Title: Money and Banking
1Money and Banking
Mr. Vaughan
2Financial-Structure Puzzles
- Eight, interrelated puzzles, about financial
structure - Financial system boasts a broad array of
marketable securities and financial
intermediariesand heterogeneity is increasing. - Internal finance is more important than external
finance for firmsnot just in U.S., but all over
developed world. - Firms seeking external finance rely more heavily
on banks than securities marketsnot just in U.S.
but all over developed world. - Only large, well-established corporations can tap
securities markets to finance operationsnot just
in U.S. but all over developed world. - Not listed in Mishkin.
3Financial-Structure Puzzles(continued)
- Eight, interrelated puzzles, about financial
structure - U.S. firms selling securities rely more heavily
on bonds than on stocks. (Common, but not
universal, pattern in developed world. - Debt contracts typically are extremely
complicated legal documents placing substantial
restrictions on borrowers. - Collateral is a common feature of debt contracts.
- As financial markets have grown more
sophisticated, financial intermediation has
become more important economically. - Financial system is heavily regulatednot just in
U.S., but all over developed world. - Not listed in your text.
4Sources of External FinanceCross-Country
Comparisons
5Understanding Financial StructureModigliani-Mille
r Theorem
- Theorem In frictionless capital markets, firm
value depends solely on cash flows from assets.
Capital structurei.e., how assets are
financedplays no role. - Corollary NPV of investment projects doesnt
depend on financing. - Definition Frictionless capital market
- Perfect Competition
- No transactions costs
- No information asymmetries
- No tax/regulatory distortions
6Understanding Financial StructureModigliani-Mille
r Theorem
- Intuition
- Cash flows from assets determine the size of pie.
- Capital structuredebt/equity mixmerely slices
pie. - Firm cannot make pie larger by slicing it
differently.
Debt
Equity
7Modigliani-Miller TheoremLogic
- Consider two firms with identical cash flows from
assets - One has debt (levered firm) in capital structure
other (un-levered firm) does not. - Investors can borrow privately on same terms as
levered firm. - Total value of firm is defined as market value of
debt plus the market value of equity. So - Total value of un-levered firm total value of
outstanding shares - Total value of levered firm total value of
outstanding debt total value of outstanding
shares.
8Modigliani-Miller TheoremLogic
- Levered Firm
- Cash Flows from Assets
- - Firms Debt Service
- Dividends Net Cash Flows
Un-levered Firm Cash Flows from Assets
Dividends - Private Debt Service Net Cash Flows
- Net cash flows are identical.
- Investors care only about net cash flows.
- Arbitrage guarantees total value of levered firm
will equal total value of un-levered firm.
9Explanations for Financial-Structure Puzzles
- MM identifies frictions that make financing
choices important - Transactions costs
- Asymmetric information costs
- Taxation and Regulation
- Financing arrangements reflect efforts to
minimize transactions costs, information costs,
tax burden, and regulatory burden.
10Transactions Costs
- Definition Time/money spent channeling funds
from surplus units to deficit units. - Forms
- Search costs
- Negotiation costs
- Enforcement costs
- Implication Small firms and large firms needing
small amounts of financing will rely on internal
finance or bank finance.
11Transactions Costs
- Another Form Bankruptcy costs
- Definition Loss of firm value arising from
financial distress - Explicit bankruptcy costs lawyers and
accountants fees, etc. - Implicit bankruptcy costs loss of sales, loss of
trade credit, key employees, etc. - Implication Firms with intangible assets and
attractive growth opportunities will shy away
from debt financing.
12Asymmetric-Information Costs
- Definition Costs of overcoming two types of
information problems - Adverse selection separating good from bad risks
before execution of financial contract. - Moral hazard insuring economic agents with
delegated authority live up to contract terms.
13Asymmetric-Information Costs Adverse Selection
- Example Lemons Problems
- If investors can't distinguish good and bad
securities, they will offer only average value. - Good securities will be undervalued, so firms
won't issue them bad securities will be
overvalued, so too many will be issued. - Investors do not want bad securities, so market
falls apart.
