Priciples of financial regulation - Appunti

Principles of Financial Regulation

Prof: Andrea Paolo Perrone

Exam: Oral test

What is the financial system and how does it work?

Modern economics in which we live are based on two main ideas:

• Specialization: Everybody specializes in producing something.
• Market Mechanism: We exchange stuffs to get what we need avoiding making everything we need.

Any economy is based on these two ideas. To get this mechanism, the exchange mechanism is essential.

(Example of growing your own coffee or buying it).

During an exchange, goods may have different values, that’s why we need money (cash, credit cards, ...), with them I can decide to buy whatever I want, money is a universal medium of exchange, therefore it works greatly. Money is essential to have exchanges and to have the market mechanism working and therefore modern economy working. Money is asymmetrically distributed; there are people who have more money and people who have less money. The distribution of money can be identified in the distinction between rich and poor. In economic terms this distribution is not important, from an economic perspective we can have people who have more money than they need and people that have less money than they need: deficit and surplus units.

Deficit units: Governments, firms

In the lifecycle of a firm, at the beginning of the business they have negative cash, revenues, and profits. Because of the expenses, you have less money than needed. They are spending units.

Governments make money through taxes; everybody works and pays taxes, and government makes money in this way. Government spends money on every kind of service given. One government can decide to spend more than what it receives through taxes. (South Arabia is not a deficit spending unit while Italy is). Because we do not want public services to be cut, government decide to spend more than what it has. Government cannot raise taxes because people get angry. So, Governments and firms are DSU.

Surplus units: Households

Typically, households save money, so they have more money than they need. The key idea is that if these money can move from households to firms and governments this is much better than the opposite. It is very wise that the surplus spending units give their money to firms and governments because deficit units are more specialized in making money useful than deficit units. SSUs DSUs → The virtuous cycle of the economic growth: having the money flowing to allow economy to develop and flow. A financial system which works is essential for development.

When we think about money flowing from SSUs to DSUs there is a key element which is time. Typically, we like more to have things now than tomorrow. If we want to keep the situation equal the lender needs something that will compensate the loss of money, the tool is the interest.

Intertemporal substitution rate

I can be indifferent to have something tomorrow than today if tomorrow they will be more, and the difference is made by this rate.

I = +π r Fisher’s equation:

• I Nominal interest rate.
• Inflation rate.π
• r Intertemporal substitution rate.

The r should be identified considering the utility function of the lender (how the lender is ok in giving money) and the credit risk (the risk that the borrower will not give the money back). The interest rate measures the intertemporal substitution rate and it is determined by two factors:

• Premium for giving up liquidity
• Measures and considers the credit risk.

Final point: The financial system

The financial system is the sum of institutions and instruments which allow the money to circulate and this circulation if money is essential for growth and development in an economy based on specialization.

The three obstacles

Theoretically money could flow smoothly from SSU to DSU, but three obstacles interfere with the circulation of money:

(1) Transaction costs

Transaction costs are the costs related to each human action. Transaction: any possible human action. People can take decisions based on transaction costs such as the cost of finding the counterparty, the SSU, for the DSU or negotiation costs e.g., legal costs.

(2) Asymmetry of information

One party knows more than the other and this is the key to fraud. Wirecard scandal is a perfect example of this situation: Wirecard wrote in the balance sheets that they had deposits of money in the far east in a bank that does not exist. The same thing happened in the case of Parmalat. “Cooking the books” is a typical fraud. The asymmetry of information leads to moral hazard. Moral hazard is also inefficient because it is a waste of resources, the victim of moral hazard wastes its money, moral hazard is not only immoral but also inefficient. Market of lemons. The buyer cannot distinguish between bad and good sellers. The buyer ends up offering an average price in case he is running in the bad seller. You do not know who the good seller is but you know what the probability is to buy a lemon. In this way good sellers have no reason to accept the average price so bad sellers win. This leads to adverse selection, so the virtuous process of selection leads to collapse.

Agency contracts

The principal gives a mandate to the agent to perform. In an agency contract the agent typically takes an action which affects the welfare of the principal, at the same time the agent has superior information about the performance of the mandate. The asymmetry of information can be overcome in some cases (example of the receipt when your secretary goes to buy you a sandwich).

Some examples of agency contracts:

• Professors are student’s agents and students are principals.
• Manager is an agent of the shareholders of the company.

