Mishkin Chapter 7

Sources
of External Funds
Financial Markets and Institutions
7-1
Pearson Prentice Hall
8 Basic Facts about Financial Structure

1. STOCKS are NOT the most important source of external
5inancing for Businesses.
2. Issuing MARKETABLE DEBT & EQUITY SECURITIES is NOT
the primary way in which businesses 5inance their
operations.
3. INDIRECT FINANCE, which involves the activities of
FINANCIAL INTERMEDIARIES, is many times more important
than direct 5inance, in which businesses raise funds directly
from lenders in 5inancial markets.
4. Financial intermediaries, particularly BANKS, are the most
important source of external funds used to 5inance
businesses.
7-2
8 Basic Facts about Financial Structure

5. Financial system is among the most heavily regulated
sectors of the economy.
6. Only LARGE, well-established corporations have easy
access to securities markets to 5inance their activities.
7. Collateral is a prevalent feature of debt contracts for both
households and businesses.
8. Debt contracts typically are extremely complicated legal
documents that place substantial restrictions on the
behavior of the borrower.
7-3
Transaction Costs
! InSluence on Financial Structure
a. Too high for small-time investors:
Stocks: Brokerage Commission - large % of Purchase Price
Bonds: smallest denomination - $10,000
b. Restricted number of investments Inability to Diversify
! How Financial Intermediaries Reduce Transaction Cost

a. Economies of Scale - bundle funds of many investors together,
e.g. Mutual funds: added bene5it diversi5ication
b. Expertise - computer technology; OUTCOME: liquidity service
7-4
Asymmetric Info: Adverse Selection & Moral Hazard

Asymmetric information: a situation that arises when one
partys insuf5icient knowledge about the other party involved in a
transaction makes it impossible to make accurate decisions when
conducting the transaction. Results to:
! Adverse Selection: an asymmetric info problem that occurs
before the transaction; e.g. big risk takers or outright crooks
! Moral hazard: an asymmetric info problem that occurs after the

transaction occurs; e.g. undesirable borrower activities that make
it less likely that the loan will be paid back
7-5

Adverse Selection: How it In*luences Financial Structure
Lemons Problem: continually give grief
PRICE: average between the lemon and peach
Few knowledgeable Owners or Managers perceive their stocks or
bonds as undervalued; unwilling to sell or borrow
Only bad 5irms (lemons) issue bonds or sell stocks
The presence of the lemons problem keeps securities markets
such as the stock and bond markets from being effective in
channeling funds from savers to borrowers.
7-6
Tools to Solve Adverse Selection

Absence of asymmetric information: lemons problem goes away
1.Private Production & Sale of Information

2. G overnment Regulation to Increase
Information
3.Financial Intermediation
4. Collateral & Net Worth
7-7

1. Private Production and Sale of Information
CRA: Furnishing the people supplying funds with full details
about the individuals or 5irms seeking to 5inance their
investment activities. Standard & Poors, Moodys, Value Line
Free-rider Problem: occurs when people who do not pay for
information take advantage of the information that other
people have paid for.
7-8

2. Government Regulation to Increase Information
SEC: government agency that requires 5irms selling their
securities to have independent audits, in which accounting
5irms certify that the 5irm is adhering to standard accounting
principles & disclosing accurate information about sales, assets,
& earnings.
This explains why 5inancial markets are HEAVILY
REGULATED.
Enron Implosion: Aug 2000: $77 B Dec 2001: bankrupt
7-9

3. Financial Intermediation
Financial Intermediaries: expert in producing information
about 5irms, so that it can sort out good credit risks from bad
ones.
Banks ability to pro5it from the information it produces avoids
the free-rider problem.

