finance exam #2

adverse selection

Happens before a transaction: when one party possesses more or better information than the other party, putting the other party at more risk

• banks end up lending to risker people

moral hazard

one party engages in riskier behavior because another party bears the costs of that risk

• incentives are distorted by insurance or contracts that shield individuals or institutions from the full consequences of their actions

when someone takes bigger risks because they know they won't have to pay for the consequences if things go wrong

banks

• borrow short-term (deposit withdrawable anytime)

• lend long-term (mortgages, business loans)

What is the problem if many depositors withdraw at once

• banks cannot quickly get money back from loans

• it runs out of cash

even if bank is actually healthy

how do bank runs happen

1. people think bank might fail

2. they rush to withdraw money

3. bank runs out of reserves

4. bank collapses

what happens when banks fail

• lending stops

• businesses can’t invest

• economy slows

8 key facts

1. stocks are not the main source of finance

2. marketable securities are not the main funding source

3. indirect finance > direct finance

4. banks are the most important source of external funds

5. financial system is heavily regulated

6. only large firms access financial markets easily

7. collateral is everywhere

8. debt contracts are complex

collateral

asset pledged to guarantee repayment

transaction costs

costs of making financial transactions

role of financial intermediares

1. economies of scale

2. diversification

3. liquidity services

solutions to adverse selection

1. private information

2. government regulation

3. financial intermediation

4. collateral & net worth

net worth

monetary value of all assets owned by an individual minus the total value of their liabilities

• reduces adverse selection by acting as a signal of high creditworthiness, providing collateral and aligning the borrowers interest with the lenders

principal-agent problem

result of separation of ownership by stockholders (principals) from control of the firm by managers (agents)

• principal: less information

• agent: more information

solving principal agent probelm

• monitoring (audits)

• government regulation

• financial intermediaries

debt contract

reduces monitoring costs by asking re-payment in fixed amounts and not subject to performance

• if firm pays —> no problem

• if firm fails —> monitor

solving moral hazard in debt contracts

1. net worth and collateral

2. monitoring and enforcements of restrictive covenants

enron scandal

hid debts using accounting tricks

misled investors

led to —> stronger financial regulation

Deposit insurance

if a bank collapses the insurance scheme guarantees that depositors will get their money back up to a certain limit

bank runs

occurs when a large number of customers simultaneously withdraw their deposits due to fears that a bank is insolvent

purchase and assumption method

way to resolve a failed bank

—> insteads of closing the bank and paying depositors directly, the regulator arranges for a healthy bank to buy parts of the failed bank and assume its obligations

“too big to fail”

• A company/bank is so large and important to the economy that the govt cannot allow them to collapse 

  • Their failure could cause major financial crisis

  • use the purchase and assumption method

• increases moral hazard incentives for big banks

financial regulation

government restrict what kinds of assets financial institutions can own

—> prevents banks from investing in very risky assets that could lead to failure

why are there bank regulations

they hold ppls deposits and are critical to financial system

• promote diversification

• prohibit holding of common stock bc they are more risky than loans or bonds

capital requirements

• must hold minimum amount of capital (their own money) relative to their assets 

  • minimum leverage ratio (for banks) so they cannot borrow excessively

Basel Accord

risk-based capital requirements

• require banks to hold capital based on the riskiness of their assets

Prompt corrective action

if the amount of a financial institution’s capital falls to low levels, serious problems result 

Chartering

screening of proposals to open new financial institutions to prevent adverse selection 

Examinations

monitor banks to prevent moral hazard

Assessment of Risk Management

A systematic process of identifying, evaluating, and prioritizing potential threats to minimize their impact. It involves estimating the likelihood of an occurrence and the severity of its consequences to make informed decisions on how to handle the risk

Value at Risk

statistical measure that estimates the maximum potential loss in value of a portfolio or asset over a specific time frame

Disclosure requirements 

• Requirements to adhere to standard accounting principles and to disclose wide range of information 

• Basel 2 accord and the SEC put a particular emphasis on disclosure requirements

financial transparency —> have to disclose information to regulators, investors or opposing parties

Restrictions on competition 

• Justified as increased competition can also increase moral hazard incentives to take more on risk

conflict of interest

A conflict of interest occurs when a financial institution has multiple roles that create incentives to act dishonestly

This happens when a person or company has two competing duties

why do conflicts of interest exist?

economies of scope; firms provide multiple services at once

ex: investment banking + research, auditing + consulting, credit rating + advisory

why is conflict of interest bad for the economy?

1. information becomes unreliable

2. investors make bad decisions

3. moneys goes to bad investments

4. good firms don’t get funding

—> economy becomes inefficient

Why is there a conflict between an investment bank's Research and Underwriting departments

• Underwriting (The Money Maker): Banks earn huge fees for helping companies sell stock.

• Research (The Truth Teller): Analysts are supposed to give honest, unbiased opinions on those same companies.

The Conflict: To win the "big money" underwriting deals, banks are tempted to publish overly positive research on a company, even if that company is performing poorly

What is "Spinning" in Investment Banking

when a bank allocated under-priced shares of a new stock (IPO) to executives of another company in exchange for that company’s future business

• creates bias in the market

Why do Auditing firms face conflicts of interest regarding Consulting

Auditors may skew their judgment or provide overly favorable audits to secure or keep high-paying consulting contracts from the same client

What are Economies of Scope, and how do they lead to Conflicts of Interest

Economies of Scope: Providing multiple services (e.g., auditing + consulting) at a lower cost because they share the same information

• the conflict: one service’s goals may contradict another’s, creating an incentive to provide misleading information, which reduces market efficiency

What is Regulatory Arbitrage?

the government guarantees repayment to creditors of large, complex financial institutions to prevent a total market collapse

• increases moral hazard for big banks because they know they will be bailed out

Why is Indirect Finance (Banks) more common than Direct Finance (Stocks/Bonds)

because of transaction costs and asymmetric information

Why is Collateral so prevalent in debt contracts

it reduces the lender’s risk. if the borrower defaults, the lender takes the asset. it also aligns incentives; the borrower will work harder to keep their house or equipment

What is the "Contagion Effect" in bank panics

because of asymmetric information, depositors can’t tell a “good” bank from a “bad” bank. if one bank fails, people panic and withdraw money from all banks, crashing the whole system

Why does a Government Safety Net cause more Moral Hazard?

for depositors: they stop checking if their bank is being risky because they know their money is insured

for banks: they take bigger risks

what is a leverage ratio

The amount of Capital (the bank's own money) divided by its Total Assets. A high ratio means the bank has a big "cushion" to absorb losses before it goes bankrupt

what is prompt corrective action?

a rule that requires regulators to step in immediately when a bank’s capitol starts to drop, rather than waiting for the bank to actually go bust