Lecture 5, 6

Financial Markets & Institution

Basic Facts about Financial System

The financial system is complex in both structure and function throughout the
world. It includes many different types of institutions: banks, insurance companies,
mutual funds, stock and bond markets, and so on all of which are regulated by
government. The financial system channels trillions of dollars per year from savers
to people with productive investment opportunities. If we take a close look at
financial structure all over the world, we find eight basic facts, some of which are
quite surprising, that we need to explain to understand how the financial system
works

The bar chart in Figure 7.1 shows how American businesses financed their
activities using external funds (those obtained from outside the business itself) in
the period 1970–2000 and compares U.S. data to those of Germany, Japan, and
Canada. The Bank Loans category is made up primarily of loans from depository
institutions; Nonbank Loans is composed primarily of loans by other financial
intermediaries; the Bonds category includes marketable debt securities such as
corporate bonds and commercial paper; and Stock consists of new issues of new
equity (stock market shares). Now let us explore the eight facts.

1. Stocks are not the most important source of external financing for businesses.
Because so much attention in the media is focused on the stock market, many
people have the impression that stocks are the most important sources of financing
for American corporations. However, as we can see from the bar chart in Figure
7.1, the stock market accounted for only a small fraction of the external financing
of American businesses in the 1970–2000 period: 11%.1 Similarly small figures
apply in the other countries presented in Figure 7.1 as well.
2. Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations. Figure 7.1 shows that bonds are a far more
important source of financing than stocks in the United States (32% versus 11%).
However, stocks and bonds combined (43%), which make up the total share of
marketable securities, still supply less than one-half of the external funds
corporations need to finance their activities. The fact that issuing marketable
securities is not the most important source of financing is true elsewhere in the
world as well. Indeed, as we see in Figure 7.1, other countries have a much smaller
share of external financing supplied by marketable securities than the United
States. Why don’t businesses use marketable securities more extensively to finance
theiractivities?

3. Indirect finance, which involves the activities of financial intermediaries, is

many times more important than direct finance, in which businesses raise funds
directly from lenders in financial markets. Direct finance involves the sale to
households of marketable securities such as stocks and bonds. The 43% share of
stocks and bonds as a source of external financing for American businesses
actually greatly.
Overstates the importance of direct finance in our financial system. Since 1970,
less than 5% of newly issued corporate bonds and commercial paper and less than
one-third of stocks have been sold directly to American households. The rest of
these securities have been bought primarily by financial intermediaries such as
insurance companies, pension funds, and mutual funds. These figures indicate that
direct finance is used in less than 10% of the external funding of American
business. Because in most countries marketable securities are an even less
important source of finance than in the United States, direct finance is also far less
important than indirect finance in the rest of the world. Why are financial
intermediaries and indirect finance so important in financial markets? In recent
years, however, indirect finance has been declining in importance. Why is this
happening?

4. Financial intermediaries, particularly banks, are the most important source of

external funds used to finance businesses. As we can see in Figure 7.1, the primary
source of external funds for businesses throughout the world comprises loans made
by banks and other nonbank financial intermediaries such as insurance companies,
pension funds, and finance companies (56% in the United States, but more than
70% in Germany, Japan, and Canada). In other industrialized countries, bank loans
are the largest category of sources of external finance (more than 70% in Germany
and Japan and more than 50% in Canada). Thus, the data suggest that banks in
these countries have the most important role in financing business activities. In
developing countries banks play an even more important role in the financial
system than they do in the industrialized countries.

5. The financial system is among the most heavily regulated sectors of the
economy. The financial system is heavily regulated in the United States and all
other developed countries. Governments regulate financial markets primarily to
promote the provision of information, and to ensure the soundness (stability) of the
financial system.
6. Only large, well-established corporations have easy access to securities markets
to finance their activities. Individuals and smaller businesses that are not well
established are less likely to raise funds by issuing marketable securities. Instead,
they most often obtain their financing from banks.

