Meaning : are all fees and commissions paid when buying or selling securities,
such as search costs, cost of distributing securities to investors, cost of SEC
TRANSACTION COSTS
Including : search cost, negotiation – implementation cost, monitoring cost
ASYMMETRIC INFORMATION
occurs before transaction takes place
ADVERSE SELECTION
Tools to solve adverse selection (lemons) problem
occur after the transaction takes place
occur when one party has an incentive to behave differently once
an agreement is made between parties
Tools to solve the problems arising from moral hazard
MORAL HAZARD
Tools to Help Solve Moral Hazard in Debt Contracts
Tools to solve agency problem
Asymmetric Information & The Role of
Financial Intermediaries
8 BASIC CHARACTERISTICS OF
FINANCIAL STRUCTURE
FINANCIAL INTERMEDIARIES
3 TYPES OF FINANCIAL INTERMEDIARIES
registration, and the time and hassle of the financial transaction
Meaning : one party often does not know enough about the other party to
make accurate decisions. This inequality is called asymmetric information.
occurs when buyers and sellers do not have access to the same
information; sellers usually have more information than buyers.
The problems which are created by asymmetric information include : adverse
selection and moral hazard
occurs when one party in a transaction has better
information than the other party
Private Production and Sale of Information:
free-rider problem
Government Regulation to Increase Information:
--> Require/encourage companies to disclose
information
--> For example, annual audits of public
corporations
Financial Intermediation:
Collateral and Net Worth:
Mortgage: an asset that compensates the
lender in case the borrower goes
bankrupt
Monitoring:
Stockholders can engage in the monitoring (auditing) of firms’
activities to reduce moral hazard:
• ensure that information asymmetry is not exploited by one party at
the expenses of the other
• the value of equity contracts cannot be certain or be observed at the
moment of purchase
Government regulation to increase information
Financial intermediaries active in the equity market:
--> avoid free-rider problem, for example: venture
capital firms
Debt contracts:
Equity contracts claims on profits in all situations >< debt
contracts is independently from the profits of the firms
➢ Debt contract are preferred to equity contracts
➢ Explain why stocks are not the most important external source
of financing for firms.
Net Worth and Collateral
Monitoring and Enforcement of Restrictive Covenants
Financial Intermediation
--> banks and other intermediaries have special
advantages in monitoring
Monitoring:
- stockholders, bondholders, outside
auditors,...
Create a strong management system:
-Transparent responsibility system
- Business code of ethics
Incentives:
- provide a compensation package to managers that try to
induce them to act in stockholders' interest
- this is performance based incentives -> stock options
Stocks are not the most important source
of external financing
Marketable securities are not the primary
source of finance
Indirect finance is more important than
direct finance
Banks are the most important source of
external funds
The financial system is heavily regulated
Only large, well-established firms have
access to securities markets
Collateral is prevalent in debt contracts
Debt contracts have numerous restrictive
convenants
Meaning : are organizations with legal status doing business in the
financial and monetary sector with the main and regular activity of
mobilizing idle capital from those who have excess capital and then
lending it to those who need capital.
Minimize transaction costs: savings thanks to scale, professionalism, and technology
Minimize risks arising from asymmetric
Roles
information
Helps investors spread risks
Meaning : is a typical financial intermediary
organization, allowed to accept deposits for lending
and provide payment services and other services.
Commercial Banks Features :
- Raise funds by issuing checkable deposits, savings deposits,
time deposits
- Use funds to make commercial, consumer and mortgage loans
and to buy government securities/ municipal bonds
- Gather small amounts of money from households and make
(bigger) loans
Mutual saving banks provide companies (usually
corporations and large companies) with services to sell
securities issued by companies.
When companies want to raise capital, they often hire
Depository institutions Savings and Loan Associations / the services of investment banks to help sell securities
Mutual Savings Banks
- Operating mainly on the primary market
+ Consulting on whether businesses should issue securities
or not?
+ What maturity date and interest rate should be applied
+ Guarantee for the issuance - ensure the selling price for
the business, take responsibility to sold to the public
+ If the issuance is large-scale, many different investment
banks will join forces to limit risks
Small cooperative lending institutions organized around a particular
group: union members, employees of a particular firm,...
Credit Unions
Acquire funds from deposits (called shares) and make consumer loans
Meaning : are financial intermediaries that acquire funds at periodic intervals
on a contractual basis
Insure people against financial hazards following a death and
sell annuities (annual income payments upon retirement)
Life insurance companies
Acquire funds from the premiums that people pay for the insurance
contract and use funds to buy corporate bonds, mortgages, and stock
(restricted in the amount they can hold)
Insure people against loss from theft, fire and accidents
Contractual savings institutions
Acquire funds from the premiums that people pay for
the insurance contract and use funds to buy municipal
Fire and Casualty insurance companies bonds (largest), corporate bonds and stocks,
government securities
Have a greater possibility of loss of funds if major
disasters occur→buy more liquid assets than life
insurance compnaies
Provide retirement income in the form of annuities to
employees who are covered by a pension plan
Acquire funds from contributions from employers and
Pension funds and government
employees (automatically deducted from paychecks or
retirement funds
contribute voluntarily)
Use funds to buy corporate bonds and stocks
Raise funds by selling commercial paper and by issuing stock and bonds
Finance Companies Lend funds to consumers and to small business
Gather big amounts of money and then lend small
amounts to consumers & SMEs
Acquire funds by selling shares to many individuals
Use funds to purchase diversified portfolios of stocks
Investment intermediaries Mutual Funds
and bonds
Investments in mutual funds can be risky
Similar to mutual fund but also function as a depoitory
institution
Sell shares to acquire funds and use to buy money market
Money market mutual funds
instruments
Shareholders can write checks against the value of their
shareholding