Lecture 1-1

Lehman Brothers Case
1
EVEN by the standards of the worst financial crisis for at least a generation, the
events of Sunday September 14th 2008 and the day before were extraordinary. The
weekend began with hopes that a deal could be struck, with or without government
backing, to save Lehman Brothers, Americas fourth-largest investment bank. Early
Monday morning Lehman filed for Chapter 11 bankruptcy protection. It has more
than $613 billion of debt.() Lehman Brothers one of the oldest and the most
successful investment banks
The biggest worry is the effect on derivatives markets, particularly the giant one for
credit-default swaps. Lehman is a top-ten counterparty in CDSs, holding contracts
with a notional value of almost $800 billion. On Sunday, banks called in their
derivatives traders to assess their exposures to Lehman and work on mitigating
risks. The Securities and Exchange Commission, Lehmans main regulator, said it is
working with the bank to protect clients and trading partners and to maintain
orderly markets.
2
This left Lehman with no option but to prepare for bankruptcy. Though the bank
has access to a Fed lending facility, introduced after Bears takeover by JP
Morgan Chase, the collapse of its share price left it unable to raise new equity
and facing crippling downgrades from rating agencies.
Moreover, rival firms that had continued to trade with it in recent weeks at
the urging of regulators had begun to pull away in the past few days.
The inability to find a buyer is a huge blow to Lehmans 25,000 employees, who
own a third of the companys now-worthless stock; in such a difficult
environment, most will struggle to find work at other financial firms. It also
makes for an ignominious end to the career of Dick Fuld, Lehmans boss since
1994, who until last year was viewed as one of Wall Streets smartest
managers.
3
Lehman losses on the 13th September, 2008
4
5
Lehman Brothers headquarters in New York City on

September 15, 2008
6
Some Lehman Brothers' employees leaving the bank's

Canary Wharf office in London, England
7
Financial crisis an investment banker of Goldman

Sachs, London
8
Lack of confidence on the financial markets
Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch,
Thomson Datastream and Bank calculations.
(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures,
normalised on the period 19992004. The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997
as it is based on a greater number of underlying measures. The recent fall in the indicator is largely due to a sharp decline in the interbank
9
market liquidity measure.
US
Euro Area
UK
10
05 June 2009
05 March 2009
05 December 2008
05 September 2008
05 June 2008
05 March 2008
05 December 2007
05 September 2007
05 June 2007
05 March 2007
05 December 2006
05 September 2006
05 June 2006
05 March 2006
05 December 2005
05 September 2005
05 June 2005
05 March 2005
05 December 2004
05 September 2004
05 June 2004
05 March 2004
05 December 2003
05 September 2003
05 June 2003
05 March 2003
05 December 2002
05 September 2002
05 June 2002
05 March 2002
05 December 2001
05 September 2001
05 June 2001
05 March 2001
05 December 2000
05 September 2000
05 June 2000
05 March 2000
US, UK, EU credit spreads
Spread between BAA corporate and government bonds
10
The uncertainty in the economy and CDS spread

The evolution of the CDS spread (mean values)
11
Source: Eichengreen, Moby, Nedeljkovic and Sarno (2009).
The uncertainty in the economy and CDS spread
12
Lack of confidence on financial markets

1/12/08
US I NT EREST RAT ES
EMU I NT EREST RAT ES
Euribor 3M
4
10Y
10Y
Eonia
Repo
3
Libor 3m
2
Discount
1
Fed Funds
Libor O/N
3M
0
0
J
O N
F M
M J
O N D
0
J
A S
O N
D J
F M A M
A S
O N D
US BOND 10Y
US DISCOUNT RATE
GERMAN BOND 10Y
ECB MARGINAL LENDING
US FEDERAL FUNDS TARGET RATE - M
US T-Bi ll 3M
ECB REPO
ECB OVERNIGHT DEPOSIT
US INTERBANK 3 MTH (LDN:BBA) - O
US INTERBANK O/N (LDN:BBA) - OFF
EURIBOR 3 M
EONIA
Sourc e: Thoms on Datastream
13
Uncertainty and increasing cost of funding
14
Losses of the banking sector
15
Source: Bank of England
Losses of the banking sector and resolution policies

Source:
Bloomberg
Recapitaliastion has been done:

firstly by take over and mergers
Sub-PrimeCrisis: Bankslosses&Capital raisedsince07/2007
10/11/2008
-800 -750 -700 -650 -600 -550 -500 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800
BNPParibas
Fortis
IKB
Credit Suisse
Then by state intervention:

