Principles of financial regulation - Appunti completi (ENG)

Principles of financial regulation – lecture notes

How did we start this day? With a coffee, of course from a bar or a machine. Why don’t people get the

coffee by growing coffee seeds? Because it’s quicker and we can spend time for something else. There is an

inconvenient, if we go to the coffee shop we save time but we spend money. When we want to save time,

we go to a place highly specialized in that activity (instead of going to the grocery store and making by

ourselves). There is an exchange, it’s the market mechanism. We live in a world where people specialize in

something and go through the market mechanism. This is more efficient than doing everything by

ourselves. So the key point is product specialization and market mechanism.

Money and unequally distribution

Can the professor exchange his lessons for the coffee? No, while the fisherman and the butcher can do this

because it’s possible to compare the two goods. How many cups of coffee is a law lesson? We don’t know

it, therefore we need something to solve the problems of measurement and proportions. This tool is

money. Money is important for a specific reason: not only because it allows measurement but because it’s

a medium of exchange (everyone likes money and accepts it). The market mechanism needs money:

• Product specialization;

• Market mechanism: needs money to measure and as a medium of exchange.

Money is not equally distributed. People with more money are the rich and people with less money are the

poor. To our discussion we will focus on this distinction but not in terms of rich and poor:

• There are people that institutionally have more money: households/consumers/us because of

savings. We will call these people surplus spending units (SSUs);

• There are people that institutionally have less money (than what they need): like the firms. We

will call these people deficit spending units (DSUs).

This is the cycle of a firm. It starts making less money

(negative cash) so they spend money without getting

them back. Then the business grows and you start

earning money. Firms are deficit spending units

(DSUs). Consumers are surplus spending units (SSUs).

Another important subject is government, which is

typically on the debt side but it has an advantage: the

capacity of raising taxes. Why they still are DSUs?

Because they spend money, so should they raise

more taxes? No, because people start to get angry

and the government cannot work (or be re-elected).

The role of the financial system

We need households to flow to the firms so we need money to flow from SSUs to DSUs. The financial

system is all about this (cashflows). This flow is super important. Why a SSU should give money to a DSU

instead of putting them under a mattress? Firms knows much better how to use the money because they

are more specialized (important) and, moreover, they enter into more market mechanisms/exchanges with

someone else. This is a virtuous cycle: the more people exchange, the more money grows and the more the

economy develops. This flowing of money from SSUs to DSUs is crucial to the development (otherwise we

have an economic disaster). If we have excess money, it definitely makes sense to exchange to someone

that can use them better than us (remember the parable of the talents).

How does the flow works

The SSU is entitled to ask more money than what he lent. We can accept to lend some money today to

someone, but only if the borrower pays us a certain price tomorrow, which compensates the utility loss

associated with giving up that money today and getting them back tomorrow. This is because money has

more worth today than tomorrow therefore the gap is filled by interests (utility of the DSUs and

opportunity cost of the SSUs). The Fischer equation is:

=+

A euro today is better than a euro tomorrow. If we want to equate these two euros, we need something

more than 1 euro that makes it equal and the longer the time, the higher the quantity. This is called

intertemporal substitution rate. The interest rate makes equal two things in different moments of time so

it’s an ISR and it depends on inflation and the real interest rate. The real interest rate is built on two things:

1. Timing of the restitution of the money: utility function enjoyed by the borrower and the

opportunity cost of the lender;

2. The borrower may not repay the loan: counterparty risk or credit risk.

The higher the credit risk, the longer the time, the higher the real interest rate (ISR). The financial system,

at the end, is the sum of institutions, instruments, players whose overall goal is to flow money from SSUs to

DSUs. The financial system is super important (think at the 2008 crisis).

The obstacles to the circulation of money and transaction costs (Ronald Coase)

The second step are the obstacles to the transfer of money which, if don’t fixed, ruin the functioning of the

system. There are three obstacles. The first one is related to transaction costs. These are what we pay to

execute transactions (not commissions). A transaction cost is the cost of every human act. Coming to

university from outside (instead of living nearby) imply a cost (the second one can sleep more). They are

like friction in physics. In the financial system they play a central role. A startupper that needs money (DSU)

will ask for a loan from private investors (not banks) like friends, family, etc. but they find it difficult so it’s

difficult to find SSUs. It takes a lot of time to raise that money. This is a transaction cost, the cost to find a

counterparty. After that, we need to negotiate with that counterparty (like the agreement on the interest

rate) so we have another transaction cost. Then we need a lawyer so another transaction cost. They can

hinder the flow of money (benefit) so even a good transaction can be hindered by transaction costs.

Asymmetry of information

Someone knows more than someone else. This situation is problematic in economic terms.

