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

4
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
5
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).

6
Sources 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.
7
Puzzle 1

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

8
Puzzle 2

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

9
Puzzle 3

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

10
Closer Look reveals

• Debts(IOU) involve Restrictive Covenant
• Banks are the major source of corporate funding
• Financial Industry is the most heavily regulated
  sector

11
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

12
Information Asymmetry

• Ex-ante (Before Deal)
• May lead to Adverse Selection 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

13
Equities as opposed to Debts

• Severe Moral Hazard Problem
• This particular problem in equity contract
• is called
• the Principal-Agent Problem

14
Securities(Direct Finance) as opposed to Loans
(Indirect Finance)

• A Severe Adverse Selection Problem
• readily known as the Lemon Jewel Problem.

15
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.

16
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

17
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

18
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

19
(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

20
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

21
Canadian Banks Operation

• Highly International
• - Substantial offshore assets or overseas loans
• Tight Domestic Regulations
• -Helps protect the Canadian Banks from
  International Competition
• -Hinders the overall domestic operations
  Relatively tight domestic credit