14Asymmetric-Information Costs Adverse Selection
- Solutions to Lemons Problems
- Information production by disinterested third
party - Limited by free-rider problem
- Signaling
- collateral
- net worth
- reputation (a form of collateral)
- Government regulation
- Financial intermediation
15Financial Frictions in Action Pecking Order
Theory of Financing
- Adverse selection make some financing vehicles
much more expensive than others. - Example
- Managers want to issue new stock only when it is
overvalued. - Stock issuance is bad signal.
- Stock issuance causes price of outstanding stock
to fall. - Decline in stock price is part of cost of
external finance.
16Financial Frictions in Action Pecking Order
Theory of Financing
- Firms use financing with smallest adverse
selection costs (i.e., smallest information
asymmetries) first. - Pecking order
- Internal Funds
- Bank Debt
- Public Debt
- Public Equity
17Financial Frictions in Action Pecking Order
Theory of Financing
- Implications
- Financial slack is valuable.
- Observed capital structures reflect availability
of positive net present value projects. - No optimal debt/equity mix.
18Asymmetric-Information Costs Moral Hazard
- Principal-Agent Problem Principal designates
agent to act on his behalf. Because monitoring/
disciplining are costly, agent has scope to
pursue his own interest at the expense of
principal. - Examples
- Separation of ownership from control allows
managers to use firm resources to pursue personal
interests instead of maximizing shareholder
value. - Separation of savers/investors allows investors
to use surplus funds to pursue personal interests
rather than accepting capital projects with
highest NPV.
19Asymmetric-Information Costs Moral Hazard
- Solutions to moral-hazard problems
- Debt finance
- Motivates managers to maximize shareholder value
by absorbing free cash flow - Reduces costs of monitoring investors
- Government regulation
- Financial intermediation
20Asymmetric-Information Costs Moral Hazard
- Features of debt contracts that reduce
moral-hazard problems - Restrictive covenants
- Collateral requirements
- Net worth requirements
- Reputation (a form of collateral or net worth)
21Catalysts in Financial Markets
Economic and Political Shocks
? Transactions Costs ? Information Costs
? Relative Return from Granting Rents
? Taxation and Regulation
? Shape of financialintermediaries and markets
22Catalysts in Financial Markets
- Technological improvements
- Advances in finance and statistical theory
- Advances in computing speed, power, and storage
space - Advances in transportation and telecommunication
23Regulation of Financial Markets
- Justification (according to Mishkin)
- 1. Increase Information to Investors
- Decreases adverse selection/moral hazard problems
- 2. Ensuring Soundness of Financial Intermediaries
- Chartering, reporting requirements, restrictions
on assets and activities, deposit insurance, and
anti-competition measures. - 3. Improving Monetary Control
- Reserve requirements
- Deposit insurance
24Regulation of Financial Markets
- Two better reasons (in MDVs view)
- Hysterical political reaction to real/ perceived
crisis - Rent seeking
- Use of government power to secure return above
opportunity cost (economic rents)
Technological and political/economic shocks
alter returns to taxing/regulating.
25Regulation of Financial MarketsGlass-Steagall
Act (1933)
- Example of hysterical political reaction to real
or perceived crisis plus rent seeking - Glass-Steagall (1933)
- Established firewall between investment and
commercial banking. - Based on idea that investment banking would
increase risk of commercial banking and conflict
of interest existed.
26Regulation of Financial MarketsGlass-Steagall
Act (1933)
- But...
- Portfolio theory indicates combining commercial
and investment banking actually reduces risk. - Evidence from 1920s indicates bonds underwritten
by investment bank subs of commercial banks
performed well (no evidence of massive fraud). - Public benefits from economies of scope available
by combining commercial and investment banking.
27Recent Trends in Financial Markets
- Financial entrepreneurship
- Globalization
- Democratization
- Deregulation
- Evolution of financial intermediation
All these trends have their roots in
technological or political/economic shocks!
28Questions over
Money and Banking Mr. Vaughan