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• A healthy and vibrant economy requires a
  financial system that moves funds from people who
  save to people who have productive investment
  opportunities

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Eight Basic Facts

1. Stocks are not most important source of external
   financing
2. Issuing marketable securities (debt and equity)
   not the primary way businesses finance operations
3. Indirect finance is much more important than
   direct finance
4. Financial intermediaries ? the most important
   source of external funds
5. The financial system is heavily regulated
   you aint seen nothn
   yet
6. Only large, well-established corporations have
   (had) easy access to securities markets to
   finance their activities ? need
   reputation and net worth
7. Debt contracts trust but collateral
8. Debt contracts trust but restrictive covenants

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Why Intermediaries? Transaction Costs

• Economies of scale
• Expertise information specialists to handle
  adverse selection and moral hazard problems
• What went wrong?
• Perverse incentives

• Asymmetric Information Problems
• Adverse selection before a transaction
• Lemons problem
• Moral hazard arises after the transaction
• Managers and principal - agent problem
• Debt and risky behavior
• Conflicts of interest
• Agency theory how asymmetric information affects
  economic behavior

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• Countering Adverse Selection
• Private production and sale of information
• Free-rider problem
• Perverse incentives who pays Moodys?
• Government regulation to increase information
• Financial intermediation information specialists
• Collateral and net worth
• Countering Moral Hazard Principal - Agent
• Align manager incentives with owners
• Stock, stock options
• Monitor ? venture capital firms
• Avoid being owner debt not equity

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Moral Hazard in Debt Markets

• Borrowers have incentives to take on risky
  projects
• Countering Moral Hazard in Debt Contracts
• Net worth and collateral
• Incentive compatible loss is borrowers, not
  lenders
• Enforce Restrictive Covenants
• Keep collateral valuable
• Provide information

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Economies of Scope and Conflicts of Interest

• Underwriting and Research in (what was)
  Investment Banking
• Information produced by researching arm used to
  underwrite the securities. The bank
  simultaneously serves two client groups whose
  information needs differ.
• Spinning an investment bank allocates hot, but
  underpriced, IPOs to executives of other
  companies in return for their companies future
  business
• Auditing and Consulting in Accounting Firms
• Auditors skew opinions to win consulting business
• May audit information systems or tax and
  financial plans put in place by their consulting
  counterparts
• May provide an overly favorable audit to retain
  business
• Sarbanes-Oxley Act of 2002
• Global Legal Settlement of 2002

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Financial Crises and Aggregate Economic Activity

• Crises can be caused by
• Increases in interest rates
• Increases in uncertainty
• Asset market effects on balance sheets
• A bursting bubble
• Problems in the banking sector
• Government fiscal imbalances
• Vicious spirals
• Financial crises we have known 1819, 1837, 1857,
  1873, 1884, 1893, 1907, 1930 - 33, 2008

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Bank Management

• Liquidity Management
• excess reserves/secondary reserves/call loans
• Asset Management return(ROA)/risk/liquidity
• Liability Management CDs/Fed funds
• Capital Adequacy Management ROE
• Credit Risk Screen,Monitor,,Collateral
• Credit default swaps ? regulatory arbitrage
• The unbundling of credit risk probably should
  be a good thing, assuming the people picking up
  the elements of credit risk understand what
  theyre doing and the risks theyre incurring.
  E. Gerald Corrigan, 1997
• Interest-rate Risk
• Gap Analysis/Duration Analysis

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• Off-Balance-Sheet Activities
• Loan sales (secondary loan participation)
• Generation of fee income
• Trading activities and risk management techniques
• Futures, options, interest-rate swaps, foreign
  exchange
• Speculation
• Risk management techniques
• Limits on exposure
• Value at risk
• Stress testing