Review of Chapters 2 and 8, and Advanced Discussion

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Review of Chapters 2 and 8, and Advanced
Discussion
Eco 2154 PPP 3

• Dr. J. D. Han

2
When a Company needs funds for a project, how
would it do?

• - It is in the Primary Market, not in Secondary
  Market, that a non-financial corporation raises
  the fund
• Internal financing use accumulated funds from
  Undistributed Corporate Profits
• External financing get the funding from outside
  of the company

3
Out of two External Financing Methods,Indirect
Financing predominates.

• 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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Who does Indirect Financing?

• Financial Intermediaries, which 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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What are being Dealt in? Financial Instruments
Indirect

• Bank Loans
• Bonds
• Stocks(equities)

Debt Contract or Instruments
Marketable Securities
indirect
In theory, they can be instruments for Direct
Financing as well. However it is pretty small.
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(Review ) 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

• 1) FI Lowers Transactions Costs
• due to expertise and EOS
• 2) Information Asymmetry
• 3) Capital Structure
• - interest payment is tax-deductible
• - real cost of borrowing is the (actual) real
  interest rate (nominal interest rate inflation
  rate)
• 4) Issues of Management Control and a Possible
  Hostile Take Over

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• Provides rationales for Financial Institutions
• Provides grounds for Government Regulations of
  Financial Institutions/Financial Sector.
• Lets focus on the second issue of Government
  Regulations

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• In Chapter 2, we have learned that government
  regulation is necessary because of the intrinsic
  problem of the Financial Sector, that is,
  Information Asymmetry. In case of indirect
  financing, Information Asymmetry occurs at 2
  levels between lenders and FI, and FI and
  borrowers.
• Etymology A-sym-metry means Not-the
  sameness-of proportions, from Greek word from
  asymmetros, from a- "not" symmetros
  "commensurable."

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Information Asymmetry leads to

• Ex-ante (Before Deal)
• May lead to Adverse Selection Problem
• Lemon and Jewel problem
• -Definition Bad financial intermediaries/assets
  look better than good financial
  intermediaries/assets.
• Ex-post (After Deal)
• May lead to Moral Hazard Problem
• -Definition Once being given money, the
  so-far-good borrower is subject to the hazard to
  be engaged in riskier activities than are agreed
  with the lender.

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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 Securities Market
  (overvalue/undervalue) bad borrowers securities
  and (overvalue/undervalue) good borrowers
  securities.

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Now, how can we reduce/resolve Information
Asymmetry?

• Information Production
• Monitoring
• To what degrees are Financial Institutions
  successful in generating Information?
• -Not Complete, and Varying Degrees
• Thus it is argued that Government Regulation
  should fill in for Information Generation/Revelati
  on, and different Financial Institutions are to
  be faced with different degrees of market
  receptions and government regulations

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IA Marketable Securities versus Bank Loans

• bank loans are less subject to information
  asymmetry than Marketable Securities. Thus, the
  financial investor prefers bank loans to
  marketable securities.
• Why? The key lies in that enough information is
  generated about the borrower in the case of bank
  loans which can use Restrictive Covenant.

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• Still banks cannot completely remove Moral
  Hazards of borrowers.
• Japanese banks may have the answer for a further
  reduction of IA and Moral Hazards.

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IA Equities versus 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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Wait a second, this has not been the case all
the time in financial history

• J. Bradford De Long at Harvard Univeristy
  concludes
• Up to the 1920s (prior to Glass-Steagall Act),
  Financial Trusts were less subject to Moral
  Hazards of their borrowers

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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
• Information Asymmetry is not to be completely
  resolved in the market.
• Ultimately, Public Provision of Information is
  required,which calls for Government Regulation.

21
However .

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

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First, Information Asymmetry is a fact of life,
and does not have to automatically ask for
government intervention.

• Marriage is subject to IA.
• However, there is no room for public intervention
  in private marriage.
• The reason is that enough, if not complete,
  information is produced/demanded by individuals.

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Second, Government Intervention should be
preceded by Private Information Market Failure

• And this happens in the Securities Market as
  opposed to Bank Loans due to Information Free
  Rider Problem
• Only then, public intervention is justified, but
  even it is not the only solution and is not for
  ever.

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• To Recap, Private Information Market fails (to
  coordinate Demand and Supply of information) if
  there is Free Rider Problem.
• This is the case of Securities Market, where
  multiple lenders(financial investors) buy a
  lender(borrower)s securities.
• Who is willing to pay for information?