1

Moral hazard (opportunistic behaviour)

You go buying clothes and you find Armani at 10 euros so it’s fake. The seller knows that the clothes are

fake and sells them to the buyer that doesn’t know it. The seller knows more, the buyer knows less. The

seller tells a lie to make money but for the buyer the money are not well allocated. In normal term this is a

fraud. Every fraud is based on the asymmetry of information (the liar exploits it to get benefit). Moral

hazard is not efficient (also for the seller/cheater) because people start recognizing the liar so the business

will collapse (investment banker example). Moral hazard leads to inefficient allocation of resources. In this

class there is asymmetry of information: we know less than professor (which is in an important position

that impacts our welfare). If professor tells lies to us, he exploits its superior information but we don’t

allocate well money.

1 “Hazard” refers to taking risks. “Moral” can either refer to the implication of an immoral behaviour (like

fraud, cheating, etc.) or simply mean “subjective”.

Adverse selection

This comes from the paper of Akerlof: “The market for lemons”. Suppose I am looking for a second-hand

Volkswagen Golf made in 2015 with 60,000 km. This type of car has a value of €20k. Now suppose there are

two sellers of that model of car with those features:

1. One good seller (not a cheater): that asks for €20k;

2. One bad seller (a cheater): that asks for the very same price, but he sells a lemon (he manipulated

the counter so that it indicates 60,000 km despite an effective amount of 100,000 km).

Because of asymmetry of information, the buyer cannot distinguish between the good sellers from the bad

sellers. As a result, he will offer to all the sellers the expected value of the car, which is the offer price

discounted by the probability of buying a lemon. Ex. if the probability of buying a lemon is 20% you offer

16k instead of 20k. The final outcome of this is that the good sellers have no reason to accept 16k for their

car that is worth 20k, and therefore only the bad sellers will remain in the market.

Real life example

Why do we prefer to go to the people that we know to ask for the money that we need, rather than going

to a perfect stranger? Because we are implicitly trying to reduce the asymmetry of information as much as

possible to get the money that we need. Indeed, the greater the asymmetry of information the greater the

risks of moral hazard and adverse selection.

Financial example of adverse selection

A depiction of asymmetry of information in the finance world is the under-pricing phenomenon in the IPOs.

The market tends to discount the price of the IPOs because it may not be that able to identify the good

companies from the bad ones. The average discount is measured using the returns in the first day of

trading, and it varies between countries. However, it tends to be positive basically everywhere.

Connection with DSUs and SSUs

DSUs have more information (agent) than SSUs (principal) so they can cheat on SSUs. On the side of the

DSUs, it allows the possibility of moral hazard (he has more information). On the side of SSUs, it allows the

possibility of adverse selection (they can’t distinguish between good and bad projects). In both cases, the

flow of money can be hindered. Therefore, we need to manage the problem of asymmetrical information.

Agency contract and agency problem

A third implication of the asymmetry of information is given by the agency problems. There is a contract in

law, the agency contract where there is someone who asks someone else to do something (to give a

mandate). Who asks is the principal, who executes is the agent. In this contract the agent has always more

information (like the price of a sandwich which is known only to him) and he can exploit this superior

information impacting the welfare of P. An agency problem arises every time there is an agency contract.

On the agent side, it’s a moral hazard. This situation is not cheap and we face two types of agency costs:

1. Monitoring: the solution is to monitor the agent (if the principal suspects a cheat) but this is costly;

2. Bonding: the agent can get mad so he tries to give a guarantee (a bond) and also this is expensive.

When the agency costs (the sum of monitoring costs and bonding costs) are larger than the benefits of the

relationship, it is likely that the relationship will be broken off. Imagine a listed company (like Stellantis),

managers/directors are the agent and investors/shareholders are the principal. The agents can make a lot

of money despite of shareholders but principal is not stupid and can go to a proxy advisor for example (very

costly). Managers don’t like to be monitored by proxy advisors. There are a bunch of ways through which

this problem can be managed in a less expensive way and making the relationship to work.

A shortcut to the agency problems

There is actually a shortcut to overcome these agency problems. The trust between the agent and the

principal is the key element. In the professor example, we don’t monitor the professor and he is not

bonding because of trust. Trust is essential for the economy in general and the financial system.

Another example of agency problem: the Wirecard scandal

Another example of agency problem is the Wirecard scandal (cooking the books). Wirecard falsified their

balance sheet together with a famous auditing firm (EY) by writing that they had deposits with a bank in the

far-East, which simply did not exist. Basically, they invented some figures to appear financially sound. The

principals were those who put money in the company and the managers had more information. The

Financial Times did the monitoring and the investors lost money.

Differences in preferences

The third obstacle in the relationship between DSUs and SSUs is the so-called diversity in preferences (for

what concern time and risk). DSUs want exactly the opposite of what SSUs want:

• SSUs have a preference for low-risk use of the money and short-term use of the money;

• DSUs have the exact opposite preference: long-term and high-risk use of the money.

So, also for this reason the interaction between DSUs and SSUs is very complicated.

