Financial intermediation

Presentation Transcript
1. An Overviewof the Financial System
2. Function of Financial Markets 1. Allows transfers of funds from person or business without
investment opportunities to one who has them 2. Improves economic efficiency2

efficiency by producing
improve the well-being of consumers by allowing them to time purchases better3

Investment Banks underwrite securities in primary markets Brokers and dealers work in secondary
-the Money
markets deal in short-term debt instruments Capital markets deal in longer-term debt and equity
instruments4
5. Principal Money Market Instruments5
6. Capital Market Instruments6
7. An Economic Analysis of Financial Structure
8. Sources of External Finance in U.S8
9. Sources of Foreign External Finance9
10. Sources of Foreign External Finance10
11. Eight Basic Facts 1. Stocks are not the most important sources of external financing for businesses
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance
their operations 3. Indirect finance is many times more important than direct finance 4. Financial
intermediaries are the most important source of external funds11
12. Eight Basic Facts (contd) 5. The 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
finance their activities 7. Collateral is a prevalent feature of debt contracts 8. Debt contracts are
extremely complicated legal documents that place substantial restrictive covenants on borrowers12

value of the cars offered for sale when I offer $800?13

14. Function of Financial Intermediaries Financial Intermediaries 1. Engage in process of indirect

finance 2. More important source of finance than securities markets 3. Needed because of
transactions costs and asymmetric information14

Economies of scale Expertise15

16. Function of Financial Intermediaries Risk Sharing 1. Create and sell assets with low risk
characteristics and then use the funds to buy assets with more risk (also called asset transformation).
2. Also lower risk by helping people to diversify portfolios16
17. Transaction Costs and Financial Structure Transaction costs hinder flow of funds to people with
productive investment opportunities Financial intermediaries make profits by reducing transaction
costs 1. Take advantage of economies of scale Example: Mutual Funds 2. Develop expertise to lower
transaction costs Explains Fact 317
18. Asymmetric Informati

Laureates of 2001. http://www.nobel.se/economics/laureates/2001/index.html18

19. A
economic behavior19
lity cannot be assessed, the buyer is willing to pay
in the

Free

Government regulation to increase information Fact

Collateral and net worth Fact 721

and control of the firm Managers pursue personal benefits and power rather than the profitability of
the firm22
23. Principal
Debt Contracts Fact 123

than the lenders would like24

Free-rider problem


Enforcement of Restrictive Covenants Discourage undesirable behavior Encourage desirable
behavior Keep collateral valuable
Facts 3 & 425
26. 26
27. Function of Financial Intermediaries: Indirect Finance
Economies of
scale
Risk Sharing (Asset Transformation)
Asymmetric Information Adverse Selection (before the transaction)more likely to select risky
borrower Moral Hazard (after the transaction)less likely borrower will repay loan27
sold in a foreign country and
denominated in that countrys currency
bond denominated in a currency other than that
foreign currencies deposited in banks outside the
home country EurodollarsU.S. dollars deposited in foreign banks outside the U.S. or in foreign

29. Financial Intermediaries29

30. Size of Financial Intermediaries30
Reduce
adverse selection and moral hazard problems
financial intermediaries: Restrictions on entry Disclosure Restrictions on Assets and Activities
Deposit Insurance Limits on Competition Restrictions on Interest Rates31
32. Regulatory Agencies32
33. Regulatory Agencies33

reduction in the quality of information in financial markets increases asymmetric information

economy is not as efficient as it could be34
35. Why Do Conflicts o

Information produced by researching companies is used to underwrite the securities. The bank is
attempting to simultaneously serve two client groups whose information needs differ. Spinning
occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other
companies in return for their companies future business35

Auditors may be willing to skew their judgments and opinions to win consulting business Auditors

may be auditing information systems or tax and financial plans put in place by their nonaudit
counterparts Auditors may provide an overly favorable audit to solicit or retain audit business36
-Oxley Act of 2002 (Public Accounting Return and
Investor Protection Act) Increases supervisory oversight to monitor and prevent conflicts of interest
Establishes a Public Company Accounting Oversight Board Increases the SECs budget Makes it
illegal for a registered public accounting firm to provide any nonaudit service to a client
contemporaneously with an impermissible audit37
38. Conflicts of Interest: Remedies
-Oxley Act of 2002 (contd) Beefs up criminal
charges for white-collar crime and obstruction of official investigations Requires the CEO and CFO to
certify that financial statements and disclosures are accurate Requires members of the audit
committee to be independent38
Requires investment
banks to sever the link between research and securities underwriting Bans spinning Imposes $1.4
billion in fines on accused investment banks Requires investment banks to make their analysts
recommendations public Over a 5-year period, investment banks are required to contract with at
least 3 independent research firms that would provide research to their brokerage customers39
40. Financial Development and Economic Growth Financial Repression Leads to Low Growth: Why? 1.
Poor legal system 2. Weak accounting standards 3. Government directs credit 4. Financial institutions
nationalized 5. Inadequate government regulation40

contain useful definitions, or further elaborate on important concepts, particularly materials covered
xamples Ive used in the past, or slides I just dont want to
delete as I may use them in the future.41
Increases in interest
rates Increases in uncertainty Asset market effects on balance sheets Problems in the banking
sector Government fiscal imbalances42
43. Events in U.S. Financial Crises43
44. Events in Mexican, East Asian, and Argentine Financial Crises44
45. Summary: Asymmetric Information Problems and Tools to Solve Them45