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266: Financial Markets and Institutions

Jon Faust

http://e105.org/e266

Faust, JHU e266, Spring 2014 – p.1/??

Who is this famous microeconomist?


Shakespeare, 1564-1616

� –Neither a borrower nor a lender be;For loan oft loses both itself and friend,And borrowing dulls the edge of husbandry.(Hamlet, act 1, scene 3,Polonius to Laertes)


Quote 2, another (somewhat less) famous guy


Walter Bagehot, 1826–1877

� –A place like Lombard Street, where in all but therarest times money can be always obtained upongood security or upon decent prospects ofprobable gain, is a luxury which no country hasever enjoyed. (cite: Lombard Street, 1873)


Walter Bagehot, 1826–1877

� –A citizen of London in Queen Elizabeth’s time. . . would have thought that it was of no useinventing railways (if he could have understoodwhat a railway meant), for you would not havebeen able to collect the capital with which to makethem.


The essence of finance is wrapped in thesetwo quotes


Aside: Lombard Street

� Lombard Street is London’s equivalent ofWall Street.

� Also a great book:Walter Bagehot, Lombard Street: A Description ofthe Money Market, First Published: 1873, London:Henry S. King and Co. Read it free at projectGutenburg. gohttp://www.gutenberg.org/ebooks/4359


http://www.gutenberg.org/ebooks/4359

How did life differ in Elizabethan vs. VictorianEngland?


Real Wages, 1209–1800





What happened?


Many things happened . . .

� Industrial revolution, political innovations,intellectual advances,. . .

� . . . but also a finance revolution


The basic problem


The Hamlet solution


The finance revolution


The innovation: Markets and Institutions


A more complete version (from our text)


Key elements of financing


Key elements of financing


But why?

� Why do these basic forms of financingexist?

� Why do they require an immense amountof financial market infrastructure andregulation?

� Why does vast bulk of financing woldwideflow through the indirect channel

� Why do these channels periodicallycollapse?


Remainder of today

� Use the simplest principles ofmicroeconomics. . .and a little common sense from Shakespeare andBagehot. . .

� to answer these questions


Remainder of today

Then we will be refining these answers allterm


Perfect competition

� To get from ‘neither a borrower or a lenderbe’ to debt, equity, banks, etc.. . .

� . . . a well-trained economist should startwith the simplest case:perfect competition


Reiew: perfect markets/competition

� What are key elements that lead to asituation of perfect competition so thatmarkets will give a Pareto efficientoutcome


A few keys to perfect competition

� Many buyers and sellers. . .� are trading homogeneous items about

which. . .� everyone is fully informed.

Shorthand: symmetric and full information amonglots of buyers and sellers

� Other: no transactions costs, each buyerand seller small relative to mkt., and soforth


A few keys to perfect competition

So let’s think about the market for financingfirms


Shakespeare again

� –Neither a borrower nor a lender be;For loan oft loses both itself and friend,And borrowing dulls the edge of husbandry.


Shakespeare again

Was Shakespeare a bad economomist?


From a perfect competition perspective. . .

� Why is the mention of friends puzzling?� Perfect markets is a vision of trade among

lots of anonymous agentsIf IOUs were traded in perfect markets there wouldbe many identical buyers and sellers of identicalIOUs and there would be no reason to buy from orsell to ‘friend’


From a perfect competition perspective. . .

� Why do loans tend to take place betweenfolks who are friends (or at least wellacquainted)?Because there is an issue of trust involved or atleast you need to have some reason to think you’llget your money back.


From a perfect competition perspective

� My IOU is not identical to anyone else’s.Some borrowers are more trustworthy than others;some lenders know more about mycreditworthiness than others.

� More technically: perfect competitiongenerally requires symmetric informationamong (lots of) buyers and sellers


From a perfect competition perspective

Financial markets tend to be dominated byasymmetric information.


Husbandry

� And what is this bit about ‘dulling the edgeof husbandry’husbandry: one definition is ‘careful managementof resources.’

� Borrowers may be less careful withborrowed money than their own.In modern parlance, one version of this is calledmoral hazard


What Shakespeare meant to say

� Were he writing today, he would surelywould have written,Given asymmetric information problems such asmoral hazard, the equilibrium level of borrowingand lending in an unfettered market would be nearzero.. . .

