Financial regulation notes

Principles of financial regulation

Lecture 1 22-2-2017

Contemporary economics is based on:

• Specialization
• Exchange based on money

Surplus spending units (SSUs): people with more money than the money they need (households).

Deficit spending units (DSUs): people with less money than the money they need (firms and governments). Firms are structurally in deficit because they make investments. Governments are structurally in deficit because the needs of the people they run change and grow.

It’s crucial that money flows from SSUs to DSUs because if you invest money you make more money out of your money.

It’s important that firms and governments get your money because otherwise they can’t invest and if they don’t invest, we get less products, lower quality and they don’t need workers and don’t create jobs.

By definition, firms’ job is to use properly money to make investments.

Interest rate is based on:

• Rate of intertemporal substitution
• Inflation
• Credit risk

The money flow can be hindered by three big obstacles:

1. Transaction costs: the process with which I obtain funds is costly:

   1. Cost of finding a counterparty
   2. Cost of negotiating the contract
   3. Cost of legal writing
   4. Cost of monitoring

2. Asymmetric information: the distribution of information between two parties is not levelled. It’s dangerous because the party with superior information could be a cheater → possibility of moral hazard.

   Asymmetry in information is a source of moral hazard (= fraud). Moral hazard is economically inefficient and a waste of money because typically gambling has no positive effects.

   The idea that the counterparty could be a cheater generates a reaction discouraging the money flow: raising of interest rates and demand for a guarantee (→ adverse selection).

   “The market for lemons”: if you look at the prices of lemons, you can see that they have a very strange pattern. When you buy a new car, you don’t know whether it is a lemon or not, only the seller knows it.

   Adverse selection is a selection of bad: the good guy is out of the market.

   Signals can overcome the asymmetry in information problem.

   Trust is the most powerful tool to overcome asymmetry in information and adverse selection generated by asymmetry in information.

3. Differences in preferences: SSUs and DSUs have different preferences:

   • SSUs: low risk, short term
   • DSUs: high risk, long term

Lecture 2 23-2-2017

People with inferior information can be attempted by adverse selection.

Agency problems

Agency is a legal word: it is a contract under which a principal asks an agent to do something on his behalf.

Problems with agency: I don’t know the sandwich price; my secretary could tell me another price and make a profit.

Agency problems arise anytime someone (the agent) can do something which impacts the wealth of the principal for its own welfare.

Agency problems in big firms, like Mediaset, are between majority and minority shareholders.

Reaction of the principal who realizes that there is a problem:

• Monitoring: the principal doesn’t know if the agent is cheating so the principal monitors the agent → huge transaction costs.

The agent can provide the principal forms of signals to assure the other that he is not cheating (in legal English giving a guarantee is “bonding”).

There are bonding costs in both principal and agent side. When these costs are too high, the relationship expires.

Banks are created to solve the three problems (transaction costs, asymmetries of information and differences in preferences) because they are intermediators: “Deposit your money to me” at SSUs, “I lend you money” at DSUs through credit contracts. Basically, the job of a bank is borrowing money from the SSUs’ deposit and lending money to the DSUs through credit.

1. Transaction costs: as an intermediary, the bank collects money from the SSUs and gives money to the DSUs. Bank overcomes transaction costs by opening a branch where you find the label “bank” (e.g. Banca Intesa, Citibank). The bank always intermediates by saying “I’m here as a bank” and by presenting itself as an intermediary, automatically solves the big deal of transaction costs. This idea has to do with economies of scale: being a professional creates economies of scale. Banks overcome transaction costs by their professionalism, exploiting their economies of scale and therefore reducing to zero their transaction costs.

2. Asymmetries of information: once again, banks manage the asymmetries of information through their economies of scale. When I open a bank account, I sign a contract with the bank and the debtor is not the final user but the bank is. So, the SSUs will be paid back by banks. Banks are the most reliable debtors, they always pay your money back. Banks assume the position of central counterparty (→ strong intermediation) and solve the problems of asymmetries in information. By becoming a central counterparty, the bank also solves the problem with asymmetry in information: the bank borrows money short-term and at no risk because the bank always pays back and lends high risk long-term.

   The business of the bank is the difference between the interest charged to the DSUs and the interest paid by SSUs.

   Bank pays 1% to SSUs and the interest rate is so low because the deposit is short-term and no risk and it asks 5% interest rate to DSUs and makes a 4% profit as a compensation for their job as intermediary and solvers of the asymmetry in information problems and of transformers of term and risk. But this structure brings with it another problem: banks exactly because they act as banks, are structurally unstable, unbalanced. In fact, banks are bound under a contract to pay the money to SSUs when they want but they may get money from DSUs only when the term of the credit contract (e.g. loan) is expired. They borrow short-term and lend long-term. And if the borrowers ask for money back, banks may not have the liquidity to pay back them because the deadline of the loan is not expired yet.

