Chapter 3 Notes Transaction Costs Asymmetric Info the Structure of the Financial System Fin Intermediaries Obstacles Evolved to reduce obstacles faced by savers and small investors in making direct monetary transactions o Hard for borrowers to find savers lenders willing to lend them funds o Hard for lenders savers to find borrowers they re comfortable lending to o Transaction costs costs associated with making direct financial transactions High TX costs reduce the probability of TX occurring Intermediaries lower them for individual and small mid size firms o Flat fees are high for relatively small investments amounts o Insufficient money to buy high dollar investments o Insufficient money to diversify riskier Economies of scale reduction in average unit cost with increased volume of goods or services o ATMs standardization specialization computer o Mutual fund pensions o Asymmetric info situation in which one party to a transaction has better info than the other In finance the receiver of funds typically knows most Adverse selection one party to transaction has better info than the other Debt market Equity markets Insurance o Mitigating factors Risk based premiums Distance to fire stations restrictive clauses driving record Free riding Impact Moral hazard the risk that borrowers could engage in actions AFTER a transaction harmful to the lender Ways to mitigate asymmetric info o Investors get info you lack o Borrowers advertise receive rewards Adverse Selection in Used Car Market The Lemons Problem o Used car sellers have info than buyer o Problem buyer can t tell difference between good and lemon cars o Price buyer will pay reflects lack of knowledge Will pay car s expected value o If good car offers too little o If lemon car pays too much o Result Sellers won t sell good cars at offered price Will lower quality of cars offered Overall quality of cars for sale decreases Used Car Dealers as Intermediaries o Dealers will price cars closer to their true value o Put reputation on the line want return business and recommendations o Government regulations require dealers to give some disclosures on car o Warranties certified vehicles o Repossess cars from defaulting buyers o May offer loans Adverse Selection Problem borrowers o Debt markets investors can t distinguish between low risk borrowers and high risk o Equity markets investors can t distinguish good firms from bad firms o Insurance those most likely to buy insurance are those most likely to file claims o Private info gathering firms have a free rider problem o Mitigate Adverse Selection Problems Financial intermediaries Loan rationing High interest rate loans are the most likely to default Require collateral high net worth in case of default o Pawnshops collateral o Collateral for bond issue Boeing planes Specialize in gathering borrow default risk info o Detailed application credit rating Relationship banking Less free riding banks investments not public Financial Markets Small medium firms can t find buyers or won t sell at price offered o Need external funds Large firms sell publicly because info is easy to get SEC requires publicly traded firms to disclose financial statements and material info that may affect a firm s stock price transparency o Do all firms have publicly traded stock Why or why not Still must monitor SEC charges Goldman Sachs with civil fraud The risk that AFTER entering into a TX a borrow takes actions that could harm a lender o Act to increase investor risk o Use funds in ways not intended by investor Moral Hazard Asymmetric info Problems Equity markets tend to have greater moral hazard than bond markets o Firm managers hired to maximize shareholder wealth Very hard to tell if they re doing it o Debt obligations are fixed Paid before shareholders o Mitigating Moral Hazard Principle agent problem possibility that mergers pursue objectives other than those of their shareholders Principles shareholders firm s owners Agents top management hired to carry out shareholders wishes Separation between manager who runs the firm and the owners Conflict of interest Reducing principle agent problem moral hazard Boards of directors election problems o Don t meet often o Not always independent of managers o Information source Incentive contracts executive compensation Financial intermediaries Restrictive covenants debt o Contractual limits on how borrowers can use investor funds o Early pay off if borrower s net worth drops below a specified level liquid debt More complex securities tend to be less liquid and less transparent o What interest rate level would be charged relative to more Credit rationing a reduction in the number or size of loans made Borrowers have trouble getting needed funds Monitoring less costly for intermediaries than for retail investors Commercial bank specialty Venture capital firms investors in small startup firms o Typically take large ownership o Have board of directorships Private equity and corporate restructuring firms acquire sufficient ownership position of an existing firm to o Remove management that isn t acting in its shareholders best interests o Take on added debt that forces increased efficiency or else liquidation through bankruptcy Key Features of the financial system Tx and info costs are obstacles between savers and borrowers Financial intermediaries help bring lenders and borrowers together by lowering transaction and information costs for both sides of transactions Financial intermediary loans are the most important external fund source for small to mid sized firms Small to mid sized firms primary job creators Debt contracts usually require collateral or restrictive covenants The bond market is more important as an external fund source to corporations than is the stock market Adverse selection and moral hazard can only be mitigated never completely eliminated Some firms are too young to have sufficient info Firms will always present themselves in the best light With time there is always additional data Data can be interpreted differently The costs of 100 monitoring if possible would be too high If restrictions on managers are too great they are prevented from taking even low level risk Regulations add expense and are imperfect
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