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#3 Why Do FIs Exist
#3 Why Do FIs Exist
Lecture Objectives
Why financial institutions exist and how they promote economic efficiency. Why financial markets have a given financial Structure in every economy in the World How & Why transaction costs influences the financial structure How & Why information costs influences the financial structure What is Asymmetric Information and related concepts of Adverse Selection and Moral Hazard
Dr. Kulbir Singh (IMT-Nagpur)
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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 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.
Dr. Kulbir Singh (IMT-Nagpur)
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Transactions Costs
Transactions costs influence financial structure
E.g., a Rs. 5,000 investment only allows you to purchase 100 shares @ Rs.50 / share (equity) No diversification Bonds even worsemost have a Rs1,000 size
In sum, transactions costs can hinder flow of funds to people with productive investment opportunities Percentage of Indian Households own any securities are small (see slide 19 & 20)
Dr. Kulbir Singh (IMT-Nagpur)
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Transactions 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
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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 The analysis of how asymmetric information problems affect economic 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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For example, annual audits of public corporations (although collapse of Enron & accounting scandal at Satyam Computers are shining examples of why this does not eliminate the problem
Dr. Kulbir Singh (IMT-Nagpur)
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(explains Fact # 3-why indirect finance is so much more impt. than direct finance and # 4- why banks are the most impt. source of external funds for financing businesses.) Greater role of banks in developg countries inform about private firms harder to getgreater role of fin. Intermed. use direct instead of indirect financing pecking order hypothesis
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Tools to Help Solve Adverse Selection (Lemons) Problems 4. Collateral and Net Worth
Explains Fact # 7
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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, Ravi, provides the remaining $1,000 and will act as the manager. If Ravi works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it.
Dr. Kulbir Singh (IMT-Nagpur)
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How Moral Hazard Affects the Choice Between Debt and Equity Contracts However, Ravi doesnt 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 Ravi the proper incentives to work hard?
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How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Tools to Help Solve the Principal-Agent Problem 1. Production of Information: Monitoring
Costly state verification. Makes equity contracts less desirable, so,fact #1explained Free-rider problem decreases monitoring..additional explanation for fact #1.
4. Debt Contracts
Contract structure allows reduced need to monitor managers explains fact #1
Dr. Kulbir Singh (IMT-Nagpur)
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In fact, debt may create an incentive to take on very risky projects. This is important to understand. Lets looks at a simple example.
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4. Financial Intermediation - banks & other intermediaries have special advantages in monitoring due their private loans and also eliminates free-rider pbm.
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Is China a Counter-example?
Even with its booming economy, Chinas financial development is still in an early stage.
Legal systems are weakfinancial contracts difficult to enforce Accounting standards are lax no high-quality inform. About creditors Regulation of banks in formative stages Banking sector is dominated by state-owned banks
Yet Chinese economy has enjoyed one of the highest growth rates in world in last 20 years? How has China been able to grow so rapidly given its low level of financial development?
Dr. Kulbir Singh (IMT-Nagpur)
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Is China a Counter-example?
ANSWER
Highest savings rateaveraging 40% Shifted underutilized labor from subsistence agriculture to productive industry sector
RESULT..high growthdue to
Huge increase in capital Gains in productivity
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Is China a Counter-example?
MORAL FOR CHINA
Allocate capital more efficiently which requires to improve its financial system. Chinese govt. has announced that State-owned banks will be privatized Legal reforms in contracts & bankruptcy
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What Are Conflicts of Interest and Why Are They Important? Financial intermediaries engage in a variety of activities to collect, produce, and distribute information. By providing multiple services, they realize economies of scope. However, these services may be competing with one another, and this creates the potential for a conflict of interest.
Dr. Kulbir Singh (IMT-Nagpur)
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Underwriting and Research in Investment Banking Some investment banks both underwrite new securities sold the public, and provide research (buy/sell recommendations) to the investing public When revenues from underwriting exceed brokerage commissions, favorable research will attract more business, at the expense of unbiased recommendations to the investing public.
Dr. Kulbir Singh (IMT-Nagpur)
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Underwriting and Research in Investment Banking In initial public offerings of equity, underwriters direct the new shares as they wish, typically to their best clients or potential new clients. Since most IPOs are underpriced, many of these shares are immediately sold for a profit (called spinning). This immediate profit may appear as nothing more than payment for future business.
Dr. Kulbir Singh (IMT-Nagpur)
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Underwriting and Research in Investment Banking Refer such two cases in the book:
The King, Queen, and Jack of the Internet & Frank Quattrone and Spinning
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Auditing and Consulting in Accounting Firms Auditors also have a conflict of interest since they are paid by the firm they audit. If the auditor gives an unfavorable audit report, the auditor may lose the auditing business as well. A well known case of the failure of auditors to provide unbiased reports was Arthur Andersens audit of Enron. In case of Satyam Computers, PricewaterhouseCoopers (PwC).action?
Dr. Kulbir Singh (IMT-Nagpur)
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Credit Assessment and Consulting in Credit-Rating Agencies Bond investors rely on credit-rating agency assessment of firms debt (debt ratings). However, ratings are only provided when the firm pays the agency. Agencies, then, have an incentive provide better ratings to attract business. Rating agencies have also started providing firms with other services, and have the same conflicts as auditors in this regard
Dr. Kulbir Singh (IMT-Nagpur)
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What Has Been Done to Remedy Conflicts of Interest? Two major policies were implemented following the scandals of the late 1990s and early 2000s. These are:
Sarbanes-Oxley Act of 2002 (USA) Global Legal Settlement of 2002 (USA)
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