L-4FinancialMarketDevelopment–PartIPresenterClintonShiellsJointChina-IMFTrainingProgramCourseonMacroeconomicManagementandFinancialSectorIssuesCT14.05ContentOutlineWhyDoWeNeedFinancialIntermediation?ImperfectInformation,OpportunisticBehavior,MarketInefficiencyFinancialMarketStructureSequencingFinancialSectorReforms2ThistrainingmaterialisthepropertyoftheInternationalMonetaryFund(IMF)andisintendedforuseinIMFInstitutecourses.AnyreuserequiresthepermissionoftheIMFInstitute.”WhyDoWeNeedFinancialIntermediation?

3MMFAnIdealFinancialWorldInanidealworldwherethereis:Perfectcompetition:absenceofmarketpowerPublicinformation:fullinformationonborrowersandtheirprojectsbylendersCostlesscontractnegotiation&enforcement:nocoststoreachingagreementonfuturepaymentstobemadeinallpossiblestatesofnature.oncetheagreementisreached,bothsideswillabide.4MMFAssumptionsmadeforanidealfinancialworlddonotholdinreality,becauseof:ImperfectInformationMatchingborrowersandlendersAsymmetricinformationOpportunisticBehaviorBrokeragecostsAdverseselectionMoralhazardCostlycontractenforcementMarketInefficiency5MMFTheRealWorldCharacteristicsofFinancialStructure#1.Stocksarelessimportantthanothersourcesofexternalfinance.#2.Marketablesecurities(equityandbonds)arenottheprimarysourceofexternalfinance.MMFCharacteristicsofFinancialStructure#3.Indirectfinancethroughfinancialintermediariesis(still)moreimportantthandirectfinancethroughsecuritiesmarkets.#4.Banksarethemostimportantsourceofexternalfundsforcorporations.MMFCharacteristicsofFinancialStructure#5.Thefinancialsectorisoneofthemostextensivelyregulatedsectorsoftheeconomy.#6.Accesstosecuritymarketisgenerallyrestrictedtolarge,establishedandwell-knowncompanies.MMFCharacteristicsofFinancialStructure#7.Collateralisanimportantfeatureofdebtcontractsforfirmsandhouseholds.#8.Mostdebtcontractsarecomplexlegaldocumentswithrestrictivecovenants.MMF10MitigatingAdverseSelectionPrivateinformationproductionandsale:RatingagenciesandinformationservicesButthereisafree-riderproblem→LessinformationisproducedthanisperhapssociallyoptimalMMF11MitigatingAdverseSelectionGovernmentregulationtoincreaseinformationprovision:Requirelistedfirmstoadheretoproperaccountingandauditingprocedures;disclosurerulesforsales,earnings,assetsandliabilities;timelyreportingrequirements.Governmentregulationreducesinformationasymmetriesbutdoesnoteliminatethem.Thisexplainswhythefinancialsectorisheavilyregulatedinmosteconomies.MMF12MitigatingAdverseSelectionFinancialintermediation:Abankby“producing”informationaboutfirmsacquiresexpertiseinassessingcreditrisks.Animportantaspectofbanklendingisthatthefree-riderproblemisavoided.Thisexplainswhylarge,established,well-knownfirmswithgoodreputationsfinditeasiertoobtainfunds.Alsoexplainswhybanksarerelativelymoreimportantindevelopingcountries.MMF13MitigatingAdverseSelectionCollateralandnetworth:Collateral,byprovidingthelender“insurance”inthecaseofdefault,reducestheconsequencesofadverseselection.Networthperformsarolesimilartocollateral,inthathigherequitycapitalprovidesacushiontoabsorblosses,serviceandpayoffdebtanddecreasestheprobabilityofdefault.MMFProblemthatresultsfromasymmetricinformationafterthetransactionhasoccurred.Theproblemarisessincethelenderisopentotheriskthattheborrowerusestheborrowedfundsinappropriatelyandhenceincreasestheprobabilitythattheloanmaynotberepaid(principal-agentproblem).Therefore,thelenderneedstofindwaystosafeguardhisinterests.14MMFMoralHazard15Increaseborrower’snetworth:Withhighnetworththeborroweralsohasalotatstakeandhencetheriskofmoralhazardisreduced.Thisexplainswhyhighnetworthindividualsandfirmsfinditeasiertoborrow.MitigatingMoralHazardMMF16Restrictiveprovisionsindebtcontract:provisionsindebtcontractsreducemoralhazardbyrulingoutundesirablebehaviorandencouragingdesirablebehaviorbyborrowers:Loancanbeusedonlyforspecificactivities.encouragebehaviorlikekeepingnetworthhighrequireborrowertokeepownershipofcollateralandmaintainitingoodcondition;periodicreportingbyfirm;lenderhastherighttoinspectandauditthefirm’sbooks.MitigatingMoralHazardMMF17Productionofinformationandmonitoringofagentactivities:Monitoringbyregularauditsandinspections.Monitoringprocessisexpensive;explainswhyequityissuanceisalessimportantsourceofexternalfunds.Monitoringsuffersfromthefree-riderproblem;hencethereislessmonitoringandinformationproductionthanoptimalMitigatingMoralHazardMMF18Governmentregulationtoincreaseinformationprovision:Accountingstandardsanddisclosurerulesfacilitatestate/profitabilityverification;penaltiesforfraudandmalfeasance.MitigatingMoralHazardMMF19Natureofcontracts:IndebtcontractsmoralhazardproblemislessseverethaninequitycontractsHencelowercostsofverificationmakedebtcontractspreferabletoequitycontractsinmanyenvironments.Anotherfactorthatoftenencouragesdebtcontractsisthetaxcode.IntheU.S.andmanyothercountries,interestpaymentsareexemptedfromcorporateincometax,whereasdividendsarenot.MitigatingMoralHazardMMF20AdverseSelection,MoralHazard&FinancialCrisesFactorsthatexacerbateadverseselectionandmoralhazardproblemsandhenceprecipitateand/ordeepencrises:IncreasesininterestratesIncreasesinuncertaintyAssetmarketeffectsonbalancesheetsPanicsMMFAllofthesecostsoffinancialintermediationcreateawedgebetweenthecostofborrowedfundsfromoutsideandthatofinternally-generatedfunds.Brokerage,acquisitionofinformation,collaterals,enforcementcosts,etc.Thiswedgeisreferredtoasthe“externalfinancepremium.”Corporatespreferinternaltoexternalfinancinganddebttoequityfinancing(“peckingorder”theoryofcorporatefinancing).21MMFExternalFinancePremiumBringtogetherborrowersandlendersinwaysthatbestallocateanation’sfinancialresourcesacrosstimeandspace;Clearingandsettlingpayments;Resourcepooling(tominimizetransactionscosts)anddiversificationofownership(risk);Informationproductionandpricediscovery;Dealingwithincentiveproblems(principal-agentproblem);Provisionofliquidity.22MMFFunctionsofFinancialSector(andMarkets)Totheseends,financialmarketscomprisedifferenttypesofinstitutionsandmarkets,eachfulfillingspecializedroleswhichreflectitsparticularcomparativeadvantage.Banksandsimilarinstitutionstendtointermediatethebulkoflendingtosmallandmediumsizedborrowerswhosecreditworthinessrequiresagooddealofinformationtoassess.Theytransferthefundsofmanysmallsaverstoborrowerswhocannotraisemoneydirectly.23MMFFunctionsofFinancialSector(andMarkets)Capitalmarketsallowborrowers,whosecreditworthinessismoreeasilyassessable,toobtainfundsdirectly,withouttheinvolvementofanintermediary.CapitalmarketsconsistmainlyofmarketsfordebtandequityBut,assophisticationgrows,theyexpandtoprovidedeepandliquidsecondarymarkets,andtoencompassotherfinancialproducts,suchasderivatives.

