Miskin (2009) Chapter 2,8
Ceccetti and Schoenholtz (2015), Chapter 3
Viney (2019) Chapters 2, 3
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Learning objectives
Understanding…
Why do financial institutions exist?
Why do different financial institutions exist?
Operation of different types of financial institution
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Outlines
Asymmetric information
Commercial banking
Non-bank financial institutions
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Why do financial institutions exist?
Demand Supply
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Sources of External Funds for
Nonfinancial Businesses in
the United States
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Sources of External Funds for Nonfinancial
Businesses: A Comparison of the United States with
Germany and Japan (1970-1996)
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Why do financial institutions exist?
Basic puzzles about Financial Structure throughout the World
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.
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.Banks are the most important source of external funds used to finance businesses.
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 for both households and businesses.
8.Debt contracts typically are extremely complicated legal documents that place substantial restrictions on
the behavior of the borrower.
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Why do financial institutions exist?
What we want
Demand Supply
What we have
Demand Supply
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Why do financial institutions exist?
What we have
Demand Supply
Adverse selection
Information asymmetry
Moral hazard
Transaction cost
Individuals tend to be significantly less risk averse when they make decisions over another person's
money compared to decisions that they make over their own money. (Chakravarty, el at, 2011)
Chakravarty, S., Harrison, G. W., Haruvy, E. E., & Rutström, E. E. (2011). Are you risk averse over other people's money?. Southern Economic Journal, 77(4), 901-913. 9
Why do financial institutions exist?
Asymmetric information—one party’s insufficient knowledge about the other party
involved in a transaction to make accurate decisions.
The presence of asymmetric information leads to adverse selection and moral hazard
problems
Adverse selection is an asymmetric information problem that occurs before the
transaction occurs. Adverse selection in financial markets occurs when the potential
borrowers who are the most likely to produce an undesirable (adverse) outcome—the
bad credit risks—are the ones who most actively seek out a loan and are thus most
likely to be selected.
Moral hazard arises after the transaction occurs: Moral hazard in financial markets is
the risk (hazard) that the borrower might engage in activities that are undesirable
(immoral) from the lender’s point of view, because they make it less likely that the loan
will be paid back.
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Adverse selection
is an asymmetric information problem that occurs before the transaction occurs.
Adverse selection in financial markets occurs when the potential borrowers who are the
most likely to produce an undesirable (adverse) outcome—the bad credit risks—are
the ones who most actively seek out a loan and are thus most likely to be selected.
Come to information cost
Lemons problem in a used car market
Lemons problem in equity contracts: if an investor can’t tell the difference between the
two firms, one with good prospects and one with bad prospects, they will be willing to pay
a price based only on their average quality.
Lemons problem in debt contracts: If a lender can’t tell whether a borrower is a good or
bad credit risk, the lender will demand a risk premium based on the average risk.
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Adverse selection
How to solve adverse selection
Private Production and Sale of Information.
Free-rider problem occurs when people who do not pay for information take advantage of the
information that other people have paid for.
Government Regulation to Increase Information.
Financial Intermediation.
Collateral and Net Worth.
Collateral: property promised to the lender if the borrower defaults.
Net worth (equity capital): the difference between a firm’s assets (what it owns or is owed)
and its liabilities (that it owes)
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Moral hazard in Equity contract – Principal–agent problem.
When managers own only a small fraction of the firm they work for, the stockholders who own
most of the firm’s equity (called the principals) are not the same people as the managers of the firm,
who are the agents of the owners.
This separation of ownership and control involves moral hazard, in that the managers in control
(the agents) may act in their own interest rather than in the interest of the stockholder-owners
(the principals) because the managers have less incentive to maximize profits than the
stockholder-owners do.
How to solve moral hazard
Production of Information: Monitoring.
Government Regulation to Increase Information.
Financial Intermediation.
Debt Contracts.
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Moral hazard in Debt contract
Moral hazard arises after the transaction occurs: Moral hazard in financial markets is the risk
(hazard) that the borrower might engage in activities that are undesirable (immoral) from the
lender’s point of view, because they make it less likely that the loan will be paid back.
How to solve moral hazard
Net Worth.
Monitoring and Enforcement of Restrictive Covenants.
Financial Intermediation.
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Financial intermediaries
• Economies of scale: the reduction in transaction costs per dollar of
transactions as the size of transactions increase.
• Risk sharing: the process of creating and selling assets with risk
characteristics that people are comfortable with and the intermediaries
then use the funds they acquire by selling these assets to purchase other
assets that may have far more risk.
• Expertise
• Screening and Certifying to Reduce Adverse Selection
• Monitoring to Reduce Moral Hazard
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Risk sharing by:
• Asset transformation: turning risky assets into safer assets for investors by
creating and selling assets with risk characteristics that people are comfortable
with and using the funds they acquire by selling these assets to purchase other
assets that may have far more risk.
• Diversification: investing in a collection (portfolio) of assets whose returns do
not always move together, with the result that overall risk is lower than for
individual assets. (You shouldn’t put all your eggs in one basket)
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Financial institution
• Commercial bank: Refer to Viney (2019) Chapter 2
• Non-bank financial institution: Refer to Viney (2019) Chapter 3
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Balance sheet of
Commercial banks in US.
https://www.federalreserve.gov/releases/
h8/current/default.htm
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Pooling savings
Diversifying Risk
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https://cic.gov.vn/#/co-login
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