Financial Markets and Institutions - Zannini, Musolino, De Rossi, Dispense di Mercato Finanziario

Scarica Financial Markets and Institutions - Zannini, Musolino, De Rossi e più Dispense in PDF di Mercato Finanziario solo su Docsity! FINANCIAL MARKETS AND INSTITUTIONS Chapter 1: why study financial markets and institutions?   Financial markets are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. They are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. —> KEY FACTOR IN PRODUCING ECONOMIC GROWTH. Activities in financial markets also have direct effects on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy.   Debt Markets and Interest Rates   A security (also called a financial instrument) is a claim on the issuer’s future income or assets. A bond is a debt security that promises to make payments periodically for a specified period of time. An interest rate is the cost of borrowing, or the price paid for the rental of funds. Interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions.   The stock market   A common stock (stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for the corporation to raise funds to finance its activities. —> the stock market is the most widely followed financial market in almost every country that has one: that’s why sometimes it is simply called “the market”.   The stock market is an important factor in business investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm’s shares means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment. The foreign exchange market   The foreign exchange market is the instrumental in moving funds between countries. For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the country they are going to (say, euros). It is also important because it is where the foreign exchange rate, the price of one country’s currency in terms of another’s, is determined. Appreciation or depreciation of the currency.   Financial institutions   Financial institutions are what make financial markets work —> without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. They play an important role in improving the efficiency of the economy.   Structure of the financial system   The financial system is complex, comprising many types of private-sector financial institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks —all of which are heavily regulated by the government. Financial intermediaries institutions such as commercial banks, savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies that borrow funds from people who have saved and in turn make loans to others.   Financial crises   At times, the financial system seizes up and produces financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and non-financial firms. Financial crises have been a feature of capitalist economies for hundreds of years and are typically followed by the most serious business cycle downturns. Banks and other financial institutions   Banks are financial institutions that accept deposits and make loans. Included under the term banks are firms such as commercial banks, savings and loan associations, mutual saving banks and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently.   Function of Financial Intermediaries: Indirect Finance —> The process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers.   Financial intermediaries can substantially reduce transaction costs (the time and money spent in carrying out financial transactions) because they have developed expertise in lowering them and because their large size allows them to take advantage of economies of scale (the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases). A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions.   Another benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors to risk—that is, uncertainty about the returns investors will earn on assets. Financial intermediaries do this through the process known as risk sharing: They create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk. Low transaction costs allow financial intermediaries to share risk at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is also sometimes referred to as asset transformation because risky assets are turned into safer assets for investors.   Financial intermediaries also promote risk sharing by helping individuals to diversify and thereby lower the amount of risk to which they are exposed (PORTFOLIO THEORY). Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together (the less the assets are correlated, the better), with the result that overall risk is lower than for individual assets. Low transaction costs allow financial intermediaries to do this by pooling a collection of assets into a new asset and then selling it to individuals. Asymmetric Information: Adverse Selection and Moral Hazard —> An additional reason is that in financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though good credit risks exist in the marketplace. Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. Financial intermediaries can alleviate these problems. With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary which in turn lends the funds out either by making loans or by buying securities such as stocks or bonds. Successful financial intermediaries have higher earnings on their investments than do small savers because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn a profit. Economies of Scope and Conflicts of Interest —> Financial intermediaries can lower the cost of information production for each service by applying one information resource to many different services —> economies of scope. However, although the presence of economies of scope may substantially benefit financial institutions, it also creates potential costs in terms of conflicts of interest. Conflicts of interest are a type of moral hazard problem that arises when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives. Conflicts of interest are especially likely to occur when a financial institution provides multiple services. The potentially competing interests of those services may lead an individual or firm to conceal information or disseminate misleading information. We care about conflicts of interest because a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient. Regulation of the Financial System Increasing Information Available to Investors Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Government regulation can reduce adverse selection and moral hazard problems in financial mar- kets and enhance the efficiency of the markets by increasing the amount of information available to investors. Ensuring the Soundness of Financial Intermediaries Asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as a financial panic. To protect the public and the economy from financial panics, the government has implemented six types of regulations: Restrictions on Entry —> State banking and insurance commissions have created tight regulations governing who is allowed to set up a financial intermediary. Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government. Only if they appear to be upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter. Disclosure —> Reporting requirements for financial intermediaries are stringent. Their bookkeeping must follow certain strict principles, their books are subject to periodic inspection, and they must make certain information available to the public. Restrictions on Assets and Activities —> Financial intermediaries are restricted in what they are allowed to do and what assets they can hold. Before you put funds into a bank or some other such institution, you would want to know that your funds are safe and that the bank or other financial intermediary will be able to meet its obligations to you. One way of doing this is to restrict the financial intermediary from engaging in certain risky activities. Another way to limit a financial intermediary’s risky behavior is to restrict it from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent. Deposit Insurance —> The government can insure people’s deposits so that they do not suffer great financial loss if the financial intermediary that holds these deposits should fail. Limits on Competition —> Politicians have often declared that unbridled competition among financial intermediaries promotes failures that will harm the public. Although the evidence that competition does indeed have this effect is extremely weak, state and federal governments at times have imposed restrictions on the opening of additional locations (branches). Restrictions on Interest Rates —> Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits. 3. The higher the coupon rate on the bond, everything else being equal, the shorter the bond’s duration. 
 4. Duration is additive: The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. 
 Duration is a particularly useful concept because it provides a good approximation, particularly when interest-rate changes are small, for how much the security price changes for a given change in interest rates. —> The greater the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates. Therefore, the greater the duration of a security, the greater its interest-rate risk. Summary The return on a bond, which tells you how good an investment it has been over the holding period, is equal to the yield to maturity in only one special case: when the holding period and the maturity of the bond are identical. Bonds whose term to maturity is longer than the holding period are subject to interest-rate risk: Changes in interest rates lead to capital gains and losses that produce substantial differences between the return and the yield to maturity known at the time the bond is purchased. Interest-rate risk is especially important for long-term bonds, where the capital gains and losses can be substantial. This is why long-term bonds are not considered to be safe assets with a sure return over short holding periods. Bonds whose term to maturity is shorter than the holding period are also subject to reinvestment risk. Reinvestment risk occurs because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain. Chapter 4: Why do interest rates change? Determinants of asset demand An asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1. Wealth, the total resources owned by the individual, including all assets. —> Holding everything else constant, an increase in wealth raises the quantity demanded of an asset. 
 2. Expected return (the return expected over the next period) on one asset relative to alternative assets. —> the expected return on an asset is the weighted average of all possible returns, where the weights are the probabilities of occurrence of that return: Re =p1R1 +p2R2 + g+pnRn —> an increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset. 
 3. Risk (the degree of uncertainty associated with the return) of one asset relative to alternative assets. —> we can use a measure of risk called the standard deviation. —> The higher the standard deviation, σ, the greater the risk of an asset. —> holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. 4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets. —> The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded. Theory of Portfolio Choice —> tells us how much of an asset people want to hold in their portfolio. It states that, holding all the other factors constant: A.The quantity demanded of an asset is usually positively related to wealth. 
 B. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. 
 C. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. 
 D. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets. 