24MMFFunctionsofFinancialSector(andMarkets)FinancialMarketStructure25MMFFinancialSystem:Thesetofmarketsandotherinstitutionsusedforfinancialcontractingandtheexchangeofassetsandrisks,includingFinancialinstrumentsFinancialintermediariesFinancialservicefirmsRegulatorybodies/legalframeworkEfficiencyofthefinancialsystemdependsonhowthesecomponentsperformtheirintrinsicfunctions.26MMFFinancialSystemFinancialmarketdevelopmentisveryattractivedespitethefactthatbanksarestillthemainfinancingintermediariesindevelopingcountries:Interestrateschargedbybanksareveryhighifthereisnocompetitionfromafinancialmarket.Inawellregulatedenvironmentwithcompetition,financialmarketsarethemostefficientmechanism.Inthemarkets,borrowersandlenderscanagreeupon:ApriceTypeofinstrumentsPenaltiesfordefault

27MMFFinancialSystemDirectfinancevs.indirectfinanceDirectfinance:borrowersborrowfundsdirectlyfromlendersinfinancialmarketsbysellingthemsecurities.Indirectfinance:borrowersborrowfundsfromlendersthroughfinancialintermediariesMoneymarketvs.CapitalmarketPrimarymarketvs.SecondarymarketInternationalmarketvs.domesticmarket28MMFFinancialMarketStructureBanksallowtheeconomytoundertakeprojectswithhighexpectedreturnsbutthatwouldnototherwisebeundertakenbecausetheyarerisky,lumpy,andilliquid.Bankstakeadvantageofeconomiesofscaleandscopebymakinglargeloans,reducingcostsperdollarBankscanattractsavingsbecausepoolingpermitsthemtoofferassetswithattractivecombinationsofexpectedreturn,risk,andliquiditythatdominatecash.Theydecreasetheamountofresourcestoovercomeimperfectinformationandcontractenforcementcosts.29MMFTheRoleofBanksBanksoffersafe,liquidassetstosaversandtendtoengageininformation-intensivelending.Banksdonotuniversallydominateotherformsoffinancialintermediation.Thatis,therearemarketnichesthatbanksleaveunfilled.Theextenttowhichbankscanfulfillthewelfare-enhancingroledescribedpreviouslydependsontheroleofpublicpolicy:financialregulationandsupervision.Theirdependenceonpublicpolicyandtheirspecializedroleintheprocessofintermediationmakesbanksvulnerabletospecialproblems.30MMFTheRoleofBanksSomeborrowersdonotpresentthetypesofagencyproblemsthatbanksaddressthroughrepeatedmonitoring:withlargenetworthcanoffergoodcollateralor,whoplacehighvalueontheirfinancialreputationsCostofbankloanislikelytorisewiththematurityoftheloan,aswellaswhenthesizeofloanislargerelativetothebank’sportfolio.Thus,theselargeborrowerswithlowagencycostsconstitutemarketnichesthatcanbefilledbybondfinancing.31MMFTheRoleofBondMarketWhetheranicheisfilleddependson:Presenceandefficiencyofspecializedfirms(underwritersandcreditratingagencies)tobearbrokerageandevaluationcosts.Adequacyoflegalprovisionsforcreditorprotection(bankruptcylaw)andqualityofitsenforcement.Thenumberoflowagency-costborrowersseekingexternalfinance.Thisdeterminesthepotentialthicknessofbondmarketsandtheliquidityoftheseclaims.32MMFBondFinancingWhenagencyproblemsaresevere(firmsveryopaqueandlownetworth),thecostsofdebtfinancingmaybeprohibitive.Equityfinancing,byreducingleverage,reducesrisktotheentrepreneur,bymakingprofitslessvulnerabletofluctuationsinrevenuesandinterestrates.Thus,risk-aversefirmsthatposesevereagencyproblemsfordebtfinancewilldemandequityfinancing.33MMFEquityFinancingEnablefirmstotakelargeriskyinvestmentprojectsthatwouldbecostlytofinancewithdebt.Stockmarketsallocaterisktorelativelylessrisk-averseindividualsandreduceliquidityriskforsuchsavers.Near-continuousvaluationoffirmsimprovestheallocationofresourcesbytransmittinginformationaboutfirms’prospectstoprospectiveinvestors.Liquidstockmarketsalsofacilitatecorporatetakeovers,whichpromoteefficiencybyimposingdisciplineonmanagers.34MMFSocialBenefitsofEquityMarketSequencingFinancialSectorReforms35MMFFinancialintermediariesmobilizesavings,allocatecapital,managerisk,easetransactions,andmonitorfirms,andareessentialforeconomicgrowthanddevelopment.SomeempiricalfindingsKingandLevine(1993,QJE):financialintermediarydevelopmentis