   One may have a smart idea: “Look, let’s get rid of the bank and let’s talk directly and why don’t we agree on a 3% interest rate?”. If you get rid of the bank, you may share the profit between the two parties → capital market.

   Capital markets are the way through which DSUs and SSUs talk to each other instead to the bank. This idea has a problem: the bank solves the three problems that without the bank come back and so we have to find another way to solve these problems having got rid of the bank.

   How can DSUs find SSUs? By resorting to investment banks. Investment banks (e.g. Goldman Sachs, JP Morgan) are not actually banks, they have intermediaries in the sense they have to put together SSUs and DSUs. They don’t act like a CCP, they are simply intermediators and don’t become debtors (weak intermediation). Investment banks are not pure mediators but have some power over both the DSUs and the SSUs (e.g. I’m Mediaset and I want to start a business in the US in the entertainment field that is super regulated. I have to raise 1 billion dollars to launch my business there from SSUs. I ask Goldman Sachs to be the intermediator. What does Goldman Sachs do? They call important SSUs and ask for money, the guy on the other side of the phone couldn’t do anything but say yes because he’s speaking to an investment bank with a great reputation and power as a guarantee). Intermediation of investment banks uses relationships.

   So, transaction costs are managed through intermediaries.

   How on capital markets asymmetric information problems are solved?

   Law can be a solution. Law may impose in the DSUs to convey to SSUs the information they have and DSUs don’t disclose. Disclosure is a tool to avoid moral hazard.

   Rating agencies’ job is based on trust and on reputation. Investment banks lend their reputation to clients. Asymmetry in information problems are solved using the reputation of the intermediary. Reputation intermediation works well in case of repeated game players, as SSUs and DSUs capital market.

3. Difference in preferences: secondary market could be a solution. But there may be a problem of liquidity, because the secondary market has to be liquid: the more liquid the market, the more you can manage the problem of difference preferences. How can you make a market liquid? How can you find many buyers and sellers at the same time? You create a stock exchange. The stock exchange is the way in which you create the liquidity of secondary market overcoming the transaction costs otherwise involved.

   To overcome the differences in preferences in capital markets, you need a secondary market to get out investments before their termination and the way to do it is to have a secondary market which is liquid and a liquid secondary market is helped by creating market places where transaction costs are reduced to zero by identifying a place and a time where buyers and sellers get together. In this case, you get very liquid market. The highest the liquidity, the better capital markets work.

   Which is the way in which in capital markets you can manage the differences in preferences in risk? You can diversify your portfolio. Diversification is the other way in which in capital markets the differences in preferences are managed. There is a form under which diversification and transaction costs are put together: capital markets know well a kind of intermediary which puts together the intermediation and the differences in preferences, in particular the diversification: mutual funds. Asset managers are the other kind of intermediary in capital markets. The role of asset managers is both intermediation (they choose the SSUs or DSUs) and diversification (they invest mutual funds in different SSUs). This activity is called asset management, managers manage other people’s money.

Lecture 3 1-3-2017

Topics:

1. How concretely in capital markets money flows from SSUs to DSUs and bonds and shares → financial instruments or securities
2. Crowdfunding and peer-to-peer lending
3. Differences between banking and capital markets from the perspective of theoretical economy.

The main difference between being shareholder or being a lender is the right to get its money back.

The lender lends money to the borrower and the borrower has an obligation to pay money back with interest. On the other side, the lender has the right to get the money back from the borrower.

The risk which the lender faces is not to get the money back which means that the borrower doesn’t pay the money back. But why should the borrower not pay the money back? Fraud because the debtor could be a crook. Normally, people tend to assume that other people are not crooks. So, for liquidity reasons or for the level of the interest rates, the main risk which the lender faces is the default of the borrower.

Share → part of the capital of the company. It gives you rights as a member of the company, a share of the company. Right of a shareholder given by the corporate contract:

• Voting rights in shareholders’ meeting, you vote to choose the managers of the company, to appoint/remove them, to approve the financials of the company, whether to distribute profit or not (→ deciding about dividends). You put your money into the company with an investment in shares and you don’t have the right to ask your money back: you don’t lend money to the company.
• If you take decisions which strongly impact the investment of the shareholders, you need the vote of the shareholders meeting.
• Right to get dividends.

So, when you become a shareholder, you have the right to participate to a shareholders’ meeting to take the main decisions regarding the company. Whereas, the day-by-day things are decided by the managers.