Nationalization (investment in
the equity)
Guarantees
LehmanBrothers
MorganStanley
RBS
WellsFargo
JPMorgan
National City
Bankof America
HSBC
UBS
WashingtonMutual
The amounts at stake are however

limited when compared to assets still
at risk
Merryll Lynch
Citigroup
Wachovia
ASIA
EUROPE
AMERICAS
WORLD
-800 -750 -700 -650 -600 -550 -500 -450 -400 -350 -300 -250 -200 -150 -100 -50 0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800
Credit Losses &Writedowns (USDbn)
Capital raised(USDbn)
16
Crises and effect on banking lending
Source IMF
17
Crises and effect on banking lending
18
Source: IMF
Banking crisis and oil prices

1/12/08
160
O IL PRI CE AND USD| EUR EXCHANG E RAT1.60

E
140
1.50
120
160
CO NFIDENCE: US AND EURO Z O NE
140
120
-5
100
-10
80
-15
60
-20
40
-25
20
-30
1.40
100
1.30
80
1.20
60
1.10
40
1.00
20
0.90
0.80
00
01
02
03
04
05
06
07
08
00
01
02
03
04
Crude Oi l-WTI Spot Cus hi ng U$/BB
US CONSUMER CONFIDENCE INDEX SA
US $ TO EURO (WMR&DS) - EXCHANGE
EM CONSUMER CONFIDENCE INDICATO
05
06
07
08
19
Confidence is affected in the real economy
20
Source :IMF; WEO Nov 08
Europe in recession
Bad news for investment
E MU: GDP Gr owth and Ca pa c ity Utilis a tion r a tes
1/12/08
5.00
85
4.50
84
4.00
3.50
83
3.00
2.50
82
2.00
81
1.50
1.00
80
0.50
79
96
97
98
99
00
01
02
03
04
05
06
07
08
EM INDUSTRY SURVEY: CAPACITY UTILISATION - EMU 11/12/13 SADJ (

EA GDP CONA
HIGH 84.80 15/5/07,LOW 79.50 14/2/97,LAST 81.60 14/11/08

HIGH 4.62 15/5/00,LOW 0.47 15/5/03,LA ST 0.63 15/8/08
21
USA in recession
Unemployment soaring towards 7% - 8%...
US Une mployment and Cons umption E x penditur es (inv er te d)
1/12/08
8.00
-1
7.50
0
7.00
1
6.50
6.00
5.50
3
5.00
4
4.50
5
4.00
3.50
6
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
US UNEMPLOYM ENT RATE SADJ

PERCENTAGE CHANGE FOR 1 YEAR - #0q #0q #0q
22
Europe in recession
Germany
E ur oz one and Ge r ma ny GDP Gr owth r a te s (qoq% )
1/12/08
2.00
2.00
1.50
1.50
1.00
1.00
0.50
0.50
-0.50
-0.50
2000
2001
2002
2003
2004
2005
2006
2007
2008
1 quarter percentage c hange - EJ GDP CONA

1 quarter percentage c hange - BD GDP (PAN BD FROM 1991) CURA
HIGH 1.18 15/2/00,LOW -0.20 15/8/08,LA ST -0.20 15/8/08

HIGH 1.76 15/2/08,LOW -0.41 14/2/03,LA ST -0.02 15/8/08
23
Europe in recession
Spain
S P AIN: HOUS ING S E CTOR AND GDP GROW TH
1/12/08
30
10
20
9
10
8
0
-10
-20
6
-30
5
-40
-50
2000
2001
2002
2003
2004
2005
2006
2007
2008
ES GDP (CURRENT) (%YOY) CURA

PERCENTAGE CHANGE FOR 1 YEAR - ES HOUSES CONSTRUCTION COMMENCED VOLN(R.H.SCALE)
24
Europe in recession
E MU: GDP Gr owth and Ca pa c ity Utilis a tion r a tes
1/12/08
5.00
85
4.50
84
4.00
3.50
83
3.00
2.50
82
2.00
81
1.50
1.00
80
0.50
79
96
97
98
99
00
01
02
03
04
05
06
07
08
EM INDUSTRY SURVEY: CAPACITY UTILISATION - EMU 11/12/13 SADJ (

EA GDP CONA
HIGH 84.80 15/5/07,LOW 79.50 14/2/97,LAST 81.60 14/11/08

HIGH 4.62 15/5/00,LOW 0.47 15/5/03,LA ST 0.63 15/8/08
25
The build up to the crisis global background

