sciaga 1

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 Asianeconomies

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 features of the market were not stress tested for downturns

New asset backed securities hid risk rather than shared orreduced 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

The Structure of the Financial System

Indirect FinanceFinancial Intermediaries

Banks and other monetary institutionsInsurance companies and pension

fundsOther financial intermediaries

34

1. Companies2. Government3. Households

Money spenders

Direct Finance

Money savers

1. Households2. Companies3. Government4. Central Bank

Financial MarketsMoney MarketsDebt Markets

Equities Markets

The lenders may supply funds either by Financial Markets or Financial Intermediaries.

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 Market3. 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- 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

Debt Instruments - Money Market Instruments

Treasury bills

Certificates of deposit

Commercial Paper

Bankers Acceptances Bankers Acceptances

Eurodollars

Repurchase Agreements (RPs) and Reverse RPs

Federal Funds

LIBOR

39

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

Coupon Bond

Using the same strategy used for the fixed-payment loan:P = price of coupon bond

C = yearly coupon payment

43

2 3

F = face value of the bond = years to maturity date

C C C C FP = . . . +1+ (1+ ) (1+ ) (1+ ) (1n

n

i i i i+ + + +

+ )ni

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 tomaturity equals the coupon rate

The price of a coupon bond and the yield to maturity are negativelyrelated

The yield to maturity is greater than the coupon rate when the bondprice is below its face value

44

Consol or Perpetuity

A bond with no maturity date that does not repay principal butpays fixed coupon payments forever

consol theof price/

=

=

c

c

PiCP

45

consol theofmaturity toyieldpaymentinterest yearly

consol theof price

=

=

=

c

c

iCP

cc PCi /: thisasequation above rewritecan =

For coupon bonds, this equation gives the current yield, an easy to calculate approximation to the yield to maturity

Discount Bond

For any one year discount bond

i = F - PP

F = Face value of the discount bond

46

P = current price of the discount bondThe 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.

Rate of Return

The payments to the owner plus the change in valueexpressed as a fraction of the purchase price

RET = CP

t

+ P

t +1 - PtP

t

RET = return from holding the bond from time t to time t + 1

47

RET = return from holding the bond from time t to time t + 1P

t = price of bond at time t

Pt +1 = price of the bond at time t + 1

C = coupon payment

CP

t

= current yield = ic

Pt +1 - Pt

Pt

= rate of capital gain = g

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

48

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

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

can be negative if interest rates rise

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.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

maturity matches the holding period

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%?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- 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

55

A share of stock is a claim on the earnings and assets of

the corporation

Capital Market - Equity

Common stock

- Residual claim

- Limited liability

Preferred stock Preferred stock

- Fixed dividends - limited

- Priority over common

- Tax treatment

56

One-Period Valuation Model

1 10

0

(1 ) (1 )= the current price of the stock

e e

Div PPk k

P

= ++ +

57

0

1

1

= the current price of the stock = the dividend paid at the end of year 1

= the required return on investment in equity = the sale price of the stock at the end of the

e

PDiv

kP first period

Generalized Dividend - Valuation Model

1 20 1 2

The value of stock today is the present value of all future cash flows

...(1 ) (1 ) (1 ) (1 )If is far in the future, it will not affect

n n

n n

e e e e

D PD DPk k k k

P P

= + + + ++ + + +

58

0

01

If is far in the future, it will not affect

(1 )The price of the

n

tt

t e

P PDPk

=

=

+

stock is determined only by the present value ofthe future dividend stream

Gordon Growth Model

P0 =D0 (1+ g)(k

e g) =

D1(k

e g)

D0 = the most recent dividend paid

60

D0 = the most recent dividend paidg = the expected constant growth rate in dividendsk

e = the required return on an investment in equity

Dividends are assumed to continue growing at a constant rate foreverThe growth rate is assumed to be less than the required return on equity

Rate of Return

The payments to the owner plus the change in valueexpressed as a fraction of the purchase price

RET = CP

t

+ P

t +1 - PtP

t

RET = return from holding the bond from time t to time t + 1

61

Pt = price of bond at time t

Pt +1 = price of the bond at time t + 1

C = coupon payment

CP

t

= current yield = ic

Pt +1 - Pt

Pt

= rate of capital gain = g

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 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

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

65

The foreign exchange rate is the price of one currency in terms

of another currency

The foreign exchange market determines the foreign exchange

rate

Over-the counter market

Dealers at different locations who have an inventory of securities standready to buy and sell securities over the counter to anyone whocomes to them and is willing to accept their prices

Because over-the-counter dealers are in computer contact and know

66

Because over-the-counter dealers are in computer contact and knowthe prices set by one another the OTC market is very competitive andnot very different from a market with an organized exchange

Many common stocks are traded OTC but a majority of the largestcorporations have their shares traded at organized stock exchangessuch as New York Stock Exchange

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

67

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)


Indirect Finance

Financial IntermediariesBanks and other monetary institutions

Insurance companies and pension funds

Other financial intermediaries

68


Money spenders

Direct Finance

Money savers



Equities Markets


Financial Intermediaries

Financial intermediaries are financial institutions through which savers candirectly provide funds to the borrowers. The word intermediary reflects the role ofthese institutions in standing between savers and borrowers.

Generally one distinguishes two types of financial intermediaries: banks andnon-bank financial intermediaries. The latter can be divided into formal andinformal.

