Chapter 3 Transaction Costs Asymmetric Information and the Structure of the Financial System Asymmetric information a situation in which one side of a market transaction has more information than the other side Obstacles to Matching Savers to Borrowers The Problems Facing Small Investors Transaction costs the costs of making a direct financial transaction such as buying a stock or bond or making a loan a Legal fees Information costs the costs that savers incur based on borrower creditworthiness and use of acquired funds a Because of these two costs savers receive a smaller return and borrowers pay more interest How Financial Intermediaries Reduce Transaction Costs People turn to financial intermediaries Economics of scale the reduction in average cost that results from an increase in the volume of a good or service produced a This is how financial intermediaries make money The Problems of Adverse Selection and Moral Hazard Typically the borrower has more information 2 problems with asymmetric information 1 Adverse selection distinguishing between low risk borrowers and high risk borrowers Adverse Selection 2 Moral Hazard unsure of whether the borrowers are using the funds as intended Expected value Probability car is good x Value if good Probability car is a lemon x Value if a lemon the stock markets Only 5 100 firms in the US are publicly traded meaning that they are able to sell stock on Credit rationing the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate Adverse selection causes many firms to grow through internal funds which are profits the firms have earned from the owners of the firm Attempts to reduce adverse selection the SEC started requiring that firms report their financial health Private information gathering firms can help minimize adverse selection but cannot eliminate it a Many subscribers pay for it but people that don t pay are called free riders Collateral assets that a borrower pledges to a lender if they default on their loan Debentures bonds issued without specific collateral only used by large well known firms Net worth the difference between the value of a firm s assets and it s liabilities a Can provide the same assurance to lenders as collateral Relationship banking the ability of banks to assess credit risks on the basis of private information about borrowers Making the Connection Has securitization increased adverse selection problems in the financial system Firms placed bets that the CDOs would lose value and therefore Securitization bundling loans such as mortgages into securities Originate to distribute business model banks still grant loans but instead of holding them until maturity banks either securitize them or sell them to other financial firms a Some say this has failed to decrease adverse selection because banks don t care if they lend to good borrowers or lemon borrowers Securitization provides risk sharing increases liquidity reduces interest rates and to diversify investment portfolios Why do banks ration credit High interest rates attract adverse selection because a business owner close to declaring bankruptcy is not going to worry about paying a high interest rate to stay in business During the recession the number of lemon borrowers increased so the bank decreased the number of loans it was willing to give out credit rationing Moral Hazard In the stock market When the borrower does not use the loaned funds as intended Separation of ownership from control structure of many large publicly traded corporations where legally shareholders own the firm but the firm is run by its top management Principal agent problem the moral hazard of managers of pursuing their own interests rather than those of the shareholders a Shareholders are principals and managers are agents Investors elect board of directors but the top management always knows more and the board sometimes only meets 4 times a year Another strategy for reducing moral hazards is incentive contracts managers may be compensated for the performance of the firm it helps align their interests with the shareholders In the bond market Much less moral hazards in the bond market Hazards do happen though when they take on riskier investments using your money without your knowledge so that they can make a higher profit after the fixed payments that they owe you Try to reduce this by writing restrictive covenants a clause in a bond contract that places limits on the uses of funds that a borrower receives a Ex Keep managers from taking on too much risk b Make bonds more complicated cost more and reduce marketability Financial intermediaries Many times when a bank loans you money they will make the check out to the car dealership rather than to you ensuring that the funds are used properly United States doesn t allow banks to buy stock in nonfinancial firms Venture Capital Firms raise funds from investors and use the funds to make investments in small start up firms a They usually take a large stake in the company and put their own employee in the board of directors partially reducing the principal agent problem Private equity firms or corporate restructuring firms become large investors in mature firms typically targeting firms that are not maximizing profits These two firms have established a market for corporate control which can reduce moral hazards by removing top management that are failing to carry out the wishes of shareholders Making the Connection Why so many ponzi schemes In the 1920s Charles Ponzi started a company called the Securities and Exchange Company that would give 50 back to its investors in just 45 days He said that he would their money in postage but instead he used it to pay existing investors and those wanting their money back Eventually people caught on and asked for their money back and sending him to jail Most spectacular scheme was Madoff offering investors 8 12 per year following a Ponzi schemes are an extreme form of moral hazard and increased during the recession complex strategy with financial derivatives Conclusions About the Structure of the US Financial System Trade credit giving over goods but accepting payment at a later date Three key features of the financial system 1 Loans from financial intermediaries are the most important external source of funds for small to medium sized firms 2 The stock market is a less important source of external funds to corporations than is the bond market a
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