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Can you again explain how the Private
Information Market fails in the securities market?

• Information is about ______________
• Demand of Information by __________
• Supply of Information by _________
• Why wouldnt be enough of supply of information?

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• Information Revolution will resolve Free Rider
  Problem
• eg) Microsoft Operating System has become
  non-duplicable or non-transferable.
• Meanwhile, within industry, Merger Acquisitions
  will reduce Moral Hazards

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Historical Evidence also tells us

• Would enough, if not complete, information be
  generated in the unregulated 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.

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Free Banking Free Entry and Self Regulated Note
Issues

• Historical Instances of Self-Regulated, or
  Free-Market Financial Industry
• Scotland 1720-1840
• U. S. A. 1836/7-1863
• Canada prior to Bank of Canada 1935
• Sweden 19C
• Hong Kong Contemporary

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Were They Stable?

• Conventional Wisdom
• -gt Yes, Scotland, Canada, Sweden and HK
• -gt No, U. S. A.
• ? We would like to challenge the second part of
  Conventional Wisdom

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Scottish Free Banking

• Period 1720-1840
• How did it work?
• -Banks could print out paper monies, or notes as
  long as they do not default on redemption request
  of the notes for species
• -No government charter needed
• Self regulated, competitive (free market driven)
  supply of money and banking practices

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Evaluation of the Scottish Free Banking

• Compared with the Contemporary British Banking
  Experience
• Stability no major bankruptcy
• -exception Ayr Bank
• Availability more banking services per capita
• Competition small banks along with large ones
• Efficiency
• spontaneous evolution of a clearing house
  (payment association)
• Rapid propagation of information

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American Experiences

• Free Banks were viciously called Wildcat Banks.
• However, Revisionist Studies by A. Rolnick and W.
  Weber have proved that they were Not So Bad.
• Why?

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Three Point Arguments

• The bank note holders(lenders) had been well
  informed of the true value of the assets/notes
  from Minnesotan Free Banks.
• Free Market is more efficient in propagating
  information than we might expect
• (Evidence Well conversed the New York/Chicago
  Market Value of Government/Railway Bonds as
  Major Assets and Reserves of the Banks)

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Lessons to be Learned from Free Banking
Experiences

• Self-Regulated,
• Regulation-Free,
• Banking/Financial Industry may be Viable
• and even be superior.

35
Securities Market

• From studies on the Amsterdam Bourse of the 17th
  century, Edward Stringham of UC San Jose,
  concludes
• In the 1600s, the first century when equities
  were traded, we can see that there was a
  considerable degree of financial innovation. We
  also see that most of the financial instruments
  were officially outlawed by the state. Brokers
  discovered new trading instruments and abided by
  their contracts not because of legal compulsion
  but because of market incentives. The regulations
  were not advancing the market, they were
  trammeling it, though the market developed in
  spite of the law. Contrary to the idea that the
  government is needed for financial innovation and
  contractual performance, the case of the
  Amsterdam Bourse provides evidence that
  securities markets can function successfully with
  little assistance from the state..

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References

• Read Neil Reynoldss inspiring article on the
  Dutch Securities market of the 16th Century,
  entitled, Self-regulation The Dutch had it
  right, The Globe and Mail, Aug.12, 2006.
• Edward Stringham, The extralegal development of
  securities trading
• in seventeenth-century Amsterdam, The
  Quarterly Review of Economics and Finance, 43
  (2003) 321344
• J. Bradford De Long, Harvard University, Did J.
  P. MORGANS MEN Add Value? An Economists
  Perspective on Financial Capitalism, 1995.
• Kam Hon Chu Is Free Banking More Prone to Bank
  Failures than Regulated Banking?, Cato Journal,
  Vol. 16 No. 1

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• Sun Bae Kim, Banking and Commerce The Japanese
  Case, Federal Reserve Bank of San Francisco
  Weekly Newsletter, March 1991.
• A.J.R. Rolnick and W. Weber, "New Evidence on the
  Free Banking Era," American Economic Review,
  1983, Vol. 73, No. 51080-1091
• A.J.R. Rolnick and W. Weber, "Explaining the
  Demand for Free Bank Notes," Journal of Monetary
  Economics, 1988, Vol. 21 47-71.