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The Structure of Finance
How Things Work in Banking
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Flow of Funds
Largest lender Households
Largest borrower Governments andBusinesses
Indirect Finance Saver to Bank (or otherintermediate) to Borrower. Ex. Car Loan
Direct Finance Saver to Borrower Ex.Buying bonds from GE
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Flow of Funds
Direct Finance
Borrower sells securities.
Securities become liabilities for seller Assets for buyer.
Asset because someone owes you money.
Liability because you have to pay someonemoney.
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Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets Investment Banks underwritesecurities in primary
markets Brokers and dealers work in secondary markets
Exchanges and Over-the-Counter (OTC)Markets
Money and Capital Markets Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and
equity instruments (mortgages are longer-term debut)
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Structure of Financial Markets
Debt Instruments Bond or mortgage,contractual agreement, pays fixed amount for agiven period
Maturity is term of contract until expiration Less than year Short-term
More than 10 years Long-term
In between length Intermediate-term
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Structure of Financial Markets
Primary Market new securities are sold, notusually sold to the public, going public
Investment Banks guarantees a price then they sell to
the public.Secondary Market NYSE, NASDAQ
Brokers agents of investors
Dealers buy and sell securities at given prices
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Structure of Financial Markets
Corporations only acquire new fundsselling securities the first time
Not on sales in secondary market.
Secondary markets increase securitiesliquidity.
Provides info about market price in primary
market.
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Structure of Financial Markets
Exchanges Centralized in one location, ex.NYSE, CBT
Over-the-Counter (OTC) Markets Different
locations with inventory of securities, butconnected online so not much different thanexchanges in difference of prices by location.
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Money Market Instruments
Think short-term borrowing and lending,less than a year.
U.S. T-BillsInitially sell at discount ofmaturity price, no interest payments.
Most liquid instrument
No possibility of default, govt can print money to
meet obligations Negotiable Bank CDsDebt sold by banks,
CDs are short term, different than a savingsaccount because of time period restraint.
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Money Market Instruments
Commercial Paper Short-term debtissued by large banks and corporations,ex. Microsoft and GM
Bankers Acceptances Issued by firmand back by a bank for a fee.International Check
Repurchase Agreements short term loanusing T-Bill as collateral
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Money Market Instruments
Federal Funds usually overnight loansbetween banks of deposits at the FED
Eurodollars Dollar help outside U.S which
mean less oversight
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Capital Market Instruments
U.S. Govt Securities Long term bonds Most widely accepted world wide.
U.S. Govt Agency Securities Ex. Ginnie Mae,
Federal Farm Credit Bank Backed by government
State and Local Govt Bonds Municipal bonds,have tax advantages
Consumer & Bank Commercial Loans Carloans, home loans, etc. mostly by banks
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Internationalization of Financial Markets
Foreign Bonds: sold in a foreign countryand denominated in that countrys currency
Eurobond: bond denominated in a currency
other than that of the country in which it issold
Eurocurrencies: foreign currencies
deposited in banks outside the homecountry
World Stock Markets
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Basics Truths of Financing
o Issuing marketable debt and equity securities isnot the primary way in which businesses financetheir operations
o Indirect finance is many times more importantthan direct finance
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Basics Truths of Financing
o Financial intermediaries are the most importantsource of external funds
o The financial system is a heavily regulated sectorof the economy (a lot effective)
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Basics Truths of Financing
o Collateral is a prevalent feature of debt contracts
o Your house for the mortgage, car for auto loan
o Debt contracts are complicated legal documentsthat place substantial restrictive covenants onborrowers
o What you can and cant do with the money.
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Transaction Costs
Acquiring resources can be expensive
There are benefits to volume
Financial intermediaries have evolved toreduce transaction costs
Economies of scale
Expertise
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Transaction Costs
Economies of scale
Transaction costs decrease as costs spreadacross more transactions grow (size or number)
Ex. Mutual Funds buy large number of shares
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Asymmetric Information
Adverse selection occurs before the transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetricinformation problems affect economic behavior
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Adverse Selection:The Lemons Problem
If quality cannot be assessed, the buyer is willing topay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at
the price for average quality
The buyer will decide not to buy at all because allthat is left in the market is poor quality items
It leads to a market not functioning properly
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Adverse Selection:The Lemons Problem
George Akerlof: Nobel prize winner, lemonsproblems and Used Cars
Used car buyers have little information. Pay averageof value of lemons and peaches
Sellers know the quality of there care
Average price for sellers of peaches is to low and willnot sell car
Average price for sellers of lemons is high and willwant to sell car.