How the financial system deal with the obstacles to the flow of money

The solution to these three problems is banking. Banking is the proper institution who allows to overcome

transaction costs, asymmetry of information and differences in preferences allowing the money flow

through economy. The job of a bank is basically to collect money from the SSUs and to lend these money to

the DSUs. The money collected from the SSUs are called deposits. The money lent to the DSUs are called

loans. Therefore, we can say that banks collect deposits to make loans. Why this process allows to manage

the transaction costs?

• Intermediation (like eBay): what about the problem of searching a counterparty? Even this

problem can be solved by a bank because it works like a real estate agency or any other

intermediary because the bank puts itself as an intermediary: it collects both the demand side and

supply side so that loan takers and deposit makers have a place to meet. This dramatically

decreases the transaction costs for both parties;

• Economies of scale (any additional unit is cheaper and cheaper because they are specialized): the

bank opens thousands of deposits and makes thousands of loans and so the bank can take nice

lawyers to write standardized contracts to use several times. Therefore, the costs of negotiating

and writing the contracts dramatically decrease. The same goes also for the monitoring costs (how

the money are used).

However, we need to point out that a bank is not really like a common intermediary (as eBay) because it

acts as a central counterparty, and this is the key element to consider in order to understand why also the

problems related to the asymmetry of information can be overcome. The bank put himself in the middle

breaking the relationship between DSUs and SSUs creating 2 new relationships (and it’s the counterparty of

both). We can call this activity as “strong intermediation”. Through strong intermediation, banks cancel the

problems related to asymmetry of information for the deposit makers. The deposit makers are happy to

have the bank as the debtor because typically banks are (or used to be) the best debtors ever, and

therefore they do not care about where their money goes. This cancels adverse selection for SSUs.

Asymmetry of information on the side of the loan takers

What about the asymmetry of information on the side of the loan takers? The bank does suffer this

asymmetry because the loan takers have still superior information. However, the point is that banks are

much better suited than the common SSUs to overcome the asymmetry of information vis a vis the loan

takers. Once again, this greater ability of banks in managing asymmetry of information has to do with the

economies of scale. A bank sees a large number of borrowers and therefore is very experienced in

analysing their creditworthiness. This implies that, once you have seen thousands of borrowers, the cost of

analysing another borrower is very low. This cancels adverse selection for banks but also moral hazard

because they use their expertise and monitoring capacity so they can be cheated less than deposit makers.

The last obstacle to be managed by banks

Then there is the last obstacle that must be managed, which is the diversity in preferences between SSUs

and DSUs. Here is where the so-called magic of banking steps in. Indeed, banking is said to transform risks

and maturities. In particular, banks can transform short-term low-risk preferences (SSUs) into long-term

high-risk preferences (DSUs). A deposit of a bank is typically a low-risk security (almost risk-free) and super

short-term (you can ask the deposit back almost immediately). On the other hand, a loan is typically high-

risk (depending also on the creditworthiness of the loan taker) and long-term. So, a bank takes short-term

obligations, but has long-term claims. How can they manage this unbalance? Banks assume that the

thousands (or sometimes millions) of depositors will not ask for the money back altogether at the same

time. The magic of the law of large numbers ends when bank runs happen (ex. Northern rock). This is why

the law steps in very strongly to manage this problem, for example by requiring banks to keep some money

aside as reserves for bad times.

Alternative to banks: capital markets and direct relationship

SSUs lend money to the bank which pays a relatively small interest (the loan is short-term and low risk). The

bank then lends money to DSUs at a higher interest rate (high-risk and long-term). The difference is the

profit/margin of the bank (intermediation margin to do this job). Can we get rid of banks? Can the SSUs

have a direct relationship with the DSUs? Yes, we could but:

• SSUs will charge a higher interest rate to DSUs: like 3% instead of 1% received by the bank. This

happens because they take more risk and the maturity is longer;

• The DSUs can negotiate a lower interest paid: this approach is great also for them because we

exclude the margin of the bank.

Why 3%? Both parties have a save of 4% (margin of the bank) so they split this saving. This approach of

direct relationship is what happens in capital markets. In capital markets we get rid of the bank as a CCP.

Capital markets and brokers

Capital markets are the alternative to banking to have the money flowing but we should find alternative

solutions to the three problems. How do we manage transaction costs in capital markets? We could have a

broker that finds an investor but once again an intermediary is needed (although different because it’s not

a CCP because the broker only arranges a contract between the two parties, the bank enters into two

contracts). Remember that:

• In banking we have strong intermediation and CCP;

• The broker performs a weak intermediation and no CCP: he doesn’t take risks because the credit

risk of the DSUs is suffered by SSUs. A broker is like an investment bank which is still a bank but it

does not do any banking. Intermediaries performing banking are called banks (or commercial

banks), intermediary performing brokerage are called investment firms in law.

The asset managers

We have another intermediary in this story that channels the resources from SSUs to DSUs without being

banks. They’re asset managers wh