In an agency relationship one could think to a way of managing the contract. In the example of professor and students, students can double check the information given to them by the professor during lessons. The cost of this is the time needed to double check the information. Monitoring (double checking) is a cost implied in the agency situation. The professor could also send signals of not being a cheater showing evidence, but also this implies costs called bonding costs. In some cases, monitoring and bonding costs let the agency contract to break up. In human life in general there is a shortcut to overcome these problems, and it is trust.

(3) Diversity in preferences

• DSUs want exactly the opposite of what SSUs want.
• SSUs’ preferences: Low risk. Short term restitution of the money.
• DSUs’ preferences: High risk. Long term restitution of the money.

How does the financial system manage the three obstacles?

Banks are the institutions that allow overcoming the three obstacles.

What is the job of a bank?

• Collecting money from SSUs Deposits.
• Lending money to DSUs Loans.

Banks collect deposits to make loans (this is an oversimplification useful for now). This approach allows to overcome transaction costs, more specifically the cost of negotiation, through economy of large scale. Banks have a banner saying “Bank” because they need to let people know that they will intermediate helping to save time. The presence of an intermediary allows people to meet at the same place more or less virtual saving a lot of transaction costs. Presenting themselves as bank they allow to save costs of counterparty research. A bank collects deposits and makes loans, in doing so it is a central counterparty, this means that the bank takes a position with the deposit maker and another position with the loan taker. The bank split the relationship between the parties in two contracts, this is a strong intermediation.

• Debtor of the depositor.
• Creditor of the money taker.

Therefore, the deposit maker who suffer the position of less information does not care about where its money goes because it’s a bank problem. Banking cancels the problem of asymmetry of information for the SSU, it is the better counterparty ever.

Does bank suffer for asymmetry of information with respect to the loan taker? Yes, it does but asks a plenty of information because it is much better suited than the depositor to find and manage information in a wise way. The bank is much better in managing asymmetry of information through the use of economy of scale. The bank sees a large number of borrowers, therefore is very experienced and this allows to overcome adverse selection from the SSU point of view and moral hazard from the DSU point of view. Bank can be cheated much less than a typical SSU. Banking is said to transform risks and maturity, transforming short term low risk preferences of SSUs into long term high risk preference of DSUs.

How does this magic work? The bank satisfies this preference because it is the best payer or debtor ever, it is low risk. Typically, deposits can be asked back at any time, at the same time a loan is typically long term. Banks take money from the deposit and gives it to loan takers for long term, but they have an obligation to give money back at any time. How does it manage this situation? Because for the law of great numbers, banks assume that depositors will not go and ask for the money back all together at the same time. Once taken this decision banks become structurally unstable in case of bank run. That is why the law steps in and asks for reserves and other things from banks. Banks have a second source for financing represented by the Central Banks.

On the side of SSUs banks can ask money to make loans to another entity called Central Bank. The Central Bank has a feature that other banks do not have; it is a lender of last resort. The bank has an account at the Central Bank that can be accredited by making a loan.

The balance sheet of banks is structurally unbalanced. The bank is a DSU for the SSU and it pays an interest rate to the SSU. The Interest Rate depends on: Reliability and Intertemporal Substitution Rate. The bank is very low risk and very short term so it has the lowest possible interest rate. Bank now offer high interest rates because of the inflation so that the real interest is equal to 0. Normally the interest rate paid by banks to depositors are near to 0. Banks make loans to DSUs based on the credit worthiness of the borrower. Form the difference between the interest rate paid and the interest rate received the bank obtain the intermediation margin. Intermediation margin is the remuneration for:

• Managing transaction cost.
• Managing asymmetry of information.
• Managing diversity in preferences.

An alternative to banking could be abandoning the model of strong intermediation and assessing a world in which SSUs and DSUs cooperate. SSUs may get rid of banks keeping in mind that the three problems will comeback. This alternative is represented by Capital Markets. In Capital Markets there is only one contract, one single loan between the parties. We could imagine a world where banks as central counterparties do not exist any longer but SSUs and DSUs need to find a way to manage the three problems. The solution is represented by capital markets.

How can we manage the transaction cost? Look for another intermediate, which typically is a bank but with a completely different job than the one seen before. In capital markets bank simply facilitate SSUs and DSUs meeting, acting as eBay. In this case the intermediate is not a central counterparty, in this case we talk about weak intermediation. We are no more talking about depositors and loan takers but about investors and issuers. This form of banking is called investment banking such as Intesa San Paolo. There is also a different form of intermediation in Capital Markets which is asset management such as Black Rock and Azimuth. In this way we go to ask SSUs for their money and use them to fund DSUs by diversification. With diversification of risk the impact of risk is lower. Like banks collect money form investors and like banks invest this money but, in this case, only investors suffer a loss and not the asset manager. Intermediation reduces all the costs reduced by banks:

• Banking: Taking deposits and making loans.
• Investing activity: Putting in contact investors and issuers.
• Asset management: Collecting money and investing them creating diversified portfolios.