 Supply and demand in the Bond Market 
 The first step is to use the analysis to obtain a demand curve, which shows the relationship between the quantity demanded and the price when all other economic variables are held constant (that is, values of other variables are taken as given —> ceteris paribus). We use the same assumption in deriving a supply curve, which shows the relationship between the quantity supplied and the price when all other economic variables are held constant. Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied: Bd = Bs. A situation like this, in which the quantity of bonds supplied exceeds the quantity of bonds demanded, is called a condition of excess supply, viceversa is called excess demand. Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price. Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price. The asset market approach —> supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows (amounts per a given unit of time) to understanding behavior in financial markets Changes in Equilibrium Interest Rates When quantity demanded (or supplied) changes as a result of a change in the price of the bond (or, equivalently, a change in the interest rate), we have a movement along the demand (or supply) curve. A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded (or supplied) changes at each given price (or interest rate) of the bond in response to a change in some other factor besides the bond’s price or interest rate. Shifts in the Demand for Bonds The theory of portfolio choice provides a framework for deciding which factors cause the demand curve for bonds to shift. These factors include changes in four parameters: 1.Wealth —> when the economy is growing rapidly in a business cycle expansion and wealth is increasing, the quantity of bonds demanded at each bond price (or interest rate) increases. In a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. With the same reasoning applied, in a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left. 2.Expected returns on bonds relative to alternative assets —> Higher expected interest rates in the future lower the expected return for long-term bonds, decrease the demand, and shift the demand curve to the left. Lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right. An increase in the expected rate of inflation lowers the expected return for bonds, causing their demand to decline and the demand curve to shift to the left. Conversely, a decrease in the expected rate of inflation raises the expected return for bonds, causing the demand curve to shift to the right. 3. Risk of bonds relative to alternative assets —> An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right. Given that both the supply and demand curves have shifted to the right, we know that the new equilibrium reached at the intersection of Bd2 and Bs2 must also move to the right. However, depending on whether the supply curve shifts more than the demand curve, or viceversa, the new equilibrium interest rate can either rise or fall. If the supply curve shifts to the right more than the demand curve, as in this figure, the equilibrium bond price moves down from P1 to P2, and the equilibrium interest rate rises. Viceversa, if the demand curve shifts to the right more than the supply curve, the equilibrium bond price moves up and the equilibrium interest rate rises. Low interest rates in Europe, Japan, and United States In the aftermath of the global financial crisis, interest rates in Europe and the United States, as well as in Japan, have fallen to extremely low levels. Indeed, we have seen that interest rates have even sometimes turned negative. Why are interest rates in these countries at such low levels? The answer is that inflation has fallen to very low levels in all these countries, sometimes even going negative, while at the same time there has been a dearth of attractive investment opportunities. Using these facts, analysis similar to that used in the preceding application explains why interest rates have become so low. Very low and even negative inflation causes the demand for bonds to rise because the expected return on real assets falls, thereby raising the relative expected return on bonds and in turn causing the demand curve to shift to the right. Low and even negative inflation also raises the real interest rate and therefore the real cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift to the left. The rightward shift of the demand curve and leftward shift of the supply curve lead to a rise in the bond price and a fall in interest rates. All of these countries have also been experiencing very low economic growth rates, which has resulted in a lack of profitable investment opportunities. As a result, the supply of bonds has decreased, shifting the supply curve to the left. The leftward shift of the supply curve for bonds leads to a further rise in the bond price and interest rates fall. Usually, we think that low interest rates are a good thing because they make it cheap to borrow. But the recent episodes of low interest rates in the United States, Europe, and Japan show that just as a fallacy is present in the adage, “You can never be too rich or too thin” (maybe you can’t be too rich, but you can certainly be too thin and damage your health), a fallacy is present in always thinking that lower interest rates are better. In the United States, Europe, and Japan, the low and even negative interest rates are a sign that these economies are not doing all that well, with slow growth and inflation that is too low. Only when these economies return to good health will interest rates rise back to more normal levels. Profiting from Interest-Rate Forecasts Make decisions about assets to hold 1.Forecast i ↓, buy long term bonds 2.Forecast i ↑, buy short term bonds Make decisions about how to borrow 1.Forecast i ↓, borrow short term 2.Forecast i ↑, borrow long term Chapter 6: Are Financial Markets Efficient? The Efficient Market Hypothesis To understand how expectations affect securities prices, we need to look at how information in the market affects these prices. To do this we examine the efficient market hypothesis, which states that prices of securities in financial markets fully reflect all available information. The rate of return from holding a security equals the sum of the capital gain on the security (the change in the price) plus any cash payments, divided by the initial purchase price of the security: R = (Pt+1 - Pt + C) / Pt The efficient market hypothesis views expectations as equal to optimal forecasts using all available informations. What exactly does this mean? An optimal forecast is the best guess of the future using all available information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the available information. This can be written more formally as Pe_t+1 = Pof_t+1. Which in turn implies that the expected return on the security will equal the optimal forecast of the return: Re = Rof. The expected return on a security Re equals the equilibrium return R*, which equates the quantity of the security demanded to the quantity supplied; that is, Re = R* and thus Rof = R* Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. Financial economists state it more simply: A security’s price fully reflects all available information in an efficient market. Rationale Behind the Hypothesis To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities, meaning returns on a security that are larger than what is justified by the characteristics of that security. Arbitrage is of two types: pure arbitrage, in which the elimination of unexploited profit opportunities involves no risk, and the type of arbitrage we discuss here, in which the arbitrageur takes on some risk when eliminating the unexploited profit opportunities. In an efficient market, all unexploited profit opportunities will be eliminated. An extremely important factor in this reasoning is that not everyone in a financial market must be well informed about a security for its price to be driven to the point at which the efficient market condition holds. Financial markets are structured so that many participants can play. As long as a few (who are often referred to as “smart money”) keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear because in so doing, they make a profit. The efficient market hypothesis makes sense because it does not require everyone in a market to be cognizant of what is happening to every security. •Weak Form Efficiency: Market prices reflect all historical information •Semi-Strong Form Efficiency: Market prices reflect all publicly available information •Strong Form Efficiency: Market prices reflect all information, both public and private Evidence on the Efficient Market Hypothesis Early evidence on the efficient market hypothesis was quite favorable to it, but in recent years deeper analysis of the evidence suggests that the hypothesis may not always be entirely correct. Evidence in favor of market efficiency has examined the performance of investment analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock prices, and the success of so-called technical analysis. Many financial economists take the efficient market hypothesis one step further in their analysis of financial markets. Not only do they believe that expectations in financial markets are rational—that is, equal to optimal forecasts using all available information—but they also add the condition that prices in financial markets reflect the true fundamental (intrinsic) value of the securities. In other words, all prices are always correct and reflect market fundamentals and so financial markets are efficient. This stronger view of market efficiency has several important implications in the academic field of finance. First, it implies that in an efficient capital market, one investment is as good as any other because the securities’ prices are correct. Second, it implies that a security’s price reflects all available information about the intrinsic value of the security. Third, it implies that security prices can be used by managers of both financial and non-financial firms to assess their cost of capital (cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making. The existence of market crashes and bubbles, in which the prices of assets rise well above their fundamental values, casts serious doubt on the stronger view that financial markets are efficient but provides less of an argument against the basic lessons of the efficient market hypothesis. Should You Be Skeptical of Hot Tips? Yes. Suppose that your broker phones you with a hot tip to