Low real interest rates stimulated borrowing and financial innovation
Long rates were low because of high saving especially by Asian
economies
Short rates were held low in the US
Buildup of debt and asset price boom
New features of the market were not stress tested for downturns
New asset backed securities hid risk rather than shared or
reduced it
Reliance on wholesale markets was unwise
26
The build up to the US crisis

Structural background:
Rush to sub prime lending in US, encouraged by government and
compensation schemes for bankers
Accelerating shift to securitisation, credit assessment neglected
for CDOs and other ABS
Low levels of liquidity and aggressive liability management by
banks
Some ABS held in SIVs and conduits, ABCP financed (Basel 1)
Context of global liquidity glut and search for yield (sub-prime and
ABS)
Suspicion of disaster myopia
27
Real interest rates

6
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
-1
-2
UK long real rate
US long real rate
UK short rreal rate
US short real rate

28
France
Germany
Spain
UK
US
20
07
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
ratio to personal disposable incomes
Personal sector borrowing
1.8
1.6
1.4
1.2
0.8
0.6
0.4
0.2
29
France House prices

UK House prices
Germany House prices
US House prices
2006Q4
2005Q1
2003Q2
2001Q3
1999Q4
1998Q1
1996Q2
1994Q3
1992Q4
1991Q1
1989Q2
1987Q3
1985Q4
1984Q1
1982Q2
1980Q3
1978Q4
1977Q1
1975Q2
1973Q3
1971Q4
1970Q1
Log scale 2000q1 = 1
Real house prices
1.4
1.3
1.2
1.1
0.9
0.8
0.7
0.6
0.5
Spain House prices

30
Financial Innovation and the Decline in Traditional

Banking
31
Rising Volumes, Diminishing Standards

Mortgage Origination Statistics
Diminishing Underwriting Standards
32 / 12
Source: Wray, 2007, Lessons from the Subprime Meltdown
3232
The scope of our course
Why Study Financial Markets?

Channel funds from savers to investors, thereby promoting economic efficiency
Affect personal wealth and behavior of business firms
Why Study Banking and Financial Institutions?

Financial Intermediation
Helps get funds from savers to investors
Banks and Money Supply
Crucial role in creation of money
Central Bank
Role of the Central Bank in providing financial stability
Why Study Money and Monetary Policy?

Influence on business cycles, inflation, and interest rates, fiscal policy
Important role in the Financial Cries
33
The Structure of the Financial System

Indirect Finance
Financial Intermediaries
Banks and other monetary institutions
Insurance companies and pension
funds
Other financial intermediaries
Money savers
1.
2.
3.
4.
Households
Companies
Government
Central Bank
Financial Markets
Money Markets
Debt Markets
Equities Markets
Money spenders
1.
2.
3.
Companies
Government
Households
Direct Finance
The lenders may supply funds either by Financial Markets or

Financial Intermediaries.
34
The Structure of Financial Markets
Financial Markets are the institutions through which a person (or an

institution) who wants to save can directly supply funds to a person (or an
institution) who wants to borrow. There are several categorization of
financial markets:
(i) Debt and Equity Markets
(ii) Primary and Secondary Markets
(iii) Exchanges and Over-the-Counter Markets
(iv) Money and Capital Markets
(v) Foreign Exchange Markets
35
Classifications of Financial Markets

1. Debt Markets
Short-term (maturity < 1 year) Money Market
Long-term (maturity > 1 year) Capital Market
2. Equity Markets
Common stocks
3. Primary Market
New security issues sold to initial buyers
4. Secondary Market
Securities previously issued are bought and sold
5. Exchanges
Trades conducted in central locations (e.g., Toronto Stock Exchange and New
York Stock Exchange)
6. Over-the-Counter Markets
Dealers at different locations buy and sell
36
Characteristics of Debt Markets Instruments

Debt instruments:
- Buyers of debt instruments are suppliers (of capital) to the firm, not
owners of the firm
- Debt instruments have a finite life or maturity date
- Advantage is that the debt instrument is a contractual promise to pay
with legal rights to enforce repayment
- Disadvantage is that return/profit is fixed or limited
- An interest rate is the cost of borrowing or the price paid for the rental of
funds
37
The Bond Market and Interest Rates
38
Debt Instruments - Money Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and Reverse RPs
Federal Funds
LIBOR
39
Principal Money Market Instruments
40
Valuation of debt instruments Yield to Maturity
The interest rate that equates the present value of cash flow
payments received from a debt instrument with
its value today
YIELD TO MATURITY IS THE MOST ACCURATE MEASURE OF
INTEREST RATES
41
Bond Page of the Newspaper
42
Coupon Bond
Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=
+
+
+. . . +
+
2
3
n
1+i (1+i ) (1+i )
(1+i ) (1+i ) n
43
Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in

