ain benefits and power rather than the profitability of the firm Tools to help solve the Principal-Agent Problem Monitoring ? Expensive Government regulation to increase information Fact 5 Financial Intermediation ? Venture capital firms provides the equity and place there own people in management Debt Contracts ? Reduces the need to monitor lizard as long as borrower is performing. Explains Fact 1, why debt is used more than equity 11 How Moral Hazard Influences Finan cial Structure in Debt Markets Even with the advantages just described, debt is still subject to moral hazard. ? Debt may shit 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 in a higher place 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, honorable mention rating. Financial Intermediaries have special advantages in monitoringFacts 3 and 4 ? 12 seal off HERE 13