buy stock in the Happy Feet Corporation (HFC) because it has just developed a product that is completely effective in curing athlete’s foot. The stock price is sure to go up. Should you follow this advice and buy HFC stock? The efficient market hypothesis indicates that you should be skeptical of such news. If the stock market is efficient, it has already priced HFC stock so that its expected return will equal the equilibrium return. The hot tip is not particularly valuable and will not enable you to earn an abnormally high return. You might wonder, though, if the hot tip is based on new information and would give you an edge on the rest of the market. If other market participants have gotten this information before you, the answer is no. As soon as the information hits the street, the unexploited profit opportunity it creates will be quickly eliminated. The stock’s price will already reflect the information, and you should expect to realize only the equilibrium return. But if you are one of the first to know the new information, it can do you some good. Only then can you be one of the lucky ones who, on average, will earn an abnormally high return by helping eliminate the unexploited profit opportunity by buying HFC stock. Do Stock Prices Always Rise When There Is Good News? No. When good news about a stock is announced, the price of the stock frequently does not rise. The efficient market hypothesis and the random-walk behavior of stock prices explain this phenomenon. Because changes in stock prices are unpredictable, when information is announced that has already been expected by the market, the stock price will remain unchanged. The announcement does not contain any new information that should lead to a change in stock prices. If this were not the case and the announcement led to a change in stock prices, it would mean that the change was predictable. Because that is ruled out in an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. If the news is expected, there will be no stock price response. This is exactly what the evidence that we described earlier suggests will occur—that stock prices reflect publicly available information. Efficient Markets Prescription for the Investor What does the efficient market hypothesis recommend for investing in the stock market? It tells us that hot tips, investment advisers’ published recommendations, and technical analysis cannot help an investor outperform the market. Indeed, it indicates that anyone without better information than other market participants cannot expect to beat the market. So what is an investor to do? The efficient market hypothesis leads to the conclusion that such an investor should not try to outguess the market by constantly buying and selling securities. This process does nothing but boost the income of brokers, who earn commissions on each trade. Instead, the investor should pursue a “buy and hold” strategy—purchase stocks and hold them for long periods of time. This will lead to the same returns, on average, but the investor’s net profits will be higher because fewer brokerage commissions will have to be paid. Chapter 7: Why do financial institutions exist? Basic Facts About Financial Structure Throughout The World The financial system is complex in both structure and function throughout the world. It includes many types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on—all of which are regulated by government. It channels trillions of dollars per year from savers to people with productive investment opportunities. Transaction Costs Transaction costs are a major problem in financial markets. —> Say you have $5,000 you would like to invest, and you think about investing in the stock market. Because you have only $5,000, you can buy only a small number of shares. Even if you use online trading, your purchase is so small that the brokerage commission for buying the stock you picked will be a large percentage of the purchase price of the shares. If instead you decide to buy a bond, the problem is even worse because the smallest denomination for some bonds you might want to buy is as much as $10,000, and you do not have that much to invest. You are disappointed and realize that you will not be able to use financial markets to earn a return on your hard-earned savings. You can take some consolation, however, in the fact that you are not alone in being stymied by high transaction costs. You also face another problem related to transaction costs. Because you have only a small amount of funds available, you can make only a restricted number of investments because a large number of small transactions would result in very high transaction costs. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk. Fortunately, financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets. Economies of Scale —> One solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for the individual investors. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. Economies of scale are also important in lowering the costs of things such as information technology that financial institutions need to accomplish their tasks. Once a large mutual fund has invested a lot of money in setting up a telecommunications system, for example, the system can be used for a huge number of transactions at a low cost per transaction. Expertise —> Financial intermediaries are also better able to develop expertise to lower transaction costs. Their expertise in information technology enables them to offer customers convenient services like being able to call a toll-free number for information on how well their investments are doing and to write checks on their accounts. An important outcome of a financial intermediary’s low transaction costs is the ability to provide its customers with liquidity services, services that make it easier for customers to conduct transactions. Money market mutual funds, for example, not only pay shareholders high interest rates but also allow them to write checks for convenient bill paying. Asymmetric Information: Adverse Selection and Moral Hazard The presence of transaction costs in financial markets explains in part why financial intermediaries and indirect finance play such an important role in financial markets. To understand financial structure more fully, however, we turn to the role of information in financial markets. Asymmetric information—a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when Until 2001 Enron Corporation, a firm that specialized in trading in the energy market, appeared to be spectacularly successful. It had a quarter of the energy-trading market and was valued as high as $77 billion in August 2000 (just a little over a year before its col- lapse), making it the seventh- largest corporation in the United States at that time. However, toward the end of 2001, Enron came crashing down. In October 2001, Enron announced a third-quarter loss of $618 million and disclosed accounting “mistakes.” The SEC then engaged in a formal investigation of Enron’s financial dealings with partnerships led by its former finance chief. It became clear that Enron was engaged in a complex set of transactions by which it was keeping substantial amounts of debt and financial contracts off its balance sheet. These transactions enabled Enron to hide its financial difficulties. Despite securing as much as $1.5 billion of new financing from J. P. Morgan Chase and Citigroup, the company was forced to declare bankruptcy in December 2001, up to that point the largest bankruptcy in U.S. history. The Enron collapse illustrates that government regulation can lessen asymmetric information problems but cannot eliminate them. Managers have tremendous incentives to hide their companies’ problems, making it hard for investors to know the true value of the firm. The Enron bankruptcy not only increased concerns in financial markets about the quality of accounting information supplied by corporations but also led to hardship for many of the firm’s former employees, who found that their pensions had become worthless. Outrage against the duplicity of executives at Enron was high, and several of them were sent to jail. Financial Intermediation —> How, then, can the financial structure help promote the flow of funds to people with productive investment opportunities when asymmetric information exists? A clue is provided by the structure of the used-car market. An important feature of the used-car market is that most used cars are not sold directly by one individual to another. An individual who considers buying a used car might pay for privately produced information by subscribing to a magazine like Consumer Reports to find out if a particular make of car has a good repair record. Nevertheless, reading Consumer Reports does not solve the adverse selection problem because even if a particular make of car has a good reputation, the specific car someone is trying to sell could be a lemon. The prospective buyer might also take the used car to a mechanic for an inspection. But what if the prospective buyer doesn’t know a mechanic who can be trusted or if the mechanic would charge a high fee to evaluate the car? Because these roadblocks make it hard for individuals to acquire enough information about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee, in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free-riding on the information they produced. Just as used-car dealers help solve adverse selection problems in the automobile market, financial intermediaries play a similar role in financial markets. A financial intermediary, such as a bank, becomes an expert in producing information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity. An important element in the bank’s ability to profit from the information it produces is that it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and bid up the loan’s price to the point that the bank receives no compensation for the information it has produced. The bank’s role as an intermediary that holds mostly non traded loans is the key to its success in reducing asymmetric information in financial markets. Our analysis of adverse selection indicates that financial intermediaries in general—and banks in particular, because they hold a large fraction of non traded loans—should play a greater role in moving funds to corporations than securities markets do. Our analysis thus explains why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses. Another important fact that is explained by the analysis here is the greater importance of banks in the financial systems of developing countries. Information