PA974001PA974-001Monetary Policy & Financial Regulation in a Globalized Economya Globalized EconomyLecture15Lecture 15 27 October 2010Instructor: Menzie ChinnFall 2010Fall 2010An Economic Analysis of Financial StructureCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-2Eight Basic Factsg1Stocks are not the most important sources of1.Stocks are not the most important sources of external financing for businesses2Issuing marketable debt and equity securities2.Issuing marketable debt and equity securities is not the primary way in which businesses finance their operationsp3. Indirect finance is many times more important than direct finance4. Financial intermediaries are the most important source of external fundsCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-3pEight Basic Facts (cont’d)g()5The financial system is among the most5.The financial system is among the most heavily regulated sectors of the economy6Only large well-established corporations6.Only large, well-established corporations have easy access to securities markets to finance their activities7. Collateral is a prevalent feature of debt contracts8. Debt contracts are extremely complicated legal documents that place substantial ti ti t bCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-4restrictive covenants on borrowersTransaction CostsFi ilit di i h l dt•Financial intermediaries have evolved to reduce transaction costs Economies of scale ExpertiseCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-5Asymmetric InformationyAd l ti b f•Adverse selection occurs before the transaction• Moral hazard arises after the transactionAth lh•Agency theory analyses how asymmetric information problems affect ibh ieconomic behaviorCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-6Adverse Selection: The Lemons ProblemThe Lemons Problem•If quality cannot be assessed the buyer is•If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average qualitygq y• Sellers of good quality items will not want to sell at the price for average qualitypgqy• The buyer will decide not to buy at all because all that is left in the market is poor quality itemspqy• This problem explains fact 2 and partially explains fact 1Copyright © 2007 Pearson Addison-Wesley. All rights reserved.8-7pAdverse Selection: SolutionsPri ate prod ction and sale of information•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 7Copyright © 2007 Pearson Addison-Wesley. All rights reserved.8-8Fact 7Moral Hazard in Equity ContractsqyClldth Pi i lAtPbl•Called the Principal-Agent Problem• Separation of ownership and control of the firm Managers pursue personal benefits and gp ppower rather than the profitability of the firmCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-9Principal-Agent Problem: Solutionspg•Monitoring (Costly State Verification)•Monitoring (Costly State Verification) Free-rider problemFact 1Fact 1• Government regulation to increase informationFact 5Fact 5• Financial IntermediationFact 3Fact 3• Debt ContractsFact 1Copyright © 2007 Pearson Addison-Wesley. All rights reserved.8-10Fact 1Moral Hazard in Debt MarketsBhitittk•Borrowers have incentives to take on projects that are riskier than the lenders ld likwould likeCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-11Moral Hazard: Solutions•Net worth and collateral•Net worth and collateral Incentive compatible•Monitoring and Enforcement of Restrictive•Monitoring and Enforcement of Restrictive CovenantsDiscourage undesirable behaviorDiscourage undesirable behavior Encourage desirable behavior Keep collateral valuable Provide information• Financial IntermediationCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-12 Facts 3 & 4Copyright © 2007 Pearson Addison-Wesley. All rights reserved.8-13Conflicts of Interest•Type of moral hazard problem caused by economies•Type of moral hazard problem caused by economies of scope•Arise when an institution has multiple objectives and•Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives•A reduction in the quality of information in financialA reduction in the quality of information in financial markets increases asymmetric information problems• Financial markets do not channel funds into productive pinvestment opportunities• The economy is not as efficient as it could beCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-14Why Do Conflicts of Interest Arise?yUnder riting and Research in•Underwriting and Research in Investment BankingIf ti d db hi i iInformation produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client pg ygroups 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 businessCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-15utu e bus essWhy Do Conflicts of Interest Arise? (cont’d)of Interest Arise? (cont’d)A diting and Cons lting in Acco nting Firms•Auditing and Consulting in Accounting Firms Auditors may be willing to skew their judgments and opinions to win consulting businessand opinions to win consulting business Auditors may be auditing information systems or tax and financial plans put in place by theirtax and financial plans put in place by their nonaudit counterpartsAuditors may provide an overly favorable audit toAuditors may provide an overly favorable audit to solicit or retain audit businessCopyright © 2007 Pearson Addison-Wesley. All rights reserved.8-16Conflicts of Interest: Remedies•SarbanesOxley Act of 2002 (Public•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Increases the SEC s budget Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client Copyright © 2007 Pearson