The banks role as an intermediary that holds mostly nontraded
loans is the key to its success in reducing asymmetric
information in 5inancial markets.
7 - 10

Implication:
a. INDIRECT FIANCE is so more important than direct 5inance;
b. BANKS are the most important source of external funds for
5inancing businesses.
As information about 5irms becomes easier to acquire, the
role of banks should decline.
7 - 11

Implication:
c. LARGE FIRMS are more likely to obtain funds from
securities markets, a direct route. Easier for investors to
evaluate the quality of the corporation.
Pecking Order Hypothesis: the larger and more
established a corporation is, the more likely it will be to
issue securities to raise funds.
7 - 12

Collateral: property promised to the lender if the borrower
defaults, reduces the consequences of adverse selection
because it reduces the lenders losses in the event of a default.
Net Worth: similar to a collateral; the difference between a
5irms assets & its liabilities; cushion of assets

7 - 13

Moral Hazard: Choice Between Debt & Equity Contracts
Moral Hazard: asymmetric info problem that occurs after the
5inancial transaction takes place, when the seller of security have
incentives to hide info & engage in activities that are undesirable.
In Equity Contracts: Principal Agent Problem
Principal - Major Stockholders : Agent Managers
Separation of ownership and control.
Managers (agents) may act in their own interest rather than in the
interest of the stockholder-owners (principals) because the
managers have less incentive to maximize pro5its than stockholder-
owners do.
7 - 14
Tools to Solve Principal-Agent Problem

1. Production of Information: Monitoring
2. Government Regulation to Increase
Information
4. Debt Contracts
7 - 15

1. Production of Information: Monitoring

PrincipalAgent Problem arises because managers have more
information than stockholders.
Monitoring: auditing & checking on management
Problem: costly state veriSication makes equity contract less
desirable
2. Government Regulation to Increase Information
- Strict adherence to standard accounting principles that make
pro5it veri5ication easier & laws to impose stiff criminal
penalties
7 - 16

Venture Capital Firm - pool the resources of their partners &
use funds to help budding entrepreneurs start new businesses
In exchange, the 5irm receives an equity share in the new
business. Several people of the venture capital 5irm participate
in the management & board of directors.
4. Debt Contracts - contractual agreement by the borrower to
pay the lender 5ixed amounts at periodic intervals. This
explains why stocks are not the most important source of
5inancing.
7 - 17

Tools to Solve Moral Hazard in Debt Markets
- Taking on more risks; High Pro5it motive, 5ixed obligation
2. Monitoring &Enforcement of Restrictive Covenants
7 - 18

- Taking on more risks; High Pro5it motive, 5ixed obligation
Making the Debt more INCENTIVE COMPATIBLE.
Valuable Collateral - borrowers have more skin in the game
The greater the borrowers net worth & collateral pledged, the
greater the borrowers incentive to behave in the way that the
lender expects and desires.

7 - 19

2. Monitoring &Enforcement of Restrictive Covenants
Restrictive Covenants: writing into the debt contract that
restrict his 5irms activities.
4 Types:
- Covenants to discourage undesirable behavior e.g. specs
- Covenants to encourage desirable behavior e.g. insurance
- Covenants to keep collateral valuable
- Covenants to provide information e.g. reports
7 - 20

Private loans are not traded, so no one else can free-ride on the
intermediarys monitoring & enforcement of the restrictive
covenants.
The intermediary making private loans thus receives the
bene5its of monitoring & enforcement and will work to shrink
the moral hazard problem inherent in debt contracts
7 - 21
Financial System of Developing Countries

1. System of property rights functions poorly
- Dif5iculty on implementing collateral &restrictive covenants
- Bankruptcy procedures are often extremely slow and cumbersome. Sue
for payment: years, then sue to obtain title, another couple of years.
- Politically powerful sectors
2. Poorly developed or corrupt legal system
- Governments direct credit to themselves
- Government intervention to favored sectors of the economy
3. Underdeveloped regulatory apparatus that retards the provision of
adequate information
- weak accounting standards, making it very hard to ascertain the quality
of a borrowers balance sheet

7 - 22
ConSlicts of Interest
- a type of moral hazard problem that arise when a
person or institution has multiple services.
- potentially competing objectives (interests) of those
services may lead an individual or firm to conceal
information or disseminate misleading information.
- Economies of Scope: By providing multiple financial

services to their customer, FIs can lower the cost of
information production for each service by applying
one information resource to many different services.
Additionally,
FIs develop broader & LT relationships