� See my upcoming book: ‘Shakespeare formicroeconomists’


The point

� Thoughtful folks have understood keyproblems with financial markets forcenturies

� It took a few hundred years for economiststo formalize the ideas.And they periodically seem to forget the lessons


So how do we overcome


So how do we overcome

Two ‘direct’ approaches: Debt and equity


Aside: equity

� Equity: I sell you a claim to a share of allproceeds(and of any residual value if we close up shop)

� Stock market shares are this kind ofarrangement


Aside: debt

� Debt: In return for cash now, I sell you anIOU A promise to pay a fixed amount at afixed date in the future


Market problems with equity finance

� I have a good idea for a business, butdon’t have funds to get started

� I offer perfectly competitive lenders thefollowing: you put up half the money andin return I’ll give you half the proceeds(whatever they may be)

� Why might I get no takers?


Folks don’t trust me

� I might just steal the money (or spend iton a nice office for myself), or

� I just tell you, ‘Gosh, business was tough,no proceeds.’


Perfect markets

� Even setting aside the possibility that I ama crook,there is not even one equity buyer, let alone alarge number, who understand my prospects aswell as I do.


Perfect markets

� Why don’t I just explain my project?I do, but this is difficult to do (that is, costly of timeor resources)

� Those of you suffering through this classand others should understand that theprocess of transferring info. from oneperson to another is not cheap or easy


More problems with equity finance

� The payment that the investor gets backdepends on the effort and choices I makein running the business.I didn’t promise yo du a fixed payment, I promisedyou a share of any proceeds.

� What is the problem here?


Hubandry/moral hazard

� Husbandry: If the fund provider gets halfthe benefit of my effort (and picks up halfof any loss), I may not work as hard or beas careful as if I were bearing all the riskand getting all the rewards.

� Moral hazard: if we transfer some of therisk faced by the agent to others, wegenerally alter the behavior of the agent.If others share the downside risk, theagent may take more risk


Hubandry/moral hazard

� Large family of issues: principal-agentproblemsAn agent (e.g., manager) is working on behalf ofsome principals (e.g., shareholders). How do theprincipals get the agent to behave? The trouble,obviously, tends to be imperfect/asymmetric info.between the two


Thus,

� For several reasons, if I am going to giveyou money in return for an equity stake, Ineed to acquire a lot of informationAbout your idea, about your trustworthiness, andon an ongoing basis about your husbandry of thefirm

� Let’s consider debt instead


The debt contract

� I propose that you give me $1 million inreturn for my promise to pay back $1.5million in 2 year’s time.

� Why does this economize on the info.needs of the lender?


The debt contract

� Now, the the payment that is ultimatelyowed is independent of the level of effortLender gets $dd 1.5 million no matter how mybusiness does

� Note: now the borrower bears all thebenefits of any extra effort, so thiscontract avoids the husbandry issues andhas better incentive effects


But. . .

� With debt, the lender needs to worryabout one thing, essentiallyDefault. How likely is default on the loan and howmuch will the lender recover in default?

� At least with debt, fund proiders only needto worry about one thing:that things get bad enough that the firm willdefault.


Thus,

� Debt reduces the info. required relative toequity,The info. needs are still pretty demanding, butmore focussed: will the firm default

� And, we have added new concepts to thefinancial world:Default and bankruptcy


Default and bankruptcy

� With only equity finance, there is nodefault or bankruptcyThe equity holder is only entitled to a share ofwhatever is there (which may be zero)


Debt and default

� What happens in unfettered (that is,unregulated lending markets) when at thetime of repayment, I say, ‘I ain’t got themoney.’?What do we call unregulated lenders?

� Loan sharks: These folks deal withincentive problems by threatening tobreak the borrower’s knees


Historical note

� For much of history, we had largelyunfettered debt markets that looked a lotlike loan shark markets


Default in ancient Greece

� The borrower (a man, b/c only men heldproperty) and his spouse, kids, andservants were placed into debt slavery forup to 5 years

� The upside: you had legal protection of lifeand limb, which other slaves didn’t have.

� In modern legal parlance, we call suchprotections limited liability protection forborrowers


Default in ancient Greece

� In England in Shakespeare’s time:debtors prisonYou essentially bought your way out of prison bypaying the debt


The upshot

� In a world like this, lots of folks with goodideas may be unwilling to borrow tofinance their own good ideas.

� And Shakespeare’s advice is lookingmore sensible.


Bankruptcy/limited liability

� Essentially all social organizations haverules regarding contracts and definebankruptcy and rules of limited liability.See, e.g., Bible, Deuteronomy 15:1-3; U.S.Constitution (Art. 1 Sec. 8), etc.

� But some are a bit more harsh than others


One more rub

� Suppose the firm has succeeded inacquiring some equity finance (i.e., hassome shareholders)

� and also has some debt� When the firm can’t pay off the debt, the

loan shark threatens the entrepreneur’sknees

� But why stop there? Why not threaten theknees of the shareholders as well?


