1. An Overview
of the Financial System

2. Function of Financial Markets
1. Allows
transfers of
funds from
person or
business
without
investment
opportunities
to one who
has them
2. Improves
economic
efficiency
2

3. Function of Financial Markets
 Perform the essential function of channeling funds
from economic players that have
saved surplus funds to those that have a shortage of
funds
 Promotes economic efficiency by producing
an efficient allocation of capital, which increases
production
 Directly improve the well-being of consumers by
allowing them to time purchases better
3

4. 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
4

5. Principal Money Market Instruments
5

6. Capital Market Instruments
6

7. An Economic Analysis of Financial
Structure

8. Sources of External Finance in U.S
8

9. Sources of Foreign External Finance
9

10. Sources of Foreign External Finance
10

11. Eight Basic Facts
1. Stocks are not the most important sources of
external financing for businesses
2. Issuing marketable debt and equity securities is not
the primary way in which businesses finance their
operations
3. Indirect finance is many times more important than
direct finance
4. Financial intermediaries are the most important
source of external funds
11

12. Eight Basic Facts (cont’d)
5. The financial system is among the most heavily
regulated sectors of the economy
6. Only large, well-established corporations have easy
access to securities markets to finance their
activities
7. Collateral is a prevalent feature of
debt contracts
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers
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13. Demonstration
 How will a buyer determine what to offer?
 How will the seller determine what to charge?
 What if I offered to buy at $800?
 Will everyone sell?
 What happens to the average value of the cars
offered for sale when I offer $800?
13

14. Function of Financial
Intermediaries
Financial Intermediaries
1. Engage in process of indirect finance
2. More important source of finance than securities markets
3. Needed because of transactions costs and asymmetric
information
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15. Transaction Costs
 Financial intermediaries have evolved to
reduce transaction costs
– Economies of scale
– Expertise
15

16. Function of Financial
Intermediaries
Risk Sharing
1. Create and sell assets with low risk characteristics and then
use the funds to buy assets with more risk (also called asset
transformation).
2. Also lower risk by helping people to diversify portfolios
16

17. Transaction Costs and Financial
Structure
Transaction costs hinder flow of funds to people with
productive investment opportunities
Financial intermediaries make profits by reducing transaction
costs
1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs
Explains Fact 3
17

18. Asymmetric Information
 “The secret of success is to know something nobody
else knows” -Aristotle Onassis
 Hot tip from the broker vs. insider trading
 Lemons Problem (Akerlof)
 The Nobel Laureates of 2001.
http://www.nobel.se/economics/laureates/2001/index.html
18

19. Asymmetric Information
 Adverse selection occurs before
the transaction
 Moral hazard arises after the transaction
 Agency
theory analyses how
asymmetric information problems affect
economic behavior
19

20. 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
 This problem explains fact 2 and partially explains
fact 1
20

21. Adverse Selection: Solutions
 Private production and sale of information
– Free-rider problem
 Government regulation to increase information
– Fact 5
 Financial intermediation
– Facts 3, 4, & 6
 Collateral and net worth
– Fact 7
21

22. Moral Hazard in Equity
Contracts
 Called the Principal-Agent Problem
 Separation of ownership and control
of the firm
– Managers pursue personal benefits and power
rather than the profitability of the firm
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23. Principal-Agent Problem: Solutions
 Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
 Government regulation to increase information
– Fact 5
 Financial Intermediation
– Fact 3
 Debt Contracts
– Fact 1
23

24. Moral Hazard in Debt Markets
 Borrowers have incentives to take on
projects that are riskier than the lenders
would like
24

25. 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
– Facts 3 & 4
25

26. 26

27. Function of Financial
Intermediaries: Indirect Finance
 Lower transaction costs
– Economies of scale
– Liquidity services
 Reduce Risk
– Risk Sharing (Asset Transformation)
– Diversification
 Asymmetric Information
– Adverse Selection (before the transaction)—more likely to select
risky borrower
– Moral Hazard (after the transaction)—less likely borrower will repay
loan
27

28. Internationalization
of Financial Markets
 Foreign Bonds—sold in a foreign country and
denominated in that country’s 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
– Eurodollars—U.S. dollars deposited in foreign banks outside
the U.S. or in foreign branches of U.S. banks
 World Stock Markets
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29. Financial Intermediaries
29

30. Size of Financial Intermediaries
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31. Regulation of the Financial System
 To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading
 To ensure the soundness of financial intermediaries:
– Restrictions on entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates
31

32. Regulatory Agencies
32

33. Regulatory Agencies
33

34. Conflicts of Interest
 Type of moral hazard problem caused by economies of scope
 Arise when 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
 Financial markets do not channel funds into productive
investment opportunities
 The economy is not as efficient as it could be
34

35. 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
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36. Why Do Conflicts
of Interest Arise? (cont’d)
 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
36

37. 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 SEC’s budget
– Makes it illegal for a registered public accounting firm to
provide any nonaudit service to a client contemporaneously
with an impermissible audit
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38. Conflicts of Interest:
Remedies (cont’d)
 Sarbanes-Oxley Act of 2002 (cont’d)
– 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
38

39. Conflicts of Interest:
Remedies (cont’d)
 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
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40. Financial Development
and Economic Growth
Financial Repression Leads to Low Growth: Why?
1. Poor legal system
2. Weak accounting standards
3. Government directs credit
4. Financial institutions nationalized
5. Inadequate government regulation
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41. Appendix
 Slides after this point will most likely not be
covered in class. However they may contain
useful definitions, or further elaborate on
important concepts, particularly materials
covered in the text book.
 They may contain examples I’ve used in the
past, or slides I just don’t want to delete as I
may use them in the future.
41

42. Financial Crises
and Aggregate Economic Activity
 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
42

43. Events in U.S. Financial Crises
43

44. Events in Mexican, East Asian, and Argentine
Financial Crises
44

45. Summary: Asymmetric Information
Problems and Tools to Solve Them
45