about private firms is harder to collect in developing countries than in industrialized countries; therefore, the smaller role played by securities markets leaves a greater role for financial intermediaries such as banks. A corollary of this analysis is that as information about firms becomes easier to acquire, the role of banks should decline. Our analysis of adverse selection also explains why large firms are more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route. The better known a corporation is, the more information about its activities is available in the marketplace. Thus, it is easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one. Because investors have fewer worries about adverse selection with well-known corporations, they will be willing to invest directly in their securities. Collateral and Net Worth —> Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely they will get the loan in the first place and perhaps at a better loan rate. The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts. Net worth (also called equity capital), the difference between a firm’s assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to that of collateral. If a firm has a high net worth, then even if it engages in investments that cause it to have negative profits and so defaults on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans. How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts The Principal–Agent Problem Equity contracts, such as common stock, are claims to a share in the profits and assets of a business. Equity contracts are subject to a particular type of moral hazard called the principal–agent problem. When managers own only a small fraction of the firm they work for, the stockholders who own most of the firm’s equity (called the principals) are not the same people as the managers of the firm, who are the agents of the owners. This separation of ownership and control involves moral hazard, in that the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder- owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do. Further indications that the principal–agent problem created by equity contracts can be severe are provided by past scandals in corporations such as Enron and Tyco International, in which managers were found to have diverted funds for their personal use. Besides pursuing personal benefits, managers might also pursue corporate strategies (such as the acquisition of other firms) that enhance their personal power but do not increase the corporation’s profitability. The principal–agent problem would not arise if the owners of a firm had complete information about what the managers were up to and could prevent wasteful expenditures or fraud. The principal–agent problem, which is an example of moral hazard, arises only because a manager has more information about his activities than the stockholder does—that is, information is asymmetric. Tools to Help Solve the Principal–Agent Problem Production of Information: Monitoring —> One way for stockholders to reduce this moral hazard problem is for them to engage in a particular type of information production, the monitoring of the firm’s activities: auditing the firm frequently and checking on what the management is doing. The problem is that the monitoring process can be expensive in terms of time and money, as reflected in the name economists give it, costly state verification. Costly state verification makes the equity contract less desirable, and it explains, in part, why equity is not a more important element in our financial structure. As with adverse selection, the free-rider problem decreases the amount of information production undertaken to reduce the moral hazard (principal–agent) problem. The moral hazard problem for shares of common stock will then be severe, making it hard for firms to issue them to raise capital. Government Regulation to Increase Information —> Governments everywhere have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also pass laws to impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits. However, these measures can be only partly effective. Catching this kind of fraud is not easy; fraudulent managers have the incentive to make it very hard for government agencies to find or prove fraud. Financial Intermediation —> Financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard, and this is another reason that indirect finance is so important. One financial intermediary that helps reduce the moral hazard arising from the principal–agent problem is the venture capital firm. Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses. In exchange for the use of the venture capital, the firm receives an equity share in the new business. Because verification of earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist on having several of their own people participate as members of the managing body of the firm, the board of directors, so that they can keep a close watch on the firm’s activities. When a venture capital firm supplies start-up funds, the equity in the firm is private, that is, not marketable to anyone except the venture capital firm. Thus, other investors are unable to take a free ride on the venture capital firm’s verification activities. As a result of this arrangement, the venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incentives to reduce the moral hazard problem. Debt Contracts —> Moral hazard arises with an equity contract, which is a claim on profits in all situations, whether the firm is making or losing money. If a contract could be structured so that moral hazard would exist only in certain situations, the need to monitor managers would be reduced, and the contract would be more attractive than the equity contract. The debt contract has exactly these attributes because it is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. When the firm has high profits, the lender receives the contractual payments and does not need to know the exact profits of the firm. If the managers are hiding profits or are pursuing activities that are personally beneficial but don’t achieve economies of scope; that is, they can lower the cost of information production for each service by applying one information resource to many different services. What Are Conflicts of Interest and Why Do We Care? Conflicts of interest are a type of moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts among those objectives. Conflicts of interest are especially likely to occur when a financial institution provides multiple services. The potentially competing interests of those services may lead individuals who work for financial institutions to conceal information or disseminate misleading information. We care about conflicts of interest because a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient. Why Do Conflicts of Interest Arise? Three types of financial service activities have led to prominent conflicts-of-interest problems in financial markets in recent years: underwriting and research in investment banks, auditing and consulting in accounting firms, and credit assessment and consulting in credit-rating agencies. Why do combinations of these activities so often produce conflicts of interest? Underwriting and Research in Investment Banking —> Investment banks perform two tasks: They research companies issuing securities, and they underwrite these securities by selling them to the public on behalf of the issuing corporations. Investment banks often combine these distinct financial services because information synergies are possible: That is, information produced for one task may also be useful in the other task. A conflict of interest arises between the brokerage and underwriting services because the banks are attempting to simultaneously serve two client groups—the security-issuing firms and the security-buying investors. These client groups have different information needs. Issuers benefit from optimistic research, whereas investors desire unbiased research. However, the same information will be produced for both groups to take advantages of economies of scope. When the potential revenues from underwriting greatly exceed the brokerage commissions from selling, the bank will have a strong incentive to alter the information provided to investors to favor the issuing firm’s needs or else risk losing the firm’s business to competing investment banks. Analysts in investment banks might distort their research to please issuers. Such actions undermine the reliability of the information that investors use to make their financial decisions and, as a result, diminish the efficiency of securities markets. Another common practice that exploits conflicts of interest is spinning. Spinning occurs when an investment bank allocates hot, but underpriced, initial public offerings (IPOs)—that is, shares of newly issued stock—to executives of other companies in return for their companies’ future business with the investment banks. Because hot IPOs typically immediately rise in price after they are first purchased, spinning is a form of kickback meant to persuade executives to use that investment bank. When the executive’s company plans to issue its own shares, he or she will be more likely to go to the investment bank that distributed the hot IPO shares, which is not necessarily the investment bank that would get the highest price for the company’s securities. This practice may raise the cost of capital for the firm, thereby diminishing the efficiency of the capital market. Auditing and Consulting in Accounting Firms Traditionally, an auditor checks the books of companies and monitors the quality of the information produced by firms to reduce the inevitable information asymmetry between the firm’s managers and its shareholders. In auditing, threats to truthful reporting arise from several potential conflicts of interest. The conflict of interest that has received the most attention in the media occurs when an accounting firm provides its client with both auditing services and non audit consulting services such as advice on taxes, accounting, management information systems, and business strategy. Supplying clients with multiple services allows for economies of scale and scope but creates two potential sources of conflicts of interest. First, auditors may be willing to skew their judgments and opinions to win consulting business from these same clients. Second, auditors may be auditing information systems or tax and financial plans put in place by their non audit counterparts within the firm and therefore may be reluctant to criticize the