Result few quality cars sold, value of used carsdeclines
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Adverse Selection: Solutions
Private production and sale of information Free-rider problem
Government regulation to increase
information Reduces uncertainty from withholdinginformation
Financial intermediation Banks specialize in assessing risk
Collateral and net worth Skin in the game
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Moral Hazard in Equity Contracts
Called the Principal-Agent Problem
Principal stockholders
Agent - managers
Separation of ownership and control of the firm Managers pursue personal benefits and power rather
than the profitability of the firm
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Principal-Agent Problem: Solutions
Monitoring (Costly State Verification)
Free-rider problem One party can takeadvantage of costly actions without paying
Government regulation to increase information
Limits ability to hide behavior
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Moral Hazard in Debt Markets
Borrowers have incentives to take on projectsthat are riskier than the lenders would like
Most debt contracts require the borrower to pay a fixed
amount (interest) and keep any cash flow above thisamount.
For example, what if a firm owes $100m in interest, nextquarter, but only has $90? It is essentially bankrupt. The
firm has nothing to lose by looking for risky projects toraise the needed cash.
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Moral Hazard: Solutions
Net worth and collateral Incentive compatible
Monitoring and Enforcement of Restrictive
Covenants Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information Financial Intermediation
Banks provide the above
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Conflicts of Interest in Financing
Moral hazard problem caused by economies ofscope
Economies of scope: lower costs by offering more
services. An institution has multiple objectives and, as a result, has
conflicts between those objectives
A reduction in the quality of information in financial
markets increases asymmetric information problems Ex: Certifying and sales
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Conflicts of Interest in Financing
Problem buyers assume information is accurate
Financial markets do not channel funds into productiveinvestment opportunities
The economy is not as efficient as it could be
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Why Do Conflicts of Interest Arise?
Underwriting and Research in InvestmentBanking
Information produced by researching companies is
used to underwrite the securities. The bank isattempting to simultaneously serve two client groupswhose information needs differ.
Spinning occurs when an investment bank allocates
hot, but underpriced, IPOs to executives of othercompanies in return for their companies future
business
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Why Do Conflicts of Interest Arise?
Morgan Stanley memo 1992: Our objective. . . Is
to adopt a policy, fully understood by the entirefirm, including the Research Department, that we
do not make negative or controversial commentsabout our clients as a matter of sound businesspractice.
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Why Do Conflicts of Interest Arise?
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments andopinions to win consulting business
Auditors may be auditing information systems or taxand financial plans put in place by their nonauditcounterparts
Auditors may provide an overly favorable audit tosolicit or retain audit business
Nothing wrong here, everythings fine
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Conflicts of Interest: Remedies
Sarbanes-Oxley Act of 2002 (Public AccountingReturn and Investor Protection Act)
Increases supervisory oversight to monitor and prevent
conflicts of interest Establishes a Public Company Accounting Oversight
Board
Increases the SECs budget
Makes it illegal for a registered public accounting firm toprovide any nonaudit service to a clientcontemporaneously with an impermissible audit
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Conflicts of Interest: Remedies
Sarbanes-Oxley Act of 2002
Beefs up criminal charges for white-collar crime andobstruction of official investigations
Requires the CEO and CFO to certify that financialstatements and disclosures are accurate
Requires members of the audit committee to beindependent
However, very expensive for small firms ($100mil or less) to comply $824,000
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Conflicts of Interest: Remedies
Global Legal Settlement of 2002 Requires investment banks to sever the link between
research and securities underwriting
Bans spinning
Imposes $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 tocontract with at least 3 independent research firms thatwould provide research to their brokerage customers
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Financial Crises andAggregate Economic Activity
Look back in history, crises can be causedby:
Increases in interest rates
Increases in uncertainty
Asset market effects on balance sheets
Problems in the banking sector
Government fiscal imbalances
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Look online for a web chapter on Conflictof Interest
http://www.nytimes.com/2007/06/13/opinion/13carlat.html