Chapter 11
Reducing Transactions Costs and
Information Costs
Banks vs. Bonds
1000000
900000
800000
700000
600000
500000
400000
300000
200000
100000
0
Bank Loans
Bonds
External
6/1/2002
PE Ratios
Average PE Ratio 1985-2001
21
20
19
18
17
16
15
14
13
US PE Ratio
HK PE Ratio
Objectives
1. Differentiate Adverse Selection and Moral
Hazard
2. Identify 5 different types of financial
institutions.
Unit Overview
Securities
Market
Institutions
Transactions
Costs
Asymmetric
Information
Costs
Investment
Institutions
Adverse
Selection
Moral
Hazard
Contractual
Savings
Institutions
Depository
Institutions
Government
Financial
Institutions
Facts of Finance
• Issuing marketable debt and securities is not the
primary source of finance for businesses. (In G-7,
less than 20% of all finance).
– Internal finance (retained profits) is an important source
of funds for business.
– Securities markets play a small (but growing) role in
external finance in all markets outside North America.
Banks are the source of half of external finance in
North America and 75-80% outside NA.
– Only most well known companies issue debt securities.
– Direct sale of securities from issuers to savers play a
tiny role in finance. Most securities held by financial
institutions.
Transactions Costs
• Debt serves a useful purpose in matching those
who currently have greater income than
consumption to those with greater consumption
than income.
• However, matching buyers and sellers involves
some costs. Institutions develop to reduce these
costs.
– Economies of scale
– Specialization
Information Costs
• As noted, all debt involves some risk that
the borrower will be unable to repay.
• Part of transactions costs involve acquiring
information about this likelihood.
• Information asymmetry between borrowers
and lenders. Borrowers always know more
about their chances than lenders.
Asymmetric Information
•
Asymmetric Information A condition that occurs when
borrowers have some information about their
opportunities or activities that they do not disclose to
lenders, creditors or insurers.
•
Two categories of imbalanced information
1. Borrower has more information about their own
prospects before the loan was made.
2. Borrower has more information about and control
over the way funds are used after the loan has been
made.
Costs of Asymmetric Information
• Two types of problems
1.Adverse Selection – A lender’s problem of
distinguishing the good-risk applicants from the
bad-risk applicants before making an
investment.
2.Moral Hazard – Borrowers incentives will not
align with lenders and will behave in ways that
are not conducive to repaying debt.
Lemon Problem: Used Cars
• Two indistinguishable (to buyers) types of cars:
lemons (often breaking down) and creampuffs
(never breaking down).
• If buyers are willing to pay a price equal to the
average value of lemon and creampuffs, they will
offer a price higher than the value of a lemon, but
less than the value of the creampuff.
• Only sellers would be lemon owners.
Lemon Problem: Bond Market
• Some firms have risky prospects (lemons) and
some firms have safe prospects (creampuffs).
• Bond buyers cannot distinguish between them.
They offer bond prices which are an average of the
price of creampuff bonds and lemon bonds.
[Another way of putting this is that interest rates
are an average of creampuff and lemon rates].
• Potential borrowers with creampuff prospects may
finance their own projects.
• Only borrowers with lemon prospects will join
bond markets.
Reducing Adverse Selection
Through Information Gathering
1.
2.
3.
Information Gathering – Bond rating agencies perform
the function of analyzing possibility of repayment.
Free Rider Problem – Gathering information about firms
is costly, but once gathered it can be shared very cheaply.
Information firms do not receive funds from all who
benefit from their services. Information may be
underprovided by markets.
Government Regulation – One solution to the free rider
problem is for the government to issue rules requiring
sellers of securities to provide honest information about
their firms.
Collateral/Net Worth
•
•
Most debt is backed by some sort of
collateral. In the case of default, lender
takes possession of some physical or
financial asset of relatively clear value.
Lenders will only lend to firms with a high
net worth. This means lenders can make
claims on the outstanding assets of
companies in the case of debt default.
Moral Hazard
• Once funds have been lent, borrowers have
control.
• If borrowers take risky actions and lose,
they share the losses with their debtors by
defaulting.
• If borrowers take risky actions and win,
they keep all the extra winnings themselves.
Moral Hazard Example
•
Lender lends $100 to borrower at 5% interest. Borrower can choose
between two investment projects each of which require an upfront
pay-off of $100.
•
Project A is a risky project but potentially lucrative. With an 80%
probability, project A will generate 0 payoff. With a 20% probability
project A will generate a $205 payoff.
•
Project B is a non-risky project which will generate a pay-off of
$110 with an 80% probability and a pay-off of $95 with an 20%
probability.
Three Questions
1.
Which project will A choose if he is risk-neutral.
2.
