Principles of Financial Regulation

UNIT 1 - FINANCIAL SYSTEMS

What are financial systems? Systems that allow the transfer of money between savers

and borrowers.

Contemporary economics is based on:

a• Exchange based on money

b• Specialization

Money has 2 advantages:

- universal mean of exchange

- measure of value

We have two categories of agents:

Surplus spending units (SSUs)àpeople with more money than the money they need

(households, but also businesses and governments can find themselves in this kind of

situation)

Deficit spending units (DSUs)àpeople 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. Thanks to the financial system,

resources are allocated in a more efficient way—> savings are transformed into

growth and

investments—> finance is great in the sense that it is crucial for

development.

direct finance

In borrowers borrow funds directly from lenders in financial markets

by selling them securities (also called Financial Instruments) which are claims on the

borrower’s future income or assets.

interest rates

Through the two positions are made equivalent/balanced—>Which are

the criteria to determine an interest rate?

- time—> inter-temporal substitution rate: comparison between present and future

utility; the longer the time the greater the utility/disutility

- risk—> compensation

π+r

Fisher equation: i =

π=inflation

r=real interest rate

Interest rate is therefore determines by: -rate of inter temporal substitution; inflation;

credit risk.

The financial system carries out its function through 3 components:

- assets

financial (medium)

- institutions

financial (entities such as banks/intermediaries)

- markets

financial (where transfer takes place)

three obstacles:

The money flow can be hindered by big

1)Transaction costs: relationships between DSU and SSU are extremely costly (the

way funds are obtained). Categories:

-costs of finding a counterpart

-costs of negotiating the contract

-costs of legal writing

-costs of monitoring

These costs are important to investors because they are one of the key determinants of

net returns. They diminish returns, and over time, reduce the amount of capital

available to invest—> giving up the deal—> inefficiency (Coase theorem).

Moreover, human beings have a number of limitations—> we don’t do what we

cognitive limitations:

recognize we should do—> we are quite far from the rational

agent assumed by the economic theory, we go for suboptimal decisions.

Our imperfection is a transaction cost—> our bounded rationality affects the way we

deal with economic transaction.

Financial intermediaries can reduce transactions costs because they have developed

expertise in lowering them and because their large size allows them to take advantage

economies of scale,

of the reduction in transaction costs per dollar of transactions as

the size of the transactions increases.

2)Asymmetry of information: It concerns a conflict of interest in any relationship

where one party is expected to act in another’s best interest: because the two parties

have different interests and the agent has more information, the principal cannot

hazard)—

directly ensure that its agent is always acting in his best interests (moral

>uncertainty/ risk of the principal of being cheated.

MH in financial markets is the risk that the borrower might engage in activities that

are undesirable from the lender’s point of view, because they make it less likely that

the loan will be paid back. Because MH lowers the probability that the loan will be

repaid, lenders may decide that they would rather not make a loan.

There is asymmetry of information because the agent can hide something to the

principal

-

the principal can monitor the agent in the achievement of the task—> the cost is

quite high

-

the agent can bond or use a signal(but these are costly way too).

These costs can be so high that the relationship cannot work anymore

Trust is the simplest way to manage all these problems—> most precious good in

finance.

Example: DSUs is the agent and can affect SSUs’ wealth.

Shareholders are principals and mangers are agents (typical US corporation); the life

of a corporation is filled with agency problems and law can correct these

inefficiencies.

The manager is supposed to make decisions that will maximize shareholder wealth;

the manager's own best interest to maximize his own wealth. He can be motivated to

act in the shareholders' best interests through incentives such as:

- performance-based compensation

- direct influence by shareholders

- threat of being fired and the threat of a takeover

The idea that the counterparty could be a cheater generates a reaction discouraging

adverse

the money flow: raising of interest rates and demand for a guarantee —>

selection. This occurs before the transaction takes place. It occurs when the potential

borrowers who are the most likely to produce an undesirable (adverse) outcome (the

bad credit risk) are the ones who most actively seek out a loan and are thus most

likely to be selected. Because this makes it more likely that loans might be made to

bad credit risks, lenders may decide not to make any loans even though there are

good credit risks in the marketplace.

Successful and trustworthy Fin. Int. are better equipped than individuals to screen out

reducing

bad credit risks from good ones, thereby losses due to adverse selection. In

addition, they have developed expertise in monitoring the parties they lend to, thus

reducing losses due to moral hazard.