One more rub

� If shareholders’ knees are at risk everytime they buy a share in the firm, thennobody will provide equity financingSo we need additional refinement of our limitedliability laws.


Aside: history

� Some say that legal/financial innovationregarding limited liability for shareholderswas as essential to the industrialrevolution as was tech. advance.Nice summary in the Economist mag.: gohttp://www.economist.com/businessfinance/displaystory.cfm?story%5Fid=347323


http://www.economist.com/businessfinance/displaystory.cfm?story%5Fid=347323

And so,. . .

� Even at this general level, we could spinout a few more problems with debt andequity financing.But hopefully you are getting the idea


Institutions: making debt and equity markets work. . .

� Equity holder can’t be sure he/she’sgetting the proper share of profits.Solution?Solution: fraud laws, accounting rules, requiredSEC filings for publicly traded firms, etc.

� Are these fixes perfect?No far from it, but they help a bit

� Countries that have better rules in place inthis regard have much larger equitymarkets.


Institutions: making debt and equity markets work. . .

� Equity holders worried about their knees.Solution?Laws limiting liability of shareholders for debtsincurred by the firm

� In the end, however, equity markets stillfar from the perfect markets ideal


Debt summary

� Debt avoids some problems, but stillrequires that fund providers learn a lotabout the firm

� And borrowers worry about their knees� And we need bankruptcy law, etc.


A final tension: two inconsistent bits of good advice

� Never invest in anything you don’tunderstand pretty thoroughly

� Diversify: don’t put all your eggs in onebasket.More formally: portfolio theory says you shouldspread your wealth over a wide array of assets.


Yeah, right

� Hold your wealth in a broad array of debtand equity in different firms.

� And understand them all thoroughlyb/c of all those husbandry/moral hazard issues

� And at the same time hold down your dayjob as a widget maker


A good idea

� Suppose a ‘financial institution’specializes in learning about firms andmonitoring the effort and management ofthe firms.In the Shakespearean perspective, the financialinstitution becomes the ‘friend’ who does thelending. Perhaps not a friend, but certainly a closeacquantance.


A good idea

� This sounds great, specialization is muchof what econ. is all about.

� But where does the financial institution getthe funds to lend?Well, how does any firm get funds?


Bank funding

� Debt and equity� Let’s suppose for a moment the financial

institutions accepts depositsFrom the standpoint of this discussion, we cantreat deposits as a form of debt: individuals givethe bank funds in return the bank gives a fixedobligation to repay


Commercial banks

� Commercial banks take deposits, whichsupport lending to to firms and individuals

� They specialize in learning about theborrowers and monitoring their activitiesIn specializing, they get good at this and do itbetter and more cheaply than individual investors(who are busy making widgets) could


But wait. . .

� The depositors won’t lend directly to thefirms b/c they don’t have enough info. totrust them.

� But why do depositors trust the banks?


But wait. . .

� The bank claims that it is gaining specialinfo. about the loans and thus, solving theinfo. problems in lending to firms.

� But if the depositors had to verify thisclaim by the bank, the depositors might aswell lend directly to the firms.


But wait. . .

� Thus, depositors put money in the bankswithout fully understanding how the banksare lending the money

� Depositors learn about thequality/character of 1 institution: the bank

� The bank then learns about thequality/character about all the individualfirms it lends to.So we economize a bit on information costs


Commercial banks, an imperfect fix

� This works great as long as the depositorsmaintain faithfor they don’t really know if the Bank is makingsound lending decisions

� What is the downside risk?Bank run

� You should all know the storyIf not, go view the movie ‘It’s a wonderful life’ gohttp://www.youtube.com/watch?v=MJJN9qwhkkE


http://www.youtube.com/watch?v=MJJN9qwhkkE


� Bank runs are a sort of self-fulfillingprophecyIf all depositors think the bank is about to fail, thenthey have an incentive to withdraw their deposits.But if they all withdraw, the bank will, indeed, fail.

� Thus, the self-interested actions ofrational individuals can lead to a badoutcomeDrat. Another market failure.



� Bank runs have a long and storied historyworldwide

� Since the depression, less so, why?Deposit insurance

� Because of the history of destructive bankruns, most governments provide someguarantee of depositsIf the bank fails, the government repays thedeposits


But, moral hazard

� Now what incentives to depositors have tomake sure the bank behaves well?none.

� And some bankers will tend to. . .have their husbandry dulled, e.g., just run off withthe money or behave in some similarly carelessway


But, moral hazard

� And so we get ‘prudential bankregulation. . . ’If the government is picking up the tab when thebank fails, it pretty much has to keep an eye on thebank behavior—because the depositors won’t


Bottom line

� Direct finance using debt and equity andindirect finance through banks are bothfraught with classic market failureproblems

� We don’t have solutions for these, butprivate and public institutions grow up asimperfect workarounds.