The non-financial intermediaries include: 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

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: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 newcompany can undertake one of the following projects (or pursue one of the following strategies), which arecharacterised by uncertain pay-offs in the two (equally likely) states of the world after one year.

States 1 2 Total value

Probabilities 0,5 0,5

Investment 1 80,000 180,000 130,000

Investment 2 200,000 40,000 120,000

Both projects require an investment of 90,000 EUR in t=0. To keep things simple, assume that all people are riskBoth projects require an investment of 90,000 EUR in t=0. To keep things simple, assume that all people are riskneutral and the risk-free interest rate is 0. The problem here is that of assymetrical information and incentives tohurt the other party. Potential providers of capital cannot observe and therefore not enforce by legal meanswhich project the enterprenuer finally implements. But they are clevel enough to understand that they areexposed to the danger of moral hazard.

a) Which project should/would the enterprenuer undertake if he were to provide all of the require funding byherself 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. Theenterprenuer does not have any money. Which repayment would a bank request to receive (and thus at thesame 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 herinvestment 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 Relationships4. 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 productiveinvestment opportunities

Example:

Say you have 5,000 you would like to invest, and you think about investing in the stockSay you have 5,000 you would like to invest, and you think about investing in the stockmarket. Because you have only 5,000 you can buy only a small number of shares. Thestockbroker tells you that your purchase is so small that the brokerage commission forbuying the stock you picked will be large percentage of the purchase price of shares. Ifinstead you decide to buy a bond, the problem is even worse. Indeed, the broker maynot be interested in your business at all, because the small size of your account doesnot make spending time on it worthwhile. You are disappointed and realize that youwill 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 byhigh transaction costs. This is a fact of life of many of us: only around on-half ofAmerican 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 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 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

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-cardealers

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 interest2. Managers act in own rather than stockholders interest

Tools to Help Solve the Principal-Agent Problem

1. Monitoring: production of information

2. Government regulation to increase information

3. Financial intermediation

4. 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 itsidea 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)3. government credit (directs)

4. financial institutions (not nationalized)

5. adequate government regulation

85

Financial Sector and Financial

System System

the difference?

86


Indirect Finance

Financial IntermediariesBanks and other monetary institutions

Insurance companies and pension funds

Other financial intermediaries

87


Money spenders

Direct Finance

Money savers



Equities Markets


and to meaningful definitions and distinctions

The Financial Sector

Encompasses the totality of institutions which specialize in providing financialservices to the non-financial sector units in the economy - i.e. banks, NBFIs,organised markets; and the relevant regulating and supervising bodies - and theirrules, structure and behaviour.

The Financial System The Financial System

Encompasses the demand for, and the supply of, financial services, and thus, ofcourse also the "professional providers", i.e. the financial sector, and the interplaybetween 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 includesthe extent to which the financial sector does not meet the demand of the non-financial sector units and forces them to self-finance, self-invest and self-insure.

88

Financial systems are commonly classified

as being bank- based or capital market- based

Capital-based financial system

Capital markets are main sources of financing for firms and serve households

Bank leding is restricted in terms of volume and maturities

Bank-client relationships is rather at

Bank-based financial system

Banks play the dominant role

Banks are the main providers of financing for firms

Banks are the most important deposit takers

93

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 protec-tion is very important

Control of management through market forces -market for corporate control

Corporate governance is shareholder oriented

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 entirefinancial sector

Corporate governance regime isstakeholder-orientated

Stock markets unimportant

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

Financial SystemsCapital-based

Financial Systems

?

94

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

?

The possible convergence of financial systems either

towards a middle groundor to the Anglo-Saxon

model is a highly controversial topic

Germany U.S.

95

Bank-based

Financial Systems

Japan

France

U.K.

Capital-based

Financial Systems

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).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 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): 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: Resource Allocator

Potential Investors

Fund Providers Investment Proposals

Resource Deprivation

Financial sector and resource allocation

99

Production

LandLaborEquipment

Investment FailureBad loan

Resource Acquisition/Allocation

Inefficient Allocation

Efficient Allocation

Case approved

Deprivation

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

100

- resolving competing claims on wealth generated

Channels to Growth- capital accumulation, physical and human- technological innovation

GROWTH

Finance promotes growth - Theory

That

is to say that countries whose financial systems

101

is to say that countries whose financial systems

perform their functions better, grow faster.

The "quality" - or the state of development of the financial

system/sector matters for the growth and development of a country

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

Empirical debate

102

Positive real interest rateModerately negative real interest rates (0 to 5%)Strongly negative real interest rates (less than 5%)

Positive real interest rateModerately negative real interest rates (0 to 5%)Strongly negative real interest rates (less than 5%)

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

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 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

Inequality declines as finance develops

oe

ffici

en

t |

104Residuals Fitted

Values

e(Private Credit | X)

e(G

row

th in

G

ini C

oe

X)

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 tolenders 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 canbe most profitably invested.

(c) how effective is corporate governance implemented?(c) how effective is corporate governance implemented?

(d) how financial sytstem evolves over time and the role of law and politics indetermining it.

Financial Stability what is the relationship between the struture of the financial system and thebanking 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 byneoclassical theories based on perfect capital markets. Institutions do not matter!

(b) credit view with the imperfect capital markets, the effects of monetary policytransmission depends on access to finance. How finance is obtained by firms,houeseholds, and governments depends on the financial structure.

105

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