systems or advice. Both types of conflicts may lead to biased audits, with the result that less reliable information is available in financial markets and investors find it difficult to allocate capital efficiently. Another conflict of interest arises when an auditor provides an overly favorable audit to solicit or retain audit business. Credit Assessment and Consulting in Credit-Rating Agencies —> Investors use credit ratings (e.g., Aaa or Baa) that reflect the probability of default to determine the creditworthiness of particular debt securities. As a consequence, debt ratings play a major role in the pricing of debt securities and in the regulatory process. Conflicts of interest can arise when multiple users with divergent interests (at least in the short term) depend on the credit ratings. Investors and regulators are seeking a well-researched, impartial assessment of credit quality; the issuer needs a favorable rating. In the credit-rating industry, the issuers of securities pay a rating firm to have their securities rated. Because the issuers are the parties paying the credit-rating agency, investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer. Another kind of conflict of interest may arise when credit-rating agencies also provide ancillary consulting services. Debt issuers often ask rating agencies to advise them on how to structure their debt issues, usually with the goal of securing a favorable rating. In this situation, the credit-rating agencies would be auditing their own work and would experience a conflict of interest similar to the one found in accounting firms that provide both auditing and consulting services. Furthermore, credit-rating agencies may deliver favorable ratings to garner new clients for the ancillary consulting business. The possible decline in the quality of credit assessments issued by rating agencies could increase asymmetric information in financial markets, thereby diminishing their ability to allocate credit. Such conflicts of interest came to the forefront because of the damaged reputations of the credit-rating agencies during the financial crisis of 2007–2009. [The credit-rating agencies have come under severe criticism for the role they played during the 2007–2009 financial crisis. Credit-rating agencies advised clients on how to structure complex financial instruments that paid out cash flows from subprime mortgages. At the same time, they were rating these identical products, leading to the potential for severe conflicts of interest. Specifically, the large fees they earned from advising clients on how to structure products that they were rating meant they did not have sufficient incentives to make sure their ratings were accurate. When housing prices began to fall and subprime mortgages began to default, it became crystal clear that the ratings agencies had done a terrible job of assessing the risk in the subprime products they had helped to structure. Many AAA-rated products had to be downgraded over and over again until they reached junk status. The resulting massive losses on these assets were one reason why so many financial institutions that were holding them got into trouble, with absolutely disastrous consequences for the economy. Criticisms of the credit-rating agencies led the SEC to propose comprehensive reforms in 2008. The SEC concluded that the credit-rating agencies’ models for rating subprime products were not fully developed and that conflicts of interest may have played a role in producing inaccurate ratings. To address conflicts of interest, the SEC prohibited credit-rating agencies from structuring the same products they rate, prohibited anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it, and prohibited gifts from bond issuers to those who rate them in any amount over $25. To make credit-rating agencies more accountable, the SEC’s new rules also required more disclosure of how the credit-rating agencies determine ratings. For example, credit-rating agencies were required to disclose historical ratings performance, including the dates of downgrades and upgrades, information on the underlying assets of a product that were used by the credit-rating agencies to rate a product, and the kind of research they used to determine the rating. In addition, the SEC required the rating agencies to differentiate the ratings on structured products from those issued on bonds. The expectation is that these reforms will bring increased transparency to the ratings process and reduce conflicts of interest that played such a large role in the subprime debacle.] What Has Been Done to Remedy Conflicts of Interest? Two major policy measures were implemented to deal with conflicts of interest: the Sarbanes- Oxley Act and the Global Legal Settlement. Sarbanes-Oxley directly reduced conflicts of interest: It made it illegal for a registered public accounting firm to provide any non-audit service to a client contemporaneously with an audit (as determined by the PCAOB). 
 Sarbanes-Oxley provided incentives for investment banks not to exploit conflicts of interest: It beefed up criminal charges for white-collar crime and obstruction of official investigations. 
 The Global Legal Settlement of 2002 required investment banks to sever the links between research and securities underwriting and It banned spinning. 
 The Global Legal Settlement also provided incentives for investment banks not to exploit conflicts of interest:It imposed $1.4 billion of fines on the accused investment banks. 
 The global settlement had measures to improve the quality of information in financial markets: It required investment banks to make their analysts’ recommendations public and, over a five-year period, investment banks were required to contract with at least three independent research firms that would provide research to their brokerage customers. The most controversial elements of the Sarbanes-Oxley Act and the Global Legal Settlement were the separation of functions (research from underwriting, and auditing from non audit consulting). Although such a separation of functions may reduce conflicts of interest, it might also diminish economies of scope and thus potentially lead to a reduction of information in financial markets. In addition, there is a serious concern that implementation of these measures, particularly Sarbanes- Oxley, is too costly and is leading to a decline in U.S. capital markets. markets increase financial frictions and deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recovers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery. Stage Three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recovery process can be short-circuited. In stage three in the figure, debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. In economies with moderate inflation, which characterizes most advanced countries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of borrowing firms’ assets. The borrowing firm’s net worth in real terms (the difference between assets and liabilities in real terms) thus declines. The substantial decline in real net worth of borrowers from a sharp drop in the price level causes an increase in adverse selection and moral hazard problems facing lenders. Lending and economic activity decline for a long time. The Great Depression Stock Market Crash In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation. To curb it, they pursued a tightening of monetary policy to raise interest rates to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in the figure. Bank Panics By the middle of 1930, stocks recovered almost half of their losses and credit market conditions stabilized. What might have been a normal recession turned into something far worse, however, when severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The weakness of the economy and the banks in agricultural regions in particular prompted substantial withdrawals from banks, building to a full-fledged panic in November and December 1930, with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. After what would be the era’s final panic in March 1933, President Franklin Delano Roosevelt declared a bank holiday, a temporary closing of all banks. “The only thing we have to fear is fear itself,” Roosevelt told the nation in his first inaugural address. The damage was done, however, and more than one-third of U.S. commercial banks had failed. Continuing Decline in Stock Prices Stock prices kept falling. By mid-1932, stocks had declined to 10% of their value at the 1929 peak, and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets. With a greatly reduced number of financial intermediaries still in business, adverse selection and moral hazard problems intensified even further. Financial markets struggled to channel funds to borrower-spenders with productive investment opportunities. As our analysis predicts, the amount of outstanding commercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level. A manifestation of the rise in financial frictions is that lenders began charging businesses much higher interest rates to protect themselves from credit losses. The resulting rise in credit spread—the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities—is shown in the figure, which displays the difference between interest rates on corporate bonds with a Baa (medium-quality) credit rating and similar-maturity Treasury bonds. Debt Deflation The ongoing deflation that started in 1930 eventually led to a 25% decline in the price level. This deflation short-circuited the normal recovery process that occurs in most recessions. The huge decline in prices triggered a debt deflation in which net worth fell because of the increased burden of indebtedness borne by firms. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unemployment rose to 25% of the labor force. The financial crisis in the Great Depression was the worst ever experienced in the United States, and it explains why the economic contraction was also the most severe ever experienced by the nation. Although the Great Depression started in the United States, it was not just a U.S. phenomenon. Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression financial crisis were disastrous. The Global Financial Crisis of 2007-2009 Causes of the 2007–2009 Financial Crisis We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit-rating process. Financial Innovation in the Mortgage Markets —> Before 2000, only the most credit-worthy (prime) borrowers could obtain residential mortgages. Advances in computer technology and new statistical techniques, known as data mining, however, led to enhanced, quantitative evaluation of the credit risk for a new class of risky residential mortgages. Households with credit records could now be assigned a numerical credit score, known as a FICO score, that would predict how likely they would be to default on their loan payments. In addition, by lowering transactions costs, computer technology enabled the bundling of smaller loans (like mortgages) into standard debt securities, a process known as securitization. These factors made it possible for banks to offer subprime mortgages to borrowers with less-than-stellar credit records. The ability to cheaply quantify the default risk of the underlying high-risk mortgages and bundle them in standardized debt securities called mortgage-backed securities provided a new source of financing for these mortgages. Financial innovation didn’t stop there. Financial engineering, the development of new, sophisticated financial instruments, led to structured credit products that pay out income streams from a collection of underlying assets, designed to have particular risk characteristics that appeal to investors with differing preferences. The most notorious of these products were collateralized debt obligations (CDOs). Agency Problems in the Mortgage Markets —> The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate-to-distribute business model was exposed to the principal–agent problem, in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on his or her payment? The more volume the broker originates, the more he or she makes. Adverse selection became a major problem. Risk-loving investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away,” i.e., default on their loans, if housing prices went down. The principal– agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or to commit fraud by falsifying information on a borrower’s mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instruments whose payoffs are linked to previously issued securities, also were an important source of excessive risk taking. Large fees from writing financial insurance contracts called credit default swaps, which provide payments to holders of bonds if they default, also drove units of insurance companies to write hundreds of billions of dollars’ worth of these risky contracts. Asymmetric Information and Credit-Rating Services —> Credit-rating agencies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products they were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized. Collateralized Debt Obligations (CDOs) The creation of a collateralized debt obligation involves a corporate entity called special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. The SPV then separates the payment streams (cash flows) from these assets into a number of buckets that are referred to as tranches. The highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk. The super senior CDO is a bond that pays out these cash flows to investors, and because it has the least risk, it also has the lowest interest rate. The next bucket of cash flows, known as the senior tranche, is paid out next; the senior CDO has a little more risk and pays a higher interest rate. The next tranche of payment streams, the mezzanine tranche of the CDO, is paid out after the super senior and senior tranches and so it availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets. Run on the Shadow Banking System —> The sharp decline in the value of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other non-depository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements, short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, it might have to post $105 million of mortgage-backed securities as collateral, and the haircut is then 5%. With rising defaults on mortgages, the value of mortgage-backed securities fell, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but they eventually rose to nearly 50%. The result was that the same amount of collateral would allow financial institutions to borrow only half as much. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009) and the more than 30% drop in residential house prices, along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets. This worsening of financial frictions manifested itself in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending standards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract. Global Financial Markets —> Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor’s announced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, suspended redemption of shares held in some of its money market funds, which had sustained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years, when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, Spain, and Italy, which led to a sovereign debt crisis. Failure of High-Profile Firms —> The impact of the financial crisis on firms’ balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securities, had a run on its repo funding and was forced to sell itself to J. P. Morgan for less than 5% of what it had been worth just a year earlier. To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearns’s hard-to-value assets. In July Fannie Mae and Freddie Mac, the two privately owned government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, were propped up by the U.S. Treasury and the Federal Reserve after suffering substantial losses from their holdings of subprime securities. In early September 2008 they were then put into conservatorship (in effect run by the government). On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy, making it the largest bankruptcy filing in U.S. history. The day before, Merrill Lynch, the third-largest investment bank, which had also suffered large losses on its holding of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September 16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rating was down- graded. It had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities. The Federal Reserve then stepped in with an $85 billion loan to keep AIG afloat (with total government loans later increased to $173 billion). Height of the 2007–2009 Financial Crisis —> The financial crisis reached its peak in September 2008 after the House of Representatives, fearing the wrath of constituents who were angry about bailing out Wall Street, voted down a $700 billion bailout package proposed by the Bush administration. The Emergency Economic Stabilization Act finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points). The impaired financial markets and surging interest rates faced by borrower-spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a -1.3% annual rate in the third quarter of 2008 and then at a -5.4% and -6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and as a result is now referred to as the “Great Recession.” Starting in March 2009, a bull market in stocks got under way, and credit spreads began to fall. With the recovery in financial markets, the economy started to recover but, unfortunately, the pace of the recovery has been slow. The European Sovereign Debt Crisis The global financial crisis in 2007–2009 led not only to a worldwide recession but also to a sovereign debt crisis that threatens to destabilize Europe. Up until 2007, all the countries that had adopted the euro found their interest rates converging to very low levels; but with the global financial crisis, several of these countries were hit very hard with the contraction in economic activity reducing tax revenues, while government bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits then led to suspicions that the governments in these hard-hit countries would default on their debt. The result was a surge in interest rates that threatened to spiral out of control. Greece was the first domino to fall in Europe. With a weakening economy reducing tax revenue and increasing spending demands, the Greek government in September 2009 was projecting a budget deficit for the year of 6% of GDP and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone had imagined because the previous government had provided misleading numbers both about the budget deficit, which was at least double the 6% number, and about the amount of government debt, which was ten percentage points higher than previously reported. —> Despite austerity measures to dramatically cut government spending and raise taxes, interest rates on Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister. The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain, and Italy (PIIGS), with their governments forced to embrace austerity measures to shore up their public finances, while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do “whatever it takes” to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in interest rates in those countries, the countries experienced severe recessions, with unemployment rates rising to double-digit levels and Spain’s unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the Eurozone has raised doubts about the euro’s survival. The bond indenture is a contract that states the lender’s rights and privileges and the borrower’s obligations. Any collateral offered as security to the bondholders is also described in the indenture. The degree of risk varies widely among different bond issues because the risk of default depends on the company’s health, which can be affected by a number of variables. —> The interest rate on corporate bonds varies with the level of risk: bonds with lower risk and a higher rating (AAA being the highest) have lower interest rates than more risky bonds (BBB). The spread between the differently rated bonds varies over time. Characteristics of Corporate Bonds At one time bonds were sold with attached coupons that the owner of the bond clipped and mailed to the firm to receive interest payments. These were called bearer bonds because payments were made to whoever had physical possession of the bonds. Bearer bonds have now been largely replaced by registered bonds, which do not have coupons. Instead, the owner must register with the firm to receive interest payments. The firms are required to report to the IRS the name of the person who receives interest income. Despite the fact that bearer bonds with attached coupons have been phased out, the interest paid on bonds is still called the “coupon interest payment,” and that interest payment divided by a bond’s par value is the coupon interest rate. Restrictive Covenants —> A corporation’s financial managers are hired, fired, and compensated at the direction of the board of directors, which represents the corporation’s stockholders. This arrangement implies that the managers will be more interested in protecting stockholders than in protecting bondholders. Managers might not use the funds provided by the bonds as the bondholders might prefer. Since bondholders cannot look to managers for protection when the firm gets into trouble, they must impose rules and restrictions on managers designed to protect the bondholders’ interests. These are known as restrictive covenants. They usually limit the amount of dividends the firm can pay (to conserve cash for interest payments to bondholders) and the ability of the firm to issue additional debt. Other financial policies, such as the firm’s involvement in mergers, may also be restricted. Restrictive covenants are included in the bond indenture. Typically, the interest rate is lower the more restrictions are placed on management through these covenants because the bonds will be considered safer by investors. Call Provisions —> Most corporate indentures include a call provision, which states that the issuer has the right to force the holder to sell the bond back. The call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called. The price bondholders are paid for the bond is usually set at the bond’s par price or slightly higher (usually by one year’s interest cost). For example, a 10% coupon rate $1,000 bond may have a call price of $1,100. If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price, and the firm will call the bond. Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond’s price, investors do not like call provisions. A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund. A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year. This provision is attractive to bondholders because it reduces the probability of default when the issue matures. Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond’s interest rate. A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders. Suppose that a firm needed to borrow additional funds to expand its storage facilities. If the firm’s bonds carried a restriction against adding debt, the firm would have to retire its existing bonds before issuing new bonds or taking out a loan to build the new warehouse. Finally, a firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available. Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds. Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature pro- vides the firm. Conversion —> Some bonds can be converted into shares of common stock. This feature permits bondholders to share in the firm’s good fortunes if the stock price rises. Most convertible bonds will state that the bond can be converted into a certain number of common shares at the discretion of the bondholder. The conversion ratio will be such that the price of the stock must rise substantially before conversion is likely to occur. Issuing convertible bonds is one way firms avoid sending a negative signal to the market. In the presence of asymmetric information between corporate insiders and investors, when a firm chooses to issue stock, the market usually interprets this action as indicating that the stock price is relatively high or that it is going to fall in the future. The market makes this interpretation because it believes that managers are most concerned with looking out for the interests of existing stockholders and will not issue stock when it is undervalued. If managers believe that the firm will perform well in the future, they can, instead, issue convertible bonds. If the managers are correct and the stock price rises, the bondholders will convert to stock at a relatively high price that managers believe is fair. Alternatively, bondholders have the option not to convert if managers turn out to be wrong about the company’s future. Bondholders like a conversion feature. It is very similar to buying just a bond but receiving both a bond and a stock option. The price of the bond will reflect the value of this option and so will be higher than the price of comparable nonconvertible bonds. The higher price received for the bond by the firm implies a lower interest rate. Types of Corporate Bonds A variety of corporate bonds are available. They are usually distinguished by the type of collateral that secures the bond and by the order in which the bond is paid off if the firm defaults. Secured Bonds are ones with collateral attached. Mortgage bonds are used to finance a specific project. For example, a building may be the collateral for bonds issued for its construction. In the event that the firm fails to make payments as promised, mortgage bondholders have the right to liquidate the property in order to be paid. Because these bonds have specific property pledged as collateral, they are less risky than comparable unsecured bonds. As a result, they will have a lower interest rate. Equipment trust certificates are bonds secured by tangible non-real-estate property, such as heavy equipment and airplanes. Typically, the collateral backing these bonds is more easily marketed than the real property backing mortgage bonds. As with mortgage bonds, the presence of collateral reduces the risk of the bonds and so lowers their interest rates. Unsecured Bonds Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer. No specific collateral is pledged to repay the debt. In the event of default, the bondholders must go to court to seize assets. Collateral that has been pledged to other debtors is not available to the holders of debentures. Debentures usually have an attached contract that spells out the terms of the bond and the responsibilities of management. The contract attached to the debenture is called an indenture. Debentures have lower priority than secured bonds if the firm defaults. As a result, they will have a higher interest rate than otherwise comparable secured bonds. Subordinated debentures are similar to debentures except that they have a lower priority claim. This means that in the event of a default, subordinated debenture holders are paid only after nonsubordinated bondholders have been paid in full. As a result, subordinated debenture holders are at greater risk of loss. Variable-rate bonds (which may be secured or unsecured) are a financial innovation spurred by increased interest-rate variability in the 1980s and 1990s. The interest rate on these securities is tied to another market interest rate, such as the rate on Treasury bonds, and is adjusted periodically. The interest rate on the bonds will change over time as market rates change. Junk Bonds A bond with a rating of AAA has the highest grade possible. Bonds at or above Moody’s Baa or Standard and Poor’s BBB rating are considered to be of investment grade. Those rated below this level are usually considered speculative. Speculative-grade bonds are often called junk bonds. Before the late 1970s, primary issues of speculative-grade securities were very rare; almost all new bond issues consisted of investment-grade bonds. If companies ran into financial difficulties, their bond ratings would fall, sometimes into the junk bond range. Holders of these downgraded bonds found that they were difficult to sell because no well-developed secondary market existed. It is easy to understand why investors would be leery of these securities, as they were usually unsecured. In 1977 Michael Milken, at the investment banking firm of Drexel Burnham Lambert, recognized that there were many investors who would be willing to take on greater risk if they were compensated with greater returns. First, however, Milken had to address two problems that hindered the market for low-grade bonds. The first was that they suffered from poor liquidity. The second problem with the junk bond market was that a very real chance existed that the issuing firms would default on their bond payments. During the early and mid-1980s, many firms took advantage of junk bonds to finance the takeover of other firms. When a firm greatly increases its debt level (by issuing junk bonds) to finance the purchase of another firm’s stock, the increase in leverage makes the bonds high risk. Frequently, part of the acquired firm is eventually sold to pay down the debt incurred by issuing the junk bonds. Milken and his brokerage firm were very well compensated for their efforts. Milken earned a fee of 2% to 3% of each junk bond issue, which made Drexel the most profitable firm on Wall Street in 1987. Milken’s personal income between 1983 and 1987 was in excess of $1 billion. Unfortunately for holders of junk bonds, both Milken and Drexel were caught and convicted of insider trading. With Drexel unable to support the junk bond market, 250 companies defaulted between 1989 and 1991. Drexel itself filed bankruptcy in 1990 due to losses on its own holdings of junk bonds. Milken was sentenced to three years in prison for his part in the scandal. Fortune magazine reported that Milken’s personal fortune still exceeded $400 million. The junk bond market had largely recovered since its low in 1990, but the financial crisis in 2008 again reduced the demand for riskier securities. This market behavior was rational, considering that in 2008 the default rate on speculative-grade bonds was three times that of investment-grade bonds. Financial Guarantees for Bonds Financially weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds. A financial guarantee ensures that the lender (bond purchaser) will be paid both principal and interest in the event the issuer defaults. Large, well-known insurance companies write what are actually insurance policies to back bond issues. With such a financial guarantee, bond buyers no longer have to be concerned with the financial health of the bond issuer. Instead, they are interested only in the strength of the insurer. Essentially, the credit rating of the insurer is substituted for the credit rating of the issuer. The resulting reduction in risk lowers the interest rate demanded by bond buyers. Of course, issuers must pay a fee to the insurance company for the guarantee. Financial guarantees make sense only when the cost of the insurance is less than the interest savings that result. Because these dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently from a centralized market. An important point to note is that although banks, companies, and governments talk about buying and selling currencies in foreign exchange markets, they do not take a fistful of dollar bills and sell them for British pound notes. Rather, most trades involve the buying and selling of bank deposits denominated in different currencies. So when we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denominated in dollars. The volume in this market is colossal, exceeding $5 trillion per day. Exchange Rates in the Long Run Like the price of any good or asset in a free market, exchange rates are determined by the interaction of supply and demand. Law of One Price If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world no matter which country produces it. —> otherwise, there would be arbitrage. Theory of Purchasing Power Parity One of the most prominent theories of how exchange rates are determined is the theory of purchasing power parity (PPP). It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an application of the law of one price to national price levels. Another way of thinking about purchasing power parity is through a concept called the real exchange rate, the rate at which domestic goods can be exchanged for foreign goods. In effect, it is the price of domestic goods relative to the price of foreign goods denominated in the domestic currency. If the real exchange rate is below one, the currency is relatively cheap and viceversa. Another way of describing the theory of PPP is to say that it predicts that the real exchange rate is always equal to 1.0, so that the purchasing power of the dollar is the same as that of other currencies such as the yen or the euro. Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests on the assumption that all goods are identical in both countries and that transportation costs and trade barriers are very low. When this assumption is true, the law of one price states that the relative prices of all these goods (that is, the relative price level between the two countries) will determine the exchange rate. Because the law of one price does not hold for all goods, a rise in the price of Toyotas relative to Chevys will not necessarily mean that the yen must depreciate by the amount of the relative price increase of Toyotas over Chevys. Furthermore, PPP theory does not take into account that many goods and services (whose prices are included in a measure of a country’s price level) are not traded across borders. So even though the prices of these items might rise and lead to a higher price level relative to another country, the exchange rate would experience little direct effect. Factors That Affect Exchange Rates in the Long Run In the long run, four major factors affect the exchange rate: relative price levels, tariffs and quotas, preferences for domestic versus foreign goods, and productivity. We examine how each of these factors affects the exchange rate while holding the others constant. Keep in mind: Anything that increases the demand for domestically produced goods that are traded relative to foreign traded goods tends to appreciate the domestic currency because domestic goods will continue to sell well even when the value of the domestic currency is higher. Similarly, anything that increases the demand for foreign goods relative to domestic goods tends to depreciate the domestic currency because domestic goods will continue to sell well only if the value of the domestic currency is lower. In other words, if a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate; if a factor decreases the relative demand for domestic goods, the domestic currency will depreciate. Relative Price Levels —> In line with PPP theory, when prices of American goods rise (holding prices of foreign goods constant), the demand for American goods falls and the dollar tends to depreciate so that American goods can still sell well. By contrast, if prices of Japanese goods rise so that the relative prices of American goods fall, the demand for American goods increases, and the dollar tends to appreciate because American goods will continue to sell well even with a higher value of the domestic currency. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country’s relative price level causes its currency to appreciate. Trade Barriers —> Barriers to free trade such as tariffs (taxes on imported goods) and quotas (restrictions on the quantity of foreign goods that can be imported) can affect the exchange rate. Suppose that the United States increases its tariff or puts a lower quota on Japanese steel. These increases in trade barriers increase the demand for American steel, and the dollar tends to appreciate because American steel will still sell well even with a higher value of the dollar. Increasing trade barriers causes a country’s currency to appreciate in the long run. Preferences for Domestic Versus Foreign Goods —> If the Japanese develop an appetite for American goods the increased demand for American goods (exports) tends to appreciate the dollar because the American goods will continue to sell well even at a higher value for the dollar. Likewise, if Americans decide that they prefer Japanese cars to American cars, the increased demand for Japanese goods (imports) tends to depreciate the dollar. Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate. Productivity —> When productivity in a country rises, it tends to rise in domestic sectors that produce traded goods rather than nontraded goods. Higher productivity, therefore, is associated with a decline in the price of domestically produced traded goods relative to foreign traded goods. As a result, the demand for traded domestic goods rises, and the domestic currency tends to appreciate. If, however, a country’s productivity lags behind that of other countries, its traded goods become relatively more expensive, and the currency tends to depreciate. In the long run, as a country becomes more productive relative to other countries, its currency appreciates. Exchange Rates in the Short Run: A Supply and Demand Analysis We have developed a theory of the long-run behavior of exchange rates. However, because factors driving long-run changes in exchange rates move slowly over time, if we are to understand why exchange rates exhibit such large changes (sometimes several percent) from day to day, we must develop a supply- and-demand analysis of how current exchange rates (spot exchange rates) are determined in the short run. The key to understanding the short-run behavior of exchange rates is to recognize that an exchange rate is the price of domestic assets (bank deposits, bonds, equities, etc., denominated in the domestic currency) in terms of foreign assets (similar assets denominated in the foreign currency). Because the exchange rate is the price of one asset in terms of another, the natural way to investigate the short-run determination of exchange rates is to use an asset market approach that relies heavily on the theory of portfolio choice. As you will see, however, the long-run determinants of the exchange rate we have just outlined also play an important part in the short-run asset market approach. Supply Curve for Domestic Assets We start by discussing the supply curve. In this analysis we treat the United States as the home country, so domestic assets are denominated in dollars. For simplicity, we use euros to stand for any foreign country’s currency, so foreign assets are denominated in euros. The quantity of dollar assets supplied is primarily the quantity of bank deposits, bonds, and equities in the United States, and for all practical purposes we can take this amount as fixed with respect to the exchange rate. The quantity supplied at any exchange rate does not change, so the supply curve, S, is vertical. Demand Curve for Domestic Assets The demand curve traces out the quantity demanded at each current exchange rate by holding everything else constant, particularly the expected future value of the exchange rate. We write the current exchange rate (the spot exchange rate) as Et, and the expected exchange rate for the next period as Eet+1. As the theory of portfolio choice suggests, the most important determinant of the quantity of domestic (dollar) assets demanded is the relative expected return of domestic assets. Let’s see what happens as the current exchange rate Et falls. Suppose we start at point A in the figure, where the current exchange rate is at 1.05 euros per dollar. With the future expected value of the exchange rate held constant at Eet+1, a lower value of the exchange rate—say, at E* = 1 euro per dollar—implies that the dollar is expected to rise more in value, that is, appreciate. The greater the expected rise (appreciation) of the dollar, the higher the relative expected return on dollar (domestic) assets. The theory of portfolio choice then tells us that because dollar assets are now more desirable to hold, the quantity of dollar assets demanded will rise, as is shown by point B in the figure. If the current exchange rate is even lower at 0.95 euro per dollar, there is an even higher expected appreciation of the dollar, a higher expected return, and therefore an even greater quantity of dollar assets demanded. This effect is shown in point C. The resulting demand curve, D, which connects these points, is downward-sloping, indicating that at lower current values of the dollar (everything else being equal), the quantity demanded of dollar assets is higher. Equilibrium in the Foreign Exchange Market thus rises, the demand curve shifts to the right, and the exchange rate rises. 
 5. When expected import demand rises, we expect the exchange rate to depreciate in the long run, so the expected return on dollar assets falls. The quantity demanded of dollar assets at each value of the current exchange rate therefore falls, the demand curve shifts to the left, and the exchange rate declines. 
 6. When expected export demand rises, the opposite occurs because the exchange rate is expected to appreciate in the long run. The expected return on dollar assets rises, the demand curve shifts to the right, and the exchange rate rises. 7. With higher expected domestic productivity, the exchange rate is expected to appreciate in the long run, so the expected return on domestic assets rises. The quantity demanded at each exchange rate therefore rises, the demand curve shifts to the right, and the exchange rate rises. 
 Effect of Changes in Interest Rates on the Equilibrium Exchange Rate Changes in domestic interest rates i^D are often cited as a major factor affecting exchange rates. The Fisher equation states that a nominal interest rate such as i^D equals the real interest rate plus expected inflation: i = ir + πe. The Fisher equation thus indicates that the interest rate iD can change for two reasons: Either the real interest rate ir changes or the expected inflation rate πe changes. The effect on the exchange rate is quite different, depending on which of