7. Collateral is a prevalent feature of debt contracts for both households and

businesses. Collateral is property that is pledged to a lender to guarantee payment
in the event that the borrower is unable to make debt payments. Collateralized debt
(also known as secured debt to contrast it with unsecured debt, such as credit card
debt, which is not collateralized) is the predominant form of household debt and is
widely used in business borrowing as well. The majority of household debt in the
United States consists of collateralized loans: Your automobile is collateral for
your auto loan, and your house is collateral for your mortgage. Commercial and
farm mortgages, for which property is pledged as collateral, make up one quarter
of borrowing by nonfinancial businesses; corporate bonds and other bank loans
also often involve pledges of collateral.

8. Debt contracts typically are extremely complicated legal documents that place
substantial restrictions on the behavior of the borrower. Many students think of a
debt contract as a simple IOU that can be written on a single piece of paper. The
reality of debt contracts is far different, however. In all countries, bond or loan
contracts typically are long legal documents with provisions (called restrictive
covenants) that restrict and specify certain activities that the borrower can engage
in. Restrictive covenants are not just a feature of debt contracts for businesses; for
example, personal automobile loan and home mortgage contracts have covenants
that require the borrower to maintain sufficient insurance on the automobile or
house purchased with the loan.
 What Is the Lemons Problem?
The lemons problem refers to issues that arise regarding the value of an investment
or product due to asymmetric information possessed by the buyer and the seller.
The theory of the lemons problem was put forward in a 1970 research paper in The
Quarterly Journal of Economics, titled,

"The Market for 'Lemons': Quality Uncertainty and the Market Mechanism,"
written by George A. Akerlof, an economist and professor at the University of
California, Berkeley.

Understanding the Lemons Problem

In his paper, Akerlof examined the used car market and illustrated how the
asymmetry of information between the seller and buyer could cause the market to
collapse, getting rid of any opportunity for profitable exchange and leaving behind
only "lemons," or poor products with low durability that the buyer purchased
without sufficient information.

The problem of asymmetrical information arises because buyers and sellers don't
have equal amounts of information required to make an informed decision
regarding a transaction. The seller or holder of a product or service usually knows
its true value or at least knows whether it is above or below average in quality.
Potential buyers, however, typically do not have this knowledge, since they are not
privy to all the information that the seller has.

Akerlof's original example of the purchase of a used car noted that the potential
buyer of a used car cannot easily ascertain the true value of the vehicle. Therefore,
they may be willing to pay no more than an average price, which they perceive as
somewhere between a bargain price and a premium price.
Solutions to the Lemons Problem
The lemons problem exists in the marketplace for both consumer and business
products, and also in the arena of investing, related to the disparity in the perceived
value of an investment between buyers and sellers. The lemons problem is also
prevalent in the financial sector, including insurance and credit markets. For
example, in the realm of corporate finance, a lender has asymmetrical and less-
than-ideal information regarding the actual creditworthiness of a borrower.

Akerlof proposed strong warranties as one means of overcoming the lemons

problem, as they can protect a buyer from any negative consequences of buying a
lemon. Another solution, one which Akerlof did not know about when he wrote the
paper in 1970, is the explosion of readily available, widespread information that
has been disseminated through the Internet and has also helped to reduce the
problem.
 FINANCIAL PANIC
A financial panic is a sudden, drastic, widespread economic collapse. All at once,
many people become convinced their money or investments are at risk and rush to
the institutions holding their assets. Unable to pay back all their customers at once,
the institutions go bankrupt, starting a domino effect that brings down the whole
economy. Typical "symptoms" of a panic are many bankruptcies, loan defaults, or
bank failures at the same time; It also includes a period of intense stock market or
real estate speculation followed by a steep decline in prices; and/or a sudden run on
banks by large numbers of people trying to withdraw their deposits.

Between 1790 and 1907 there were 21 financial panics in the United States. The
first major panic occurred in 1819, when the Bank of the United States, the nation's
central bank, tried to reduce the number of new speculative banks being founded in
the United States. The bank called in its loans to the new speculative banks and
required them to redeem their paper bank notes for hard gold and silver. Many of
these banks had printed far more notes than they had real reserves and quickly
failed. The Panic of 1837 was also the result of the government's attempt to control
the rapid spread of bank notes not backed up by hard currency. The Panic of 1857
came about when U.S. banks overextended themselves loaning money to railroads,
and railroads defaulted on their bonds. Several hundred U.S. banks failed.