Ten Years (Face Value = $1,000)
When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate
The price of a coupon bond and the yield to maturity are negatively
related
The yield to maturity is greater than the coupon rate when the bond
price is below its face value
44
Consol or Perpetuity
A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever
P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
can rewrite above equation as this : ic = C / Pc

For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
45
Discount Bond
For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
46
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
Pt +1 - Pt
C
RET =
+
Pt
Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 - Pt
= rate of capital gain = g
Pt
47
Rate of Return and Interest Rates
The return equals the yield to maturity only if the holding

period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices,
resulting in a capital loss if time to maturity is longer than the
holding period
The more distant a bonds maturity, the greater the size of the
percentage price change associated with an interest-rate
change
48
Rate of Return and Interest Rates (contd)
The more distant a bonds maturity, the lower the rate of

return that occurs as a result of an increase in the interest rate
Even if a bond has a substantial initial interest rate, its return
can be negative if interest rates rise
49
Rate of Return and Interest Rates (contd)
At first it frequently puzzles students that a rise in interest rates

can mean that a bond has been a poor investment.
The trick to understand it is to recognize that a rise in the interest
rates means that the price of a bond has fallen.
A rise in interest rates therefore means that a capital loss has
occurred, and if this loss is large enough, the bond can be a poor
investment indeed.
Lets look..
50
One-Year Returns on Different-Maturity 10%-Coupon-Rate

Bonds When Interest Rates Rise from 10% to 20%
51
Interest-Rate Risk
Prices and returns for long-term bonds are more volatile than
those for shorter-term bonds
There is no interest-rate risk for any bond whose time to
maturity matches the holding period
52
Example
Which $1,000 bond has the higher yield to maturity, a 20-year

bond selling for $800 with a current yield of 15% or a one
year bond selling for $800 with a current yield of 5%?
53
Characteristics of Equity Markets Instruments
Equity instruments (common stock is most prevalent equity

instrument):
- Buyers of common stock are owners of the firm
- Common stock has no finite life or maturity date
- Advantage of common stock is potential high income since
return is not fixed or limited
- Disadvantage is that debt payments must be made before
equity payments can be made
54
The Stock Market
Common stock represents a share of ownership in a

corporation
A share of stock is a claim on the earnings and assets of
the corporation
55
Capital Market - Equity

Common stock
- Residual claim
- Limited liability
Preferred stock
- Fixed dividends - limited
- Priority over common
- Tax treatment
56
One-Period Valuation Model
Div1
P1
P0 =
+
(1 + ke ) (1 + ke )
P0 = the current price of the stock
Div1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period
57
Generalized Dividend - Valuation Model
The value of stock today is the present value of all future cash flows
Dn
Pn
D1
D2
+
+ ... +
+
P0 =
n
1
2
(1 + ke ) (1 + ke )
(1 + ke ) (1 + ke )n
If Pn is far in the future, it will not affect P0
Dt
P0 =
t
(1
+
k
)
t =1
e
The price of the stock is determined only by the present value of
the future dividend stream
58
Lehman losses on the 13th September, 2008
59
Gordon Growth Model
P0 =
D0 (1+ g)
D1
=
(ke g) (ke g)
D0 = the most recent dividend paid

g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate forever
The growth rate is assumed to be less than the required return on equity
60
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
P - Pt
C
+ t +1
RET =
Pt
Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 - Pt
= rate of capital gain = g
Pt
61
Principal Capital Market Instruments
62
Primary and Secondary Market
Primary Markets: the new issues of stocks, bonds or other seucrities

typically marketed to the public by investment bankers
IPOs and seasoned new issues
in the case of bonds, a public offering and a private
placement refers to the issue that usually is sold to one or
a few institutional investors and is generally held to
maturity
Secondary Market: trading of already-issued securities among
investors. Trading in the secondary markets does not affect the
outstanding amount of securities; the ownership is usually transferred
from one investor to another.
63
IPOs a tombstone advertisement
64
The Foreign Exchange Market
The foreign exchange market is where funds are converted

from one currency into another
The foreign exchange rate is the price of one currency in terms
of another currency
The foreign exchange market determines the foreign exchange
rate
65
Over-the counter market
Dealers at different locations who have an inventory of securities stand

ready to buy and sell securities over the counter to anyone who
comes to them and is willing to accept their prices
Because over-the-counter dealers are in computer contact and know
the prices set by one another the OTC market is very competitive and
not very different from a market with an organized exchange
Many common stocks are traded OTC but a majority of the largest
corporations have their shares traded at organized stock exchanges
such as New York Stock Exchange
66
Internationalization of Financial Markets (Glossary)