3) Differences in preferences. different preferences

SSUs and DSUs have in terms of

time and risk (short term-low risk vs long term-high risk)

DSUs have to wait until the end of the production cycle to make profits; since they

are entrepreneurs they are taking more risks

SSUs like low risk and short term

DSUs like high risk and long term.

We have to find a way to manage this mismatch, otherwise the money would not

flow.

Possible ways:

- banks

- capital markets

THE ROLE OF BANKS

Are created to solve the problems because they are intermediaries: basically, the job

of a bank is borrowing money from the SSUs’ deposit and lending money to the DSUs

through credit. savers:

SSUs are called they lend money to banks through deposits—> contracts

where the saver has a right to get his money back or the interests on the deposit

(liabilities for banks).

borrowers:

DSUs are called they receive money from banks through loans/mortgages.

Mortgage is much broader concept than loan: if the borrower doesn’t pay back the

money, the bank has the right to sell the collateral (house)—>it’s a guaranteed loan.

Mortgage requires a piece of real estate as a guarantee—> if you give as guarantee

pledge.

something different from real estate, it’s called

You can also give a bond as guarantee; in this case the bond is a promise to pay on

behalf of a different person.

of information:

-Asymmetry once again, banks manage the asymmetries of

economies of scale(because

information through their banks deal with many lenders

and many borrowers, the average cost for matching unit falls progressively). By

becoming a central counterparty, the bank solves the problem with asymmetry in

information: the bank borrows money short-term and at no risk because the bank

always pays back and lend high risk long- term. specialization:

Banks manage information asymmetries by their their expertise and

relationship-based approach allows banks to collect and elaborate information more

easily.

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.

But this structure brings with it another problem: banks /because they act as banks/

structurally unstable, unbalanced.

intermediaries) are 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. in preferences.

-Differences secondary market could be a solution. See capital

markets. implications

Two important with banks:

banks’ profit is based on the difference (in economic terms: spread) between the

-

interest paid on deposits and the interest received on loans (transaction costs problem)

-the asimmetry between deposits and loans brings about a structural risk of

instability; thus, mantaining reserves to satisfy the demand for deposits’ return is

crucial

THE ROLE OF CAPITAL MARKETS (Investment Banks)

They allow money to flow directly from SSUs to DSUs, thus:

- avoiding the cost of banking intermediation

- shifting credit risk on original lenders and requiring matching of preferences

If we imagine to get rid of the bank and rely on a direct agreement between the two

parties, they can save the interest charged on both sides by the bank; the problem is

that the three imperfections that make the market inefficient will come back again.

Crucial difference between commercial banks and investment banks operating in the

capital markets—> there isn’t a strong interposition between the two contractual

parties as commercial banks do, but it is only an intermediation that helps DSUs get

interposition).

in contact with SSUs (weak

Transaction costs are managed by the presence of financial intermediaries, which

arrange transactions more cheaply exploiting their economies of scale and

specializations.

Information asymmetries in capital markets are overcome in different ways:

- - Strategies related to third parties: financial intermediaries signal the quality of

reputation

relevant financial assets by pledging their (the brand matters because

participants have the possibility to trust it given past experiences and for the fact that

there is no reason for cheating).

Another strategy may involve the use of a third professional party whose

- agencies

judgement is reliable—>rating that operate in the market: show the level of

quality of financial assets and are trusted by everyone.

Regulation transparency

- increases and manages agency problems (in

disclosure.

particular when financial assets are risk capital)—>mandatory

Preferences asymmetries secondary markets,

are dealt with by the presence of

-

often regulated, which provide liquidity—> allowing diversification and

communicating information; it is a financial market in which securities that have been

previously issued can be resold (the primary markets for securities are not well known

to the public because the selling of securities to initial buyers often takes place behind

closed doors). A regulated market is a virtual place where it is possible to find

available counterparts for every transaction needed at lower transaction costs.

Liquidity is crucial and represents the level of quality of a secondary market because

it allows easy trading of bearing-rights instruments at low transaction costs. 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.

BANKS VS CAPITAL MARKETS

From both a theoretical and a historical perspective, financial system may be more

relationship-based systems)

bank-oriented/centered (in economic terms: or capital

arm’s length systems)

markets- oriented (in economic terms: —> trade-off.