Which project would B choose if he is risk-neutral
3.
Which project is most advantageous to a risk-neutral society.
Expected Value
• We can use the statistical concept of
expected value to answer these questions.
• Expected payoff to a project with two
possible outcomes
PayoffE = Prob(Outcome1)*Payoff1 +Prob(Outcome2)*Payoff2
Which project is socially beneficial?
• Expected payoff to project A is
.8∙$0 +.2·$205 = $41
Since cost is $100, the expected payoff to project
A is less than the cost. To a risk neutral or risk
averse society this project will be bad.
• Expected payoff to project B is
.8∙$110 +.2·$95 = $107
Since cost is $100, the expected payoff to pro ject
B is more than cost. To a risk neutral society this
project is good (though the risk might be to large
for a suffiiciently risk-averse society).
Pay-off to Borrower and Lender
• Project A. With 80% probability, the payoff to the project will be $0 so
both the borrower and lender get $0. With 20% probability, the pay-off
to the project will be $205, so the lender will be repaid $105 and the
borrower will keep $205-$105 = $100. The expected payoff to the
project for the lender will be .2∙$105+.8∙0=$21. The expected payoff to
project A for the borrower is .2∙$100+.8∙0=$20.
• Project B. With 20% probability, the payoff to the project will be $95,
so the lender will only be repaid $95 and the borrower keeps $0. With
80% probability, the payoff to the project will be $110, so the lender is
repaid $105 and the borrower keeps $5. The expected payoff to the
project for the lender will be .2∙$95+.8∙$105 =$103. The expected
payoff to project A for the borrower is .2∙$0+.8∙$5=$4
Which project will be undertaken?
• If the borrower has control of the funds, then he will
choose project A. The expected value of the payment to
him is higher for the riskier project. This is because the
lender bears all of the upside of a risky investment and
none of the downside.
• The lender of course prefers the reverse. He would choose
the socially beneficial project B.
• This example demonstrates the problem of moral hazard in
debt markets. Because he shares none of the downside, the
borrower will choose inefficiently risky projects once he
has control of the funds.
Restrictive Covenants
•
Debt agreements place restrictions on
activities of borrowers.
–
–
–
Restrict spending of funds
Require maintenance of minimum net worth
Require maintenance of value of collateral
Financial Intermediaries
• Most funds raised internally through owners
savings or retaining earnings.
• Banks specialize in acquiring information
and reducing monitoring costs.
• Typically, they do not share information so
do not face the free rider problem as
severely.
Adverse Selection
Moral Hazard
Debt Market
Problems
Credit Rationing – High
Interest Rates Attract Bad
Risks
Assumption of Greater
Risk by Borrowers
Solutions
1.
2.
Collateral
Net Worth
Requirements
Restrictive Covenants
1.
Restrict Activities
2.
Require Net Worth
Equity Market
Problems
High Growth Companies
Do Not List Shares
Principal Agent Problem
Managers Serve
Themselves
Solutions
?
Leveraged Buyouts
Chapter 12
Financial Institutions
Investment &
Contractual Savings
Mutual Funds
Hedge Funds
Pension Funds
Insurance
Financial Markets
1. Primary: Investment Banks
2. Secondary: Exchanges
3. Secondary: Brokers &
Dealers
Investment
Finance
Companies
Government
Mortgage
Companies
Savers
Depository Institutions
1.
2.
Banks
RLB’s & DTC’s
Borrowers
Security
Market
Information Investment
Banks
Investment Contract
Savings
Depository Government
Finance
Companies
Commercial
Banks
Risk
Brokers
Dealers
Markets
OTC
Mutual
Funds
Insurance
Pension
Funds
Liquidity
Brokers
Dealers
Markets
OTC
Mutual
Funds
Pension
Funds
Commercial
Banks
Mortgage
Companies
Types of Financial Institutions
•
•
•
•
•
Security Market Institutions
Investment Institutions
Contractual Savings Institutions
Depository Institutions
Government and Quasi-Government
Institutions
Security Market Institutions:
Primary Markets
• Investment Banks – Advise and aid firms in
issuing bonds and stocks to primary markets.
• Underwriting – Underwriter guarantees a price for
bonds, makes profits if they can sell it for more.
• Syndicates – Groups of investment banks gathered
by a lead bank to share in underwriting.
Secondary Market Institutions:
Secondary Markets
• Exchanges – (Hong Kong Exchanges and Clearing Ltd.)
– Hong Kong Stock Exchange
• Main Board: Established Companies
• Growth Enterprise Market
• Bond Market
– Hong Kong Futures Exchange. Main Product: Hang
Seng Futures Indexes
• Brokers match buyers and sellers. Dealers own
stocks of assets
Stocks traded through a centralized clearing system Central Clearing and
Settlement System (CCASS) operated by HK Securities Clearing
Company Limited.
