Eco 2154 PPP #3
Review of Chapters 2 and 8,
and
Advanced Discussion
Dr. J. D. Han
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
Out of two External Financing
Methods,
Indirect Financing predominates.
Direct Finance vs. Indirect Finance
Indirect Finance
Through
Financial
Intermediaries
Savers
Households
Investors
Financial
Market
Direct Finance
Doing by itself
Business Firms
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).
What are being Dealt in?
Financial Instruments
Indirect
Marketable
Securities
indirect
Debt Contract or
Instruments
Bank Loans
Bonds
Stocks(equities)
In theory, they can
be instruments for
Direct Financing as
well. However it is
pretty small.
(Review ) Observation of Facts:
Sources of External Corporate Financing
in U. S. : 1970-1985
stocks
2%
bonds
32%
loans
66%
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.
Puzzle 1:
Stocks or Equities are relatively
unimportant
compared with
Debt Contracts/Instruments
(= Bonds + Loans)
Puzzle 2:
Marketable Securities(=Bonds +
Stocks) are not so important as
Bank Loans
Puzzle 3
• Direct Finance is insignificant compared to
Indirect Finance.
• Financial Intermediaries buy most of
Marketable Securities
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
1) Provides rationales for Financial
Institutions;
2) Provides grounds for Government
Regulations of Financial
Institutions/Financial Sector.
Let’s focus on the second issue of
Government Regulations
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 samenessof proportions, from Greek word from asymmetros,
from a- "not" + symmetros "commensurable."
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.
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.
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/Revelation, and
different Financial Institutions are to be faced with
different degrees of market receptions and
government regulations
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.
• Still banks cannot completely remove
Moral Hazards of borrowers.
• Japanese banks may have the answer for
a further reduction of IA and Moral
Hazards.
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).
* 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 GlassSteagall Act), Financial Trusts were less
subject to Moral Hazards of their
borrowers……”
(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.
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.
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.
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.
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?”
*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 wouldn’t be enough of supply of
information?
• Information Revolution will resolve Free
Rider Problem
eg) Microsoft Operating System has
become non-duplicable or nontransferable.
• Meanwhile, within industry, Merger &
Acquisitions will reduce Moral Hazards
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.
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
Were They Stable?
• Conventional Wisdom
-> Yes, Scotland, Canada, Sweden and HK
-> “No”, U. S. A.
 We would like to challenge the second
part of Conventional Wisdom
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
* Evaluation of the Scottish Free Banking
Compared with the Contemporary British
Banking Experience
1. Stability: no major bankruptcy
-exception: Ayr Bank
2. Availability: more banking services per capita
3. Competition: small banks along with large
ones
4. Efficiency:
- spontaneous evolution of a clearing house
(payment association)
- Rapid propagation of information
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?
*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
Lessons to be Learned from
Free Banking Experiences
Self-Regulated,
Regulation-Free,
Banking/Financial Industry may be Viable
and even be superior.
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…..”
References
• Read Neil Reynolds’s 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) 321–344
• J. Bradford De Long, Harvard University, “Did J. P. MORGAN’S
MEN Add Value?: An Economist’s 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
• 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. 5:1080-1091
• A.J.R. Rolnick and W. Weber, "Explaining the
Demand for Free Bank Notes," Journal of
Monetary Economics, 1988, Vol. 21: 47-71.