A) Relationship-based systems

Key features:

a) direct long-term

Transactions are conducted on the basis of a and generally

relationship

Better forms of insurance:

- tends to smooth temporary shocks and the prospect of

future rents may induce a lender to interact and bail out possible financially distressed

borrowers. The opposite is true for systematic shocks.

reducing access to financing:

The cost is represented by a it is quite difficult to be

-

granted a loan because a long-lasting relationship is needed and it takes time and

many efforts.

b) private information.

The lender has

c) direct influence monopolistic power

Lender has on the borrower and in the

market ownership

- The simplest form of power is when the lender has (implicit or explicit)

of the firm. The lender can also serve as the sole or main lender, supplier, or customer.

In all of these forms, the financier typically attempts to secure her return on

investment by retaining some kind of monopoly over the firm she finances. As with

every monopoly, this requires some barriers to entry. These barriers may be due to

regulation, or to a lack of transparency - or "opacity" - of the system, which

substantially raises the costs of entry to potential competitors. Time is this barrier. It

takes time to establish a relationship.

price signals:

- Weaker role for In such a system financing will take place only when

competition is somehow restricted, and hence when prices tend to be not very

informative. For example, given that the lender has private information that nobody

does, there may be a possible distortion in the composition of prices (the lender could

exploit its position and increase interest rate so the way prices is formed is

conditioned by the power of the bank). The consequence could be a widespread and

costly misallocation of resources.

d) greater government intervention

There is a

A relationship-based system is naturally more prone to government direction because

it depends more heavily on the government to maintain the restrictions on

competition that enable it to work. Furthermore, in an opaque environment financial

intermediaries need some government supervision to be perceived as reliable. This

supervisory power, however, gives the government a powerful lever that can be used

to coerce these intermediaries into actions it deems desirable.

opacity

- The of the relationship-based system makes it easier for the Government to

intervene also because it is less visible and hides the real cost of this intervention.

Example: if the government wants to reduce expansion in a certain economy, it may

either directly increase taxes on consumption (unpopular move) or order banks to

raise the reserve requirements (banks would make fewer loans and as a result, people

would spend less slowing the growth). works well

Therefore we can conclude by saying that a relationship-based system

when markets and firms are smaller:

- that’s why in the US, which is mostly a

market-based system, there are more big enterprises while in Italy SMEs are more

widespread (better with small, homogeneous and closed economy/emerging markets)

legal protection is weaker:

- relationship financing is largely self-governing and self-

enforcing, requiring just the protection of the most basic property rights. Parties want

to maintain their reputation, so they tend to “honor” the spirit of the agreement (often

in the absence of any written contract) in order to ensure a steady flow of future

business within the same network of firms

little transparency innovation incremental,

- there is and is mostly rather than

revolutionary: if the technology is a minor modification of tried and tested

technologies, the payoffs from funding eventually successful technologies is likely to

be small in a market-based system, but here lenders have the ability to probe deeper

and screen out most of the likely failures.

B) Arm’s length systems

Key features:

a) There is no need for a strong and long-term relationship between lenders and

relationship).

borrowers (short-term

greater access to financing:

- there is a variety of potential lenders who are

willing to invest according to my needs where a long-term relationship is not needed

greater exposure to shocks:

- the cost is represented by a in an arm’s-length

system, competition eliminates future rents, destroying any incentive to pay for the

cost of a bailout. More importantly, such intervention cannot even be insured

contractually at a reasonable cost and unconditional insurance would create the

conditions for severe moral hazard. The opposite is true for systematic shocks.

b) no special information

Parties involved have about each other that is not already

available to the general public.

- The firm will be able to tap a wider circle of potential lenders because there

will be more widespread financial information about it. Thus, when information can

be easily diffused, competition to lend increases, and the benefits of an arm’s length

system also increase. In this sense, the advent of the Internet is playing a big role in

making arm’s length financing more attractive—> Liquidity.

c) Open competition among lenders.

- Stronger role for price signal: the more transactions that come into the market,

the more likely it is that decisions made on the basis of price are likely to be the right

ones (prices are more informative).

Example: given that there is no private information (insider trading is a crime) so

everyone has the same information, if the lender increases the interest rate, the

borrower would find another lender who offers less, therefore there is no distortion in

the way price is formed.

d) Government intervention visible difficult.

is more and, thus, more

Therefore a market-based system works better:

- when ma