Reason to invest in shares: if the company is successful, you can sell your shares in the secondary market and you may get a price much higher than the money you invested, giving someone else the rights mentioned before, the “power” in the company.

The success of a company depends on managers’ behaviour, on their quality, and on external/exogenous factors (e.g. changes in policies, geopolitical reasons). So, you have risks not depending on the quality of the management.

When you have bonds or loan-based things, we have one risk: default risk. When you invest in shares, you have different rights, different risks and typically the investment is riskier and profitable.

Derivatives: contracts which derive their value from some underlying assets. From a legal point of view, they are risk-shifting instruments. When you agree about a derivative, you transfer the risk you have on someone else, like with insurances. If you want to speculate, you accept the risk that the former guy would like to transfer. The business of derivatives is a matter of risk-shifting. This definition helps to understand why the financial technology puts together bonds, shares, and derivatives (e.g. a convertible bond is a bond with embedded a put/call option inside, so it’s a hybrid between bonds and options). The reason why you create these hybrids is because you want to shift the risk.

Dis-intermediation: “let’s get rid of intermediation and let’s put the internet where the intermediaries used to stay”: no banks, no investment banks, they only stay on the internet (e.g. peer-to-peer lending and crowdfunding).

Peer-to-peer lending: practice of lending money to individuals or businesses through online services that match lenders directly with borrowers (e.g. Smartika). It is a form of reducing transaction costs. Problem: huge information asymmetry because the machine helps me and the lender getting together without transaction costs but at the same time we don’t know each other. So, there is a huge problem of moral hazard by my side and adverse selection by its side. This kind of platforms does something more than putting together people. Generally, it splits loans (e.g. A inputs $100.000 million on the platform and the platform doesn’t give all his money to the borrower but typically splits the money in $80 loans). This is a form of diversification. In case there is no payment, the platform says: “I will provide you with legal assistance to get your money back”, doesn’t guarantee the payment. This isn’t dis-intermediation at all, it’s a different form of intermediation → weak intermediary. P-2-P works much better than equity crowdfunding.

Crowdfunding: getting funds through the crowd. You put an idea on a platform and ask for money. People give money to get something back and because they share the idea. Types of crowdfunding:

• Equity crowdfunding: it doesn’t work. It is a nice idea in the terms of the philosophy behind it. It works bad in terms of raising money because is something hybrid with a donation. In fact, people in crowdfunding face a huge information asymmetry, they don’t know where money goes.
• Revenue crowdfunding: who gives money gets a product in exchange for its contribute.
• Reputational crowdfunding: is a different form of donation with something else.

Crowdfunding is like a donation.

Paper by Rajan – Zingales: if we look around the world, we find that there are countries where financial systems are built around banks (e.g. Italy, Germany, France): bank centric countries. There are other countries (e.g. U.S., U.K., Australia) where you find capital markets. The reasons for this difference are:

• Cultural: the financial system developed as they are because people think in a certain way. A lot of economic institutions are based on philosophy (e.g. quote from a German banker about capital markets: “Shareholders are stupid and impertinent. Stupid because they give their money to somebody else without effective control over what the person is doing with it and impertinent because they ask for a dividend as a reward for their stupidity”. Banks were thought as political and economic institution. So, banks should be put at the centre of financial systems.).
• Political: how in the U.S. the financial system moved to capital markets:

  In the late 19^th century there was a combination of two factors that played against banks: populistic failure of bankers “bankers are the bad guys” and the idea that banks were concentrated in New York: being pro banks meant being pro New York and giving to the State of New York a competitive advantage over all the other states and from a federal perspective no one wanted that. If you put together the populistic fear of bankers and this political idea, you explain why at the beginning of 20^th century the U.S. passed several legislations trying to reduce the impact of banks on the American economy. Therefore, there was a huge development of capital markets.

• Historical
• Economical

Could we say that one system is better than the other? Maybe not, maybe yes. One can say that a system based on capital market works much better than a system based on banks, or the opposite. In recent years, we had a very significant academic scholarship trying to make this point (paper from a Harvard professor).

To understand the difference between these two system, two categories should be introduced:

1. Relationship-based system (= bank-oriented systems) → close relationship between the lender and the borrower. Banks have a stable long-term relationship with clients.
2. Arm’s length systems (= capital markets-based systems) → in capital market you don’t care about the clients, it’s a short-term approach.

If you have a long stable relationship, you access information that other people don’t. The bank knows a lot of things about clients. To the opposite, the bank has insider information about the borrower. In arm’s length relationships, it’s the opposite. Nobody has specific information about the other. Typically, everybody knows