� Most workarounds bring their ownproblems, requiring more work aroundse.g., deposit insurance makes bank regulation vital


Bottom line

All these fixes are imperfect, tend to havetheir own bad side-effects, and are subject tocatastrophic failure


Bottom line

� That’s why finance is fascinatingEither to study or as a career

� And why finance is vital to the economy.


An alternative view: ‘free’ or ‘unfettered’markets do a good job of allocating scarcefinancial resources.


Alan Greenspan

� Former Chm. Alan Greenspan of the FedMy view of the range of dispersion of outcomeshas been shaken [by the crisis], but not myjudgment that free competitive markets are by farthe unrivaled way to organize economies. Wehave tried regulation ranging from heavy to centralplanning. None meaningfully worked. (FT ForurmApr. 6 08) gohttp://blogs.ft.com/economistsforum/2008/04/ldots

alan-greenspan-a-response-to-my-critics/


http://blogs.ft.com/economistsforum/2008/04/alan-greenspan-a-response-to-my-critics/

Dr. Dick Armey

� former econ. prof., house majority leader(1995-2003), Republican

� –[When I was a professor,] I used to teach mystudents that markets are smart, and governmentis dumb. This is because markets are the best wayto correctly price and allocate resources.


Dr. Dick Armey

� Armey citegohttp://www.freedomworks.org/press-releases/reid-and-pelosi-propose-

mortgage-bailouts-and-more


http://www.freedomworks.org/press-releases/reid-and-pelosi-propose-mortgage-bailouts-and-more

How about a Democrat?

� Larry Summers, Harvard Econ. Prof.,former Secy. Treasury under Clinton,former head of Obama’s NationalEconomic Council


Larry Summers

� in 2000As we have learned from experience, marketover-confidence can lead to vulnerability. We mustbe vigilant as well toward issues such as lack oftransparency, the risks that hedging strategies andmodels may not live up to their design, and thetoxic combination of excessive leverage andilliquidity.


Ok, not so warm and fuzzy about free markets . . .

� . . . but he continues:As I have stated before, it is the private sector, notthe public sector, that is in the best position toprovide effective supervision and reduce thelikelihood that these issues rise to a level thatcould threaten market stability. gohttp://www.treas.gov/press/releases/ls1005.htm


http://www.treas.gov/press/releases/ls1005.htm

Wow.

that whole free market thing must be prettygreat. . .


Well, uhh, oops.

� Summers, 2009:No substantially interconnected institution ormarket on which the system depends should befree from rigorous public scrutiny. Required levelsof capital and liquidity must be set. . . And theremust be far more vigorous and serious efforts todiscourage improper risk taking . . .


What explains the change of heart?

� Summers forgot (or had never properlylearned?) what Shakespeare andBagehot both deeply understood

� The near collapse of the world economytends to jostle ones thinkingwell, maybe not Greenspan’s


Finance is a hotbed of sloppy thinking

� Greatest thinkers were/are in a muddleabout finance

� Fundamental changes in views arehappeningbut you can be pretty sure that whatever theircurrent views, folks like Summers and Greenspanwill assert those views with great conviction

� Your job is to learn to think for yourselfand sort through this stuffCan’t rely on the experts (including me)


Finally, a Nobel Peace prize

� 2006 Nobel Peace Prize, MuhammadYunus & Grameen Bank


Yunes in Nobel lecture

� –Today, Grameen Bank gives loans to nearly 7.0million poor people. . . In a cumulative way the bankhas given out loans totaling about US 6.0 billion.The repayment rate is 99 percent. Grameen Bankroutinely makes profit. . . . According to GrameenBank’s internal survey, 58 per cent of ourborrowers have crossed the poverty line.


Improve the intertemporal allocation of resources

� And great fame (and perhaps riches) willbe yours.

� Finally, a heartwarming story of marketsdoing the right thing?!?


Well, uhhh, oops. . .

� BBC, Nov. 2010:When India’s microfinance industry started,. . . microfinance was a critical cash lifeline forpeople in rural and remote India.. . . This latestcrisis has shown that there is a great and growingneed for regulation and protection of this emergingmarket.



� –The government of Andhra Pradesh is now in theprocess of registering every microfinance firmworking in the state. gohttp://www.bbc.co.uk/news/business-11711617


http://www.bbc.co.uk/news/business-11711617


Unfettered financial markets work well?



Not so much.


Or as Vonnegut might say,

� And so it goes. . .