7 - 23
- a concern because substantial reduction in the quality
of info in financial markets increases asymmetric info
- prevents financial markets from channeling funds to
most
productive
investment
opportunities.
Consequently, the financial markets & the economy
become less efficient
3 Types of nancial service activities:
1. Underwriting & Research in investment banks
2. Auditing and Consulting in Accounting Firms
3. Credit Assessment & Consulting in Credit Rating Agencies
7 - 24
3 Types of nancial service activities
1. Underwriting & Research in investment banks
- Conict between 2 client groups w/ diering potential
revenues
a. security-issuing rms
b. security-buying investors
- Spinning: when an investment bank allocates hot, but
underpriced, initial public oerings (IPOs) to executives of
other companies in return for their companies future
business with the investment banks
7 - 25
2. Auditing and Consulting in Accounting Firms
- Auditors may be willing to skew their judgments & opinions
to win consulting business from same clients
- Auditors may be auditing info systems or tax & nancial
plans put in place by their non-audit counterparts within
the rm, and therefore may be reluctant to criticize the
systems or advice.
- Auditor provides overly favorable audit to solicit or retain
audit business. Case: Collapse of Arthur Andersen 1 of the
5 largest accounting rms in the US
7 - 26
3. Credit Assessment & Consulting in Credit Rating Agencies
- Probability of default to determine the creditworthiness of
particular debt securities
- In the credit rating industry, the issuers of securities pay a
rating rm such as Standard and Poors or Moodys to have
their securities rated
- When credit rating agencies also provide ancillary
consulting services: Debt issuers often ask rating agencies
to advise them on how to structure their debt issues.
7 - 27
What has been done to Remedy Conicts of Interest
1. Sarbanes-Oxley Act of 2002
- Public Accounting Return and Investor Protection Act
- Increased supervisory oversight:
! Established a Public Company Accounting Oversight
Board (PCAOB), overseen by the SEC, to supervise
accounting rms & ensure that audits are independent &
controlled for quality
! It increased the SECs budget to supervise securities
markets
7 - 28
- Directly reduced conicts of interest
! Illegal for a registered public accounting rm to provide
any nonaudit service to a client contemporaneously with
an impermissible audit (as determined by PCAOB)
! It beefed up criminal charges for white-collar crime and
obstruction of ocial investigations.
7 - 29
- Improve the quality of information in the nancial markets
! required a CEO & CFO, as well as its auditors, to certify
that periodic nancial statements & disclosures of the
rm (esp. o-balance-sheet transactions) are accurate
! required members of the audit committee to be
independent; that is, they cannot be managers in the
company or receive any consulting or advisory fee
7 - 30
2. Global Legal Settlement of 2002
- December 20, 2002, with 10 largest investment banks by
the SEC, the New York Attorney General, NASD, NASAA,
NYSE, and state regulators.
- Directly reduced conicts of interest
! required investment banks to sever the links between
Research & Securities Underwriting.
! Banned spinning

7 - 31
2. Global Legal Settlement of 2002
- Incentives for investment banks not to exploit conicts of
interest: Imposed $1.4 billion of nes
- Measures to improve quality of info in nancial markets
! Required investment banks to make their Analysts
Recommendations public
! Over 5-yr period: Required to contract with at least 3
independent research rms that would provide research
to their brokerage customers.
7 - 32

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Sources

Financial Markets and Institutions

Pearson Prentice Hall

8 Basic Facts about Financial Structure

Pearson Prentice Hall

8 Basic Facts about Financial Structure

Pearson Prentice Hall

! How Financial Intermediaries Reduce Transaction Cost

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

! Moral hazard: an asymmetric info problem that occurs after the

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Tools to Solve Adverse Selection

1.Private Production & Sale of Information

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

the free-rider problem.

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Tools to Solve Principal-Agent Problem

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

1. Production of Information: Monitoring

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Pearson Prentice Hall

Asymmetric Info: Adverse Selection & Moral Hazard

Financial Markets and Institutions

Pearson Prentice Hall

Financial System of Developing Countries

Financial Markets and Institutions

Pearson Prentice Hall

- Economies of Scope: By providing multiple financial

FIs develop broader & LT relationships

Pearson Prentice Hall

Pearson Prentice Hall