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International Business

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Submitted By nhimxubong
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Mishkin Chapter 8
An Economic Analysis of Financial Structure (pp. 168-192) Modified & Extended Mishkin Notes
Professor Leigh Tesfatsion Department of Economics Iowa State University Ames, IA 50011-1070

Last Revised: 6 April 2011
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Key In-Class Discussion Questions
• What basic “stylized facts” characterize the current U.S. financial system? • Do transactions costs and asymmetric information help to explain these stylized facts? • Enron Case Study (Mishkin p. 177, and asymmetric information problems in securities markets exemplified by the Enron bankruptcy scandal? online html notes “Enron Scandal & Moral Hazard”): In what ways (if any) are

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Financial Structure
Manner in which firms finance their activities using external funds.
MIX SOURCE

Equity

Debt

Securities

Markets

FIs
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External Finance Sources 1970-2000

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The Decline of Banks as a Source of External Finance (Mishkin 12, Fig 2, p. 287)

Source: Federal Reserve Flow of Funds Accounts; Federal Reserve Bulletin.
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One reason for the decline…the U.S. savings & loan crisis in the 1980s

Mishkin Chapter 11, Figure 1
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Recent Trends
• Decreasing role for banks in supplying loans to U.S. firms. • Competing financial institutions now offering traditional banking services (e.g., Merrill Lynch) • Growing use of securities markets (e.g., corporate bond issue), especially by large corporations. • Loans → Securities. Securitization = Previously illiquid loans (e.g., mortgages) are increasingly being bundled together and turned into publicly marketable securities in standardized amounts.

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Recent Trends… Continued
• Nevertheless, banks continue to perform a critical function for external finance: namely, liquidity insurance for large corporations. – Lines of credit to large corporations to help insure them against market shocks. – Banks are better equipped for this than other types of FIs. – Flow of funds into bank deposit accounts (“safe havens”) tends to increase when negative economic shocks occur. – So bank funds available for lines of credit tend to increase when shocks occur.
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U.S. Summary Data: External Finance Mix and Source Over 1970-2000
• Regarding Mix: Debt ≈ 89 % Equity ≈ 11 % • Regarding Source: Securities Markets ≈ 43 % Financial Intermediaries ≈ 57 % Note: There is some controversy regarding the interpretation of this data. See Mishkin, Chapter 8, p. 170, footnote 1.
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Eight Puzzles: World Financial Structure
1. Stocks not most important source of business

external finance.

2. Security issues (bonds, stocks) not most important source of business external finance. 3. Indirect finance (financial intermediation) much more important than direct finance as source of external funding. 4. Loans (from bank and non-bank FIs) are the most important source of external finance.

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Eight Puzzles… Continued
5. Financial system is among the most heavily regulated sectors of an 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 with restrictive covenants that constrain behavior of borrowers.
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Mishkin’s Answers to Eight Puzzles

Transactions Costs
(Costs of Organizing Production)

Explains

Puzzle 3 Importance of Indirect Finance

Information Costs
(Costs of Reducing Moral Hazard and Adverse Selection)

Explains

All Eight Puzzles

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Three Distinct Types of Costs Associated with Loan Contracts
(1) What “production costs” are associated with external financing via loan contracts? External Financing as a Production Process: Borrowed Funds Returns from Borrowing

(“direct inputs to production”)

(“output”)

Production Costs of External Financing = Costs of securing “direct inputs to production” = Principal plus interest payments
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Three Types of Costs… Continued
(2) Transactions Costs Production Process: Borrowed Funds Returns from Borrowing (“Input”) (“Output”)

Transaction Costs = Costs of organizing production = Search/match costs to bring together the borrower and lender + Costs of preparing loan contract
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Three Types of Costs… Continued
(3) Information Costs Production Process: Borrowed Funds (“Input”) Returns from Borrowing (“Output”)

Information Costs
= Costs of reducing adverse selection and/or moral hazard problems associated with the loan contract (information gathering, monitoring, and contract enforcement)
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Transaction Costs and Puzzle 3 (Importance of FIs)
•Transaction costs hinder flow of funds to people with productive investment opportunities •FIs make profits by reducing transaction costs (online html notes, pp. 4-5)

1. Specialize in matching borrowers and lenders 2. Asset transformation → Economies of scale Example: Pooling funds into Mutual Funds

Explains Puzzle 3
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Adverse Selection
Definition Review (cf. Mishkin, Chapter 2) • A type of asymmetric info problem that arises for a potential buyer before a purchase occurs. • Steps taken to protect against uncertain quality of what is being bought can result in lower average quality of the pool of items being offered for sale.

loan contracts, bonds,…) to protect against poor quality borrowers can adversely affect quality of their loan applicant pools.