Investment Institutions
•
Investment Institutions match retail
lenders/borrowers with security markets.
1. Mutual Funds raise funds in retail markets and
use the funds to invest in securities markets.
2. Finance Companies raise funds in securities
markets and make loans in retail markets.
3. Hedge Funds are partnerships of wealthy people
investing in financial markets.
Purpose: Direct participation in security markets
may involve too great transaction costs for some
borrowers/savers.
Mutual Funds
•
•
Mutual Funds – Intermediaries that raise funds from
investors and use the funds to buy securities. For savers,
a cheap way of acquiring a share of a diversified
portfolio. (AKA Unit Trusts)
Types of Funds
1.
2.
3.
4.
Closed End vs. Open End: Closed end funds are not redeemable
at will but shares are traded. Open end funds can be redeemed
from initial issuer. Value of shares are based on value of
portfolio assets.
Load vs. No Load – Purchasers of load funds pay commissions.
No load funds pay only management fees based on earnings.
Indexed vs. Managed Funds – Indexed Funds have portfolios
that proportionally matches a broad pre-determined set of assets
like the S&P 500 or the Hang Seng Index. Managed Funds try to
use strategy to maximize returns.
Money Market – MMMF’s hold short-term assets. Popular since
deposits are checkable.
Finance Companies
• Finance companies issue commercial paper or
securities to raise funds. The funds are then lent to
retail borrowers to finance purchases of assets.
• Types of finance companies
– Consumer: Make loans to households
– Business: Make short-term loans to businesses.
– Sales: Manufacturers own finance companies that lend
to people who purchase their products. (Toyota Motor
Credit).
Hong Kong Finance Companies
• Restricted License Banks – Can take
deposits of at least HK$500,000, no
maturity restrictions. {Merchant Banks,
Business Finance}
• Deposit Taking Companies Can take
deposits of HK$100,000 or more with three
month maturity. Typically consumer finance
arms of banks.
Maturity
Size
Requirements
Restricted None
License
Banks
Deposit
3 Months
Taking
Companies
Names
$500,000
GE Capital
Hang Seng
Finance
$100,000
Dao Heng
Finance
Wing Lung
Finance
Hedge Funds
• Hedge funds are partnerships which require large
contributions from their subscribers.
• Advantage of this structure is that the funds are
largely unregulated allowing them to use
innovative, unique, or arcane financial strategies.
Some hedge funds may keep strategies secret even
from partners.
• Some hedge funds often active in derivatives
markets.
• Some have criticized hedge funds as destabilizing
to the financial system.
Contractual Savings
•
•
Some institutions channel funds to
securities markets whose source is regular,
required payments.
Contractual Savings institutions includes:
1. Insurance Companies
2. Pension Funds
Insurance Companies
• Risks like accidental death or fire are
unpredictable at the individual level but are easily
quantifiable among large groups.
• Insurance companies get regular up front
payments (premiums) from group members
worried about some risk and make large payments
(claims) to unlucky victims.
• Premiums are invested in securities markets.
Returns are used to pay insurance companies costs
and generate profits for insurance companies.
Types of Insurance
• Property and Casualty – Insurance for fire, car
accidents, etc.
• Life Insurance
– Term life: Regular payments are made to the insurance
company. If you die while covered, your estate files a
claim. Otherwise, the insurer keeps the premium.
– Whole life: Regular payments are made to the company
for many years. If you do not die by some final date,
the insurance company makes a final payment to you or
sets up a series of annual payments until your death.
Pension Funds
• Employers set aside some of their compensation
as contributions to investment funds that will pay
retirement benefits to workers.
• In the United States, there are tax advantages to
paying wages through this channel. In Hong
Kong, less so and pension funds are less
important.
• Types of Pension Funds
– Defined Benefit: The employer promises to make certain payments
when employees retire.
– Defined Contribution: Employer makes a specific contribution to a
fund often invested by employees themselves.
Mandatory Provident Funds
• Since last years, employees without a retirement
plan must enroll in an investment fund.
• Both the employer and employee are required to
put 5% into a fund.
• Funds are invested in a set of essentially mutual
funds chosen by the employer and employee.
Savings can be shifted across funds at some costs.
Depository Institutions
• Depository Institutions collect potentially
small deposits in retail markets and make
direct loans to borrowers.
• Commercial banks play an important role in
evaluating risks and monitoring borrowers.
• Licensed Banks
Government Institutions
•
Hong Kong Mortgage Corporation set up
in 1997. Begin operating in secondary
mortgage market in two phases.
1. Issue securities and purchase mortgages
for its own portfolio.
2. Sell mortgage backed securities.