Until now we have seen how to manage transaction costs

Problems of asymmetry of information and difference in preferences need to be analyzed. How can we manage Asymmetry of Information? DCUs may cheat on money suppliers using their superiority of information. Because asymmetry of information exists SSUs may be unable to distinguish between good DCUs and bad ones. Asymmetry of information leads to Moral Hazard. Regulation is the tool to fill the gap of information and overcome Moral Hazard.

How about the Adverse Selection problem?

A credible and informed third party could help solving this problem. (Example of letter of references from professors for Harvard’s applicants). In capital markets there are a number of companies who play this role.

Reputational Intermediation: The third party lends its reputation and by doing that the investor will trust the third party and because of this will trust the money asker.

How can we manage diversity in preferences?

Recap:

• DSUs want exactly the opposite of what SSUs want.
• SSUs’ preferences: Low risk. Short term restitution of the money.
• DSUs’ preferences: High risk. Long term restitution of the money.

Diversification could be the answer to the problem. Why? If I put my money with a plenty of companies some will perform good and other bad but my return has more chance to be positive. This happens because of correlation. Invest in different issuers not correlated to each other. Mutual funds are large boxes where large amount of money are put into and these boxes invest in diversified portfolios so that the overall investment is less risky. Diversification helps managing differences in preferences for what concerns risk.

How about for the diversity in preferences for what concern time? The claim for money can be sold for a certain amount of money which will be lower than claimed. This is how the secondary market works. Selling claims on the secondary market is really complicated because of credit risk and asymmetry of information. Selling a claim, I am not selling a tangible asset but a right, a legal idea. To demonstrate that I have a right there is a contract. To allow a secondary market there is the idea of transforming a right into a tangible thing: security. These are pieces of paper which incorporate a right. The circulation of rights in the secondary market is much easier this way. Bonds, stocks and shares are a clear example of this. After the incorporation how do we find a counterparty? If I want to buy good fish at a reasonable price for Christmas I go to the fresh market. The market is a place both physical or virtual where it is possible to find at a certain time all those who want to buy and sell the same security. The easier is to sell something on the secondary market and it is easier to enter and exit in the and from the market, the more the market is liquid, the more I am willing to invest in the long time.

Capital markets

Capital markets deal with the problem of diversity in preferences through diversification and liquid secondary markets. Capital markets are the second possibility to overcome the problem of circulation of money (the first way is banking) due to transaction costs, asymmetry of information and difference in preferences.

Fintech

In the past 10 years new players popped outperforming the very same function of banking in the capital markets but using a different form. Crowd funding, peer to peer lending. These are online platforms and they are a very powerful way to manage transaction costs. The project is made through the crowd, it is a very democratic way of doing the business. Obviously, there is a problem of Asymmetry of Information but the company could be the credible and informed third party. Fintech are ways to manage transaction cost or asymmetry of information using different tools form the traditional ones but to reach the same objectives. To manage Asymmetry of Information they use big data. Big data Whatever you do on the net you leave a stream of data behind and there is someone who collects the data and sells it. The function that fintech is performing is the same, the tool is different and very powerful.

Financial systems

There are financial systems where banks play a marginal role and other countries in which bank play a major role. Is there a better system?

Why do we have countries where banks are central and essentials and other where capital markets are prominent?

• For historical reasons.

From populist perspectives banks are bad for humanity (rich vs poor). Strong Managers Weak Owners: In America populist movement involved people as well as states, which decided to lower banks power. In Chicago banks cannot build branches around the city, so there is a skyscraper in which they operate. We had this political and legal orientation against banks limiting the scope of bank activities and creating a gap filled by capital markets.

• It is also a cultural factor

Germany, as Italy, is strongly bank oriented.

• Economic reasons

Money is needed to build up an infrastructure like the one of the railways in America. A huge amount of capital was needed and capital markets were a good source.

Can we say that one system is better than another?

The judgment is relative, it depends on the situations. When and Why?

Why banks perform better in some situations and capital markets do the same in different situations?

Banks are a clear example when considering...