Foreign Bonds: sold in a foreign country and denominated in that
countrys currency
Eurobond: bond denominated in a currency other than that of the
country in which it is sold
Eurocurrencies: foreign currencies deposited in banks outside the
home country
Eurodollars: U.S. dollars deposited in foreign banks outside the
U.S. or in foreign branches of U.S. banks
World Stock Markets
Help finance federal government also (role of Japan)
67

Indirect Finance
funds
Money savers
1.
2.
3.
4.
Households
Companies
Government
Central Bank
Financial Markets
Money Markets
Debt Markets
Equities Markets
Money spenders
1.
2.
3.
Companies
Government
Households
Direct Finance

68
Financial intermediaries are financial institutions through which savers can

directly provide funds to the borrowers. The word intermediary reflects the role of
these institutions in standing between savers and borrowers.
Generally one distinguishes two types of financial intermediaries: banks and

non-bank financial intermediaries. The latter can be divided into formal and
informal.
The non-financial intermediaries include:

Insurance companies
Pension funds
Mutual Funds
NGOs
Money Transfer Agencies
Over the past several decades, the non-bank financial institutions have become
important players in financing business.
69
Principal Financial Intermediaries and Value of Their Assets
70
Why do we need financial intermediaries?
71
Adverse Selection and Moral Hazard: Assymetric

information
Adverse Selection:
Before transaction occurs
Potential borrowers most likely to produce adverse outcomes are ones most likely
to seek loans and be selected
Example:
Moral Hazard:
After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities
making it more likely that wont pay loan back
Example:
72
Example Assymetric Information

A risk neutral enterpreneuer considers founding a private limited company (limited liability in GB). The new
company can undertake one of the following projects (or pursue one of the following strategies), which are
characterised by uncertain pay-offs in the two (equally likely) states of the world after one year.
States
Probabilities
Investment 1
Investment 2
1
0,5
80,000
200,000
2
0,5
180,000
40,000
Total value
130,000
120,000
Both projects require an investment of 90,000 EUR in t=0. To keep things simple, assume that all people are risk
neutral and the risk-free interest rate is 0. The problem here is that of assymetrical information and incentives to
hurt the other party. Potential providers of capital cannot observe and therefore not enforce by legal means
which project the enterprenuer finally implements. But they are clevel enough to understand that they are
exposed to the danger of moral hazard.
a) Which project should/would the enterprenuer undertake if he were to provide all of the require funding by
herself or if she could effectively commit herself to invest in the project which she promises to others.
b) Now assume that the entreprenuer looks for a loan to fully finance her preferred investment project. The
enterprenuer does not have any money. Which repayment would a bank request to receive (and thus at the
same time: what would bet he agreed nominal interest rate on a loan of 90,000 EUR) provided that:
i) the enterprenuer/borrower can make a credible and binding commitment concerning her
investment choice
ii) the enteprenuer/borrower cannot make a credible and binding commtiment which project she
selects. Please explain why commitment is important in this specific case. What might motivate
the borrower not to select the seeminlgy efficient alternative?
73
Reducing the Adverse Selection and Moral Hazard

Problems
Solving Asymmetric Information Problems
1. Screening
2. Monitoring and Enforcement of Restrictive Covenants
3. Specialize in Lending
4. Establish Long-Term Customer Relationships
5. Loan Commitment Arrangements
6. Collateral and Compensating Balances
7. Credit Rationing
74
Transaction Costs and Financial Structure

Transaction costs hinder flow of funds to people with productive
investment opportunities
Example:
Say you have 5,000 you would like to invest, and you think about investing in the stock
market. Because you have only 5,000 you can buy only a small number of shares. The
stockbroker tells you that your purchase is so small that the brokerage commission for
buying the stock you picked will be large percentage of the purchase price of shares. If
instead you decide to buy a bond, the problem is even worse. Indeed, the broker may
not be interested in your business at all, because the small size of your account does
not make spending time on it worthwhile. You are disappointed and realize that you
will not be able to use financial markets to earn a return on your hard-earned savings.
You can take some consolation, however, in fact you are not alone in being stymied by
high transaction costs. This is a fact of life of many of us: only around on-half of
American households own any securities.
75
Transaction Costs and Financial Structure

Transaction costs hinder flow of funds to people with productive investment
opportunities
Financial intermediaries make profits by reducing the transaction costs:

1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs
76
What is the role of Financial Intermediaries in a

Financial System?
Mobilization of funds and converting the unproductive and illiquid savings into the
productive investments thanks to information unavailable to private and public markets
Delegated monitoring thanks to monitoring of financing firm, the financial
intermediaries are able to ensure that the distributed funds are allocated with the aim of
its destination
Corporate control through the ability of monitoring borrowers, the financial
intermediaries allow the economy to overcome moral hazard problems and reduce the
agency costs
Risk-sharing banks, mutual funds and other financial intermediaries all provide useful
vehicle for pooling, trading and risk-diversifying leading to the shift of investors portfolios
towards more uncertain but higher return
Intertemporal risk-smoothing as long-lived institutions, they may facilitate
intergenerational risk arising from investing in the long-run projects offering relatively low
returns in the boom times and high in the slack times.
77
Adverse Selection and Financial Structure
Lemons Problem in the Securities Markets

If cant distinguish between good and bad securities, willing to pay only
average of good and bad securities values.
Result: Good securities undervalued and firms wont issue them; bad
securities overvalued, so too many issued.
Investors wont want to buy bad securities, so market wont function well.
Less asymmetric information for well known firms, so smaller lemons
problem
78
Puzzle in the Financial Structure

Sources of Foreign External Finance
79
Tools to Help Solve Adverse Selection (Lemons)

Problem
Private Production and Sale of Information
Free-rider problem interferes with this solution
Government Regulation to Increase Information
Financial Intermediation
A. Analogy to solution to lemons problem provided by used-car
dealers
B. Avoid free-rider problem by making private loans
Collateral and Net Worth
80
Moral Hazard: Debt versus Equity
Moral Hazard in Equity: Principal-Agent Problem

1. Result of separation of ownership by stockholders (principals) from control
by managers (agents)
2. Managers act in own rather than stockholders interest
1.
2.
3.
4.
Tools to Help Solve the Principal-Agent Problem

Monitoring: production of information
Government regulation to increase information
Financial intermediation
Debt contracts
81
Moral Hazard and Debt Markets
Moral hazard: borrower wants to take on too much risk
Tools to Help Solve Moral Hazard

1. Net worth
2. Monitoring and enforcement of restrictive covenants
3. Financial intermediation - Banks and other intermediaries have
special advantages in monitoring
82
Summary: Asymmetric Information Problems and Tools

to Solve Them
83
Importance of the Financial Systems
Imagine yourself taking a business-school exam in international financial

management. The test is a case study. It concerns Opacia, an emerging
economy which is in a bit of a mess. Corporate financial statements mean
little as firms routinely lend to each other off balance sheet. You have no
idea how big the countrys foreing liabilities are, though you know that its
banks and companies like to borrow dollars short-term, usually finance
long-term local investment projects. There is no effective bankruptcy law,
and corruption is rife.
Is it a safe place to invest money?
84
What do you need in order to sleep well after having invested your
money in Opania?
Would you invest there at all?
1. legal system
2. accounting standards
3. government credit (directs)
4. financial institutions (not nationalized)
5. adequate government regulation
85
Financial Sector and Financial

System
the difference?
86

Indirect Finance
funds
Money savers
1.
2.
3.
4.
Households
Companies
Government
Central Bank
Financial Markets
Money Markets
Debt Markets
Equities Markets
Money spenders
1.
2.
3.
Companies
Government
Households
Direct Finance

87
and to meaningful definitions and distinctions

The Financial Sector
Encompasses the totality of institutions which specialize in providing financial
services to the non-financial sector units in the economy - i.e. banks, NBFIs,
organised markets; and the relevant regulating and supervising bodies - and their
rules, structure and behaviour.
The Financial System
Encompasses the demand for, and the supply of, financial services, and thus, of
course also the "professional providers", i.e. the financial sector, and the interplay
between demand and supply.
Thus the Financial System is more than the Financial Sector
In addition to the financial sector and to the demand for its services, it also includes
the extent to which the financial sector does not meet the demand of the nonfinancial sector units and forces them to self-finance, self-invest and self-insure.
88
Sources of Foreign External Finance
89
There are considerable and persistent

differences between national financial systems
Financial System
Indicators 2004
Financial System
Indicators 1994
% of GDP
% of GDP
160
160
140
140
120
120
100
100
80
80
60
60
40
40
20
20
% of GDP
% of GDP
160
160
140
140
120
120
100
100
80
80
60
60
40
40
20
20
0
Euro area
Bank loans
United United States

Kingdom
Japan
Non-Japan
Asia
Stock market capitalisation
0
Euro a re a Unit e d
Unit e d
Kingdom S t a t e s
J a pa n
NonJ a pa n
Asia
Bond market (public)
Bond market (private)
Source: Allen, F., F.Chui and A.Maddaloni, Financial Systems in Europe, the USA and Asia,Oxford Review of Economic Policy,Vol.20(4), 2004
90
Portfolio allocation of non-bank intermediaries structure

varies across countries and regions
Portfolio Allocation
average 1995-2002
(a) Monetary Financial Institutions
(b) Insurance Companies and Pension Funds
91
There are considerable and persistent

differences between national financial systems
Non-financial corporations
Households
average 1995-2002
92
Financial systems are commonly classified

as being bank- based or capital market- based
Bank-based financial
system
Capital-based financial
system
Banks play the dominant role
Capital markets are main sources of

financing for firms and serve households
Banks are the main providers of financing

for firms
Bank leding is restricted in terms of

volume and maturities
Banks are the most important deposit

takers
Bank-client relationships with firms are
close; most firms have their house - banks
Banks play an important role in the
governance of non-financial firms
Banks are organised as true universal
banks and they dominate the entire
financial sector
Corporate governance regime is
stakeholder-orientated
Stock markets unimportant
Bank-client relationships is rather at

arms length
Banks are often specialized either by law
or by tradition
Non-financial intermediaries play
important role
Investor information and investor protection is very important
Control of management through market
forces -market for corporate control
Corporate governance is shareholder
oriented
93
It is a challenge for empirical research to determine

whether the growth impact of a financial system
depends on its quality
Open Ends
Bank-based
Capital-based
Financial Systems
Financial Systems
?
Banks and stocks markets have independent effects on growth as they provide different financial services
(Levine and Zervos, 1998)
There may be a positive relationship between different measures of financial sector size, but the type of the
system does not seem to matter (Levine, 1999)
It would be important to better measure financial sector quality. Looking at its internal consistency might
provide an answer to this question
94
The possible convergence of financial systems either

towards a middle groundor to the Anglo-Saxon
model is a highly controversial topic
U.S.
Germany
Bank-based
Financial Systems
Japan
France
Capital-based
Financial Systems
U.K.
95
Financial System and Economic Growth
Recent research has found than an important reason why many

developing countries or ex-communist countries like Russia,
(which are referred to as transition countries) experience very
low rates of growth is that their financial systems are
underdeveloped (a situation referred to as financial repression).
The economic analysis of financial structure helps to explain how
an underdeveloped financial system leads to a low state of
economic development and economic growth.
(World Bank, Finance for Growth: Policy Choices in a Volatile
World)
96
Financial System and Economic Growth

Central Questions
Do countries with better developed banks and financial markets

enjoy substantially greater economic success?
Does this translate in higher capital accumulation or productivity
growth?
Why do not all countries take advantage of this?
97
Alternative Views
Economists hold startlingly different views about the impact of finance on
long-run economic growth?
Finance promotes growth (Hamilton-Schmupeter):
banks are the happiest engines that ever were invented for creating
economic growth
Finance hurts growth (Adams):
banks have done more harm to the mortality, tranquility, and even
wealth of this nation than they have done or ever will do good
Finance follows growth (Robinson)
Finance doesnt matter (Solow growth accounting):
growth is mainly due to technological progress, leaving little role for
finance
98
Financial sector and resource allocation

Fund Providers
Investment
Proposals
Potential
Investors
Financial Sector:
Resource Allocator
Resource
Deprivation
Investment
Failure
Bad loan
Inefficient Allocation
Production
Land
Labor
Equipment
Case
approved
Resource Acquisition/Allocation
Efficient Allocation
99
Finance promotes growth - Theory

Financial Functions
- pooling resources, subdividing shares
- transferring resources across time and space
- managing risk
- generating and providing information
- resolving competing claims on wealth generated
Channels to Growth
- capital accumulation, physical and human
- technological innovation
GROWTH
100
Finance promotes growth - Theory
That
is to say that countries whose financial systems
perform their functions better, grow faster.
101
The "quality" - or the state of development of the financial

system/sector matters for the growth and development of a country
Empirical debate
Positive real interest rate

