II.

1 Economic Analysis of
Financial Institutions

Money, Banking and Financial Markets

 Financial Sources

Debt
Financial
Firms
Stock Investors

Banks
How will government fit here:
1)US Govt debt purchased by i
G3 Data (1970-1996)
Six important characteristics of the
World Financial Structure
1. Neither stock nor debt issuance is the more
important source of external finance for firms
2. Indirect finance is much more important for
firms than direct finance
Six important characteristics of the
World Financial Structure
3. Banks are the most important source of
loanable funds in the world

4. The financial system is one of the most

regulated in the economy
Six important characteristics of the
World Financial Structure
5. Only large firms have access to direct
finance

6. Collateral is common in debt contracts

Why?
Transaction costs and financial
intermediaries
Types of costs
Large commissions (buying shares or bonds)
Need of a minimum amount of money to enter
these markets
With little money, you cannot diversify much. Risky.
 Transaction costs and financial
intermediaries
Financial intermediaries lower this cost, for two reasons:
Economies of scale
Costs of investing in shares or bonds are fixed. Thus, grouping many investor funds
lowers the average fixed cost.
Investment funds, example of financial intermediary
Computer technologies, other fixed cost
 Transaction costs and financial
intermediaries
Financial intermediaries mitigate these costs for two
reasons:
Experience
They obtain cheaper services
They have more liquidity services available.
Financial Intermediaries (Banks) have more means
to deal with the ASYMMETRIC INFORMATION
problem, which floods financial markets
 Asymmetric Information

One side of the contract is more

informed than the other
Two forms: Adverse Selection
and Moral Hazard

Borrower more informed

(borrower more informed about the profile of the company, purpose of the loan, abi

Asymmetric information with lender

 Adverse Selection (AS)
Financial investor does not know exactly the nature, characteristics and
opportunities of the proposed projects: stock, debt, bank loans: Selection
problem EX-ANTE
Unlikely to select smaller companies with no history of paying back loans

Original idea by Akerloff: Used car market (lemons markets). Only bad
firms will survive in the market
If there is 100 new firms asking for a loan, the bank wants to choose the high quality firms to lend to. Banks will set the interest rate in the
median( because they dont know which is high quality, which is low quality). However, this means that bad firms will get a lower interest rate
than they deserve, and high quality firms get higher than they deserve. Soon the high quality firms will exit (cause interest rate too high)
 How to mitigate AS
Create an information market on the state of
the firm and the projects subject to finance (v/s
free-rider problem)

Government regulation to increase information

(following the recent crisis, for instance)
 How to mitigate AS
Financial intermediation: banks have means to
know the client better (Relationship Lending)
Hard & Soft information (soft information from
small firms)

Collateral
 Moral Hazard (MH)
Problem which occurs once the contract has been
performed. Once finance is provided, what is done with the
loan? can do anything with loan
EX-POST problem.

Firm Management only have a small fraction of the shares.

Separation between property and control: Incentive problem
 How to mitigate MH
Monitoring: Verifying the work of managers (it can be
costly)
Government regulation to produce more information
Financial intermediation maintaining constant
contact with firm management
(Relationship Lending)
 How to mitigate MH
Collateral
Contracts with provision on the risk of
investments:
Incentivating good practices
Making collateral more valuable
Providing information on a continuous basis
Summary: Direct Finance is more impersonal than Indirect Finance,
where contracts are personalized.

Thus, risks associated with AS and MH are higher in Direct Finance

 Financial Development and Economic Growth

Financial development is needed for economic development, but AS

and MH plague financial markets in emerging/poor economies:
Legal system does not work well in these countries
In case of default, it is costly to obtain the collateral
Sometimes governments require banks to lend to non-profitable firms (Japan)
 Financial Development and Economic Growth

Financial development is neede for economic development,

but AS and MH plague financial markets in emerging/poor
economies:
Nationalized Banks
Inefficient regulation of the financial system, bad accounting systems