Example: Steps taken by lenders (buyers of

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Adverse Selection Helps Explain Puzzles 1-7 (Online Html Notes, pp. 6-8)
“Lemons Problem” in Securities Markets 1. If can’t distinguish between good and bad securities, willing to pay only average of good and bad securities’ values. 2. Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued. 3. Investors won’t want to buy bad securities, so market won’t function well (except for large well-known firms whose quality is known). Explains Puzzle 1, Puzzle 2, and Puzzle 6
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Tools to Help Solve Adverse Selection Problems in Financial Markets
1. Private Production and Sale of Information

Free-rider problem interferes with this solution
2. Government Regulation (e.g., SEC) to Increase Info Explains Puzzle 5 (heavy regulation of financial sector) 3. Financial Intermediation A. Analogy to solution to lemons problem provided by usedcar dealer - an intermediary between buyer/seller B. Financial intermediaries can specialize in information gathering about would-be borrowers Explains Puzzles 3 and 4 (Use of Indirect Fin/banks) 4. Collateral and Net Worth as Quality Signals Explains Puzzle 7 (prevalence of contract restrictions)
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Moral Hazard
Definition Review (Mishkin, Chapter 2) • A form of asymmetric info problem that arises for a buyer of a relational good after the purchase transaction occurs. • Seller changes his/her behavior after purchase so that risk calculations used by the buyer to determine a “fair purchase price” no longer are accurate, and the seller’s behavioral change is difficult for the buyer to observe. Lender (buyer) purchases bond from borrower (seller) thinking loan will be used for a relatively low risk investment.
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Example:

A Special Type of Moral Hazard
(Cf. Online Html Notes, pp. 8-10) Principal-Agent Problem: 1. Moral hazard problem that arises in stock markets due to separation of ownership by stockholders (principals) from control by managers (agents) 2. Managers might act in their own interest rather than in stockholders’ interest

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(cf. Online Html Notes, pp. 8-10)
1. Monitoring difficult for stockholders; Debt contracts less prone to moral hazard since payments independent of profits (Puzzle 1) 2. Government regulation (e.g., SEC) helps to increase investor information (Puzzle 5) 3. Monitoring easier for FIs such as venture capital firms than for individual investors, and FIs can include restrictive covenants in loan contracts aimed at reducing moral hazard (Puzs 1-4,7-8)

Moral Hazard and Puzzles

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Table 1 (Mishkin P. 186): Asymmetric Information Problems and Tools to Solve Them

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8-23

Conflicts of Interest
(Cf. Mishkin pp. 189-190)
• Moral hazard problems can arise from economies of scope – the fact that the cost of info production for individual services is reduced by applying one info source to many services. • In particular, moral hazard can arise when an institution performs multiple roles and conflicts arise between these roles. • Conflicts of interest can lead institutions to conceal info or disseminate misleading info, reducing the quality of info in financial markets and increasing asymmetric info problems • In this case, financial markets will not channel funds into productive investment opportunities as efficiently as they could.

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8-24

Conflict of Interest Examples
• Auditing and Consulting in Accounting Firms – Auditors may be willing to skew their judgments and opinions to win consulting business – Auditors may be auditing information systems or tax and financial plans put in place by the consulting division of their own company! – Auditors may provide an overly favorable audit to solicit or retain audit business
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Conflict of Interest Examples…Continued
• Provision of both underwriting and research services by investment banks
– Investment banks research a company issuing securities for the benefit of potential investors. Incentive is to provide unbiased info. – But the investment bank also underwrites these same securities by purchasing and reselling them to investors on behalf of the issuing company. Incentive is to provide optimistic info to investors to increase resale price.

– Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future underwriting business
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Conflict of Interest Remedies ?
• Sarbanes-Oxley Act of 2002 – Increased the SEC’s budget to supervise security markets – Requires increased financial disclosure by corporations – Establishes a Public Company Accounting Oversight Board to supervise accounting firms – Requires separation of functions (research from underwriting, and auditing from nonaudit consulting)

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Conflict of Interest Remedies…Cont’d
• Sarbanes-Oxley Act of 2002 (cont’d) – Beefs up criminal charges for white-collar crime and for obstruction of official investigations – Requires the CEO and CFO to certify that financial statements and disclosures are accurate – Requires members of the Audit Committee (subcommittee of a company’s Board of Directors that oversees the company’s audit) to be independent of the company they are auditing.
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8-28

Conflict of Interest Remedies…Cont’d
• Global Legal Settlement of 2002
• Lawsuit brought by then-New York Attorney General Eliot Spitzer against 10 large investment banks (e.g., Merrill Lynch, J. P. Morgan, …) was settled on December 20, 2002: – Requires investment banks to sever the link between research and securities underwriting – Bans spinning – Imposed $1.4 billion in fines on accused investment banks – Requires investment banks to make their analysts’ recommendations public – Over a 5-year period, investment banks are required to contract with at least 3 independent research firms for provision of research to their brokerage customers
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