Moderately negative real interest rates (0 to 5%)
Strongly negative real interest rates (less than 5%)
Starting with Bagehot, it has

always been clear to
economists that finance is
important
But this knowledge has been
discarded by the neo-classical
theory of economic growth
It only came back with the
theory of endogenous
growth (Romer, Lucas)
A start of empirical work was
made in the WDR of 1989
In 1993, King and Levine
empirically confirmed
Schumpeters view that:
finance matters
102
The legal system a country relies upon has a significant

influence on economic growth
The protection of shareholders and creditors by the legal system helps explain the
patterns of corporate finance in different countries:
breadth and depth of capital markets
pace of new security issues
corporate ownership structure
dividend policy
efficiency of investment allocation
Investor protection is crucial:

expropriation of minority shareholders and creditors in many countries is
extensive
outside investors face a risk that the returns on their investments will never
materialize because the managers or controlling shareholders may expropriate
them (insiders)
103
e(Growth in Gini Coefficient |

X)
Inequality declines as finance develops
e(Private Credit | X)
Residuals
Values
Fitted
104
Why does a financial structure of a country

matter?
There are at least three reasons why the financial struture is important:
Efficiency in terms of our previous figure, the issue is how effectively funds flow from borrowers to
lenders so that everbodys wealth is maximized.
(a) how financial system allows risk to be shared and who bears that risk
(b) incentives to produce and use information; in particular,where the resources can
be most profitably invested.
(c) how effective is corporate governance implemented?
(d) how financial sytstem evolves over time and the role of law and politics in
determining it.
Financial Stability what is the relationship between the struture of the financial system and the
banking crises, currency crises, asset-price bubbles and crashes, contagion and financial fragility.
Monetary Policy Transmission Channels two views:

(a) money view- interest rates affect consumption and investment as predicted by
neoclassical theories based on perfect capital markets. Institutions do not matter!
(b) credit view with the imperfect capital markets, the effects of monetary policy
transmission depends on access to finance. How finance is obtained by firms,
houeseholds, and governments depends on the financial structure.
105

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Lehman Brothers Case

Lehman Brothers Case

Lehman Brothers Case

Lehman losses on the 13th September, 2008

Lehman Brothers headquarters in New York City on

Some Lehman Brothers' employees leaving the bank's

Financial crisis an investment banker of Goldman

Lack of confidence on the financial markets

US, UK, EU credit spreads

Spread between BAA corporate and government bonds

The uncertainty in the economy and CDS spread

The uncertainty in the economy and CDS spread

Lack of confidence on financial markets

EMU I NT EREST RAT ES

GERMAN BOND 10Y

ECB MARGINAL LENDING

US FEDERAL FUNDS TARGET RATE - M

ECB OVERNIGHT DEPOSIT

US INTERBANK 3 MTH (LDN:BBA) - O

US INTERBANK O/N (LDN:BBA) - OFF

Sourc e: Thoms on Datastream

Uncertainty and increasing cost of funding

Losses of the banking sector

Losses of the banking sector and resolution policies

Recapitaliastion has been done:

Sub-PrimeCrisis: Bankslosses&Capital raisedsince07/2007

Then by state intervention:

The amounts at stake are however

Credit Losses &Writedowns (USDbn)

Crises and effect on banking lending

Crises and effect on banking lending

Banking crisis and oil prices

O IL PRI CE AND USD| EUR EXCHANG E RAT1.60

CO NFIDENCE: US AND EURO Z O NE

Crude Oi l-WTI Spot Cus hi ng U$/BB

US CONSUMER CONFIDENCE INDEX SA

US $ TO EURO (WMR&DS) - EXCHANGE

EM CONSUMER CONFIDENCE INDICATO

Sourc e: Thoms on Datastream

Confidence is affected in the real economy

EM INDUSTRY SURVEY: CAPACITY UTILISATION - EMU 11/12/13 SADJ (

HIGH 84.80 15/5/07,LOW 79.50 14/2/97,LAST 81.60 14/11/08

Sourc e: Thoms on Datastream

US UNEMPLOYM ENT RATE SADJ

Sourc e: Thoms on Datastream

1 quarter percentage c hange - EJ GDP CONA

HIGH 1.18 15/2/00,LOW -0.20 15/8/08,LA ST -0.20 15/8/08

Sourc e: Thoms on Datastream

ES GDP (CURRENT) (%YOY) CURA

Sourc e: Thoms on Datastream

EM INDUSTRY SURVEY: CAPACITY UTILISATION - EMU 11/12/13 SADJ (

HIGH 84.80 15/5/07,LOW 79.50 14/2/97,LAST 81.60 14/11/08

Sourc e: Thoms on Datastream

The build up to the crisis global background

The build up to the US crisis

Real interest rates

UK long real rate

US long real rate

UK short rreal rate

US short real rate

ratio to personal disposable incomes

Personal sector borrowing

France House prices

Log scale 2000q1 = 1