Fundamental Characteristics of Financial Industry and Natural EvolutionI

1
Fundamental Characteristics of Financial Industry
and Natural Evolution(I)

• Dr. J. D. Han

2
Relationship between Financial System and
Corporate Financing Macro Environment and
Micro Response

• The first determines the characteristics of the
  second.

Financial System

• Corporate Financing

3
When a Company needs funds for a project, how
would it do?

• Internal financing use accumulated funds from
  Undistributed Corporate Profits
• External financing get the funding from outside
  of the company

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Two External Financing Methods

• Direct Finance vs. Indirect Finance

Indirect Finance
Through Financial Intermediaries
Savers Households
Investors Business Firms
Financial Market
Direct Finance Doing by itself
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Financial Intermediaries channel surplus funds
from Savers to Investors

• Financial Intermediaries consists of
• Depository Institutions (banks, trust co., credit
  unions),
• Investment Intermediaries (securities co.,
  finance co.),
• And Contractual Savings Institutions (insurance
  co, pension funds).

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Financial Instruments
Indirect

• Bank Loans
• Bonds
• Stocks(equities)

Debt Contract or Instruments
Marketable Securities
indirect
Direct
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Observation of FactsSources of External
Corporate Financingin U. S. 1970-1985
Note these are funds raised through issues of
New Securities-Stocks and Bonds. Of course,
stock exchanges trade existing stocks as well,
which account for the majority of the outstanding
market values.
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Puzzle 1

• Stocks or Equities are relatively unimportant
• compared with
• Debt Contracts/Instruments
• ( Bonds Loans)

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Puzzle 2

• Marketable Securities(Bonds Stocks) are not
  so important as Bank Loans

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Puzzle 3

• Direct Finance is insignificant compared to
  Indirect Finance.
• Financial Intermediaries buy most of Marketable
  Securities

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Answers to All these Puzzles

• Transactions Costs
• Financial Institutions or Intermediaries
  lower Transactions Cost
• Information Asymmetry
• Some financial instruments have more severe
  problems of Information Asymmetry than others
• - Equities gt Bonds gt Bank Loans
• Capital Structure (Comparative Cost of Funding)
• - interest payment is tax-deductible
• - real cost of borrowing is the (actual) real
  interest rate (nominal interest rate inflation
  rate)
• Issues of Management Control and a Possible
  Hostile Take Over

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Information Asymmetry

• Ex-ante (Before Deal)
• May lead to Adverse Selection Problem
• Lemon and Jewel problem
• -Definition Bad goods drives good goods out of
  the market
• Ex-post (After Deal)
• May lead to Moral Hazard Problem
• -Definition The borrower is subject to the
  hazard that he has incentives to be engaged in
  riskier activities than are agreed with the
  lender

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Marketable Securities(Direct Finance) versus
Bank Loans (Indirect Finance)

• Information Asymmetry causes a severe Adverse
  Selection Problem or Lemon Jewel Problem in
  the case of all marketable securities
• bank loans are less subject to information
  asymmetry(cause) or adverse selection(consequence)
  . Why? The key lies in that enough information
  is generated about the demander of the fund in
  the case of bank loans while, due to information
  free rider problem, it is not the case for
  marketable securities.
• As bank loans are less risky than marketable
  securities- Thus, the financial investor prefers
  bank loans to marketable securities.

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Closer Look reveals

• Debts(IOU) involve Restrictive Covenant, or
  Mandatory Monitoring (of the debtors financial
  conditions)

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Equities as opposed to Debts

• Equities without Restrictive Covenant are subject
  to a more severe Moral Hazard Problem than debts
  with Restrictive Covenant are.
• This particular problem in equity contract
• is called the Principal-Agent Problem
• Thus, equities have doubly risky in the eyes of
  finanical investors, and get less fund(demand).

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Adverse Selection Fatal Attraction

• Called Lemon Jewel Problem by G. Ackerloff
• Security price is set between value of a good
  firm and value of a bad firm
• The bad firms securities have lower prices and
  thus higher rates of returns, looking attractive.

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Illustration of Lemons Problem

• Second-Hand Car Market
• Market Price Average Value of Bad and Good
  Cars
• Lemon Market Price gt Its Real Value (Low)
• Jewell Market Price lt Its Real Value (High)
• Jewell is not offered in the market

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Solutions to Adverse Selection

• Custom-Made Private Information
• Financial intermediaries are specialized in
  collecting and processing information
• -gt explains why bank loans dominates.
• General Private Provision of Information
• The Market sells Information
• It is ultimately incomplete due to Free
  Rider Problem in the Financial Market
• Public Provision of Information
• is warranted and required for Securities Market
• -gt explains why financial industry is heavily
  regulated

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Solutions to Moral Hazard Problem

• Production of Information Monitoring
• - The most severe problem exists, and costly
  state verification and free-rider problem will
  lead to insufficient monitoring in the stock
  market
• - The same is true, if to a lesser extent, in
  the bond market
• - The least severe problem, but collateral is
  inevitable in the bank loan market
• Government Regulation to increase Information
• - Disclosure Requirement
• Directly Participating in Management
• - Venture Capital Firm
• - Japanese and German Banks

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(Recap) Why should the financial industry be
regulated by government?

• Because information asymmetry is an intrinsic
  problem of the industry adverse selection and
  moral hazards
• -gt First level of Market Failure
• Unlike other sectors, due to free rider problem,
  information asymmetry is not to be rectified by
  Private Provision of Information
• -gt Second level of Market Failure
• Ultimately, Public Provision of Information is
  required,which calls for Government Regulation

21
Canadian Puzzle

• Equities account for a substantial share of
  external corporate financing
• (Refer to P.159 of Paper 1)
• Bank Loans have a relatively smaller share in
  Canada than elsewhere
• lt- One answer Due to the Canadian banks
  business operations

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However .

• The above view is a majority view, but
  everyone does not agree with it. This
  revisionist view has been gaining an increasing
  popluarity in the era of finanical
  liberalization.

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(Revisionist) Should the financial sector be
regulated by government?

• Would enough information be generated in the
  unregulated or free-market financial sector so as
  to ensure that the investor with due diligence or
  prudence may be protected from frauds in a
  reasonable way to a certain acceptable degree?
• If so, government intervention is not
  necessary.
• Theoretically, it is possible, and
  empirically, there is a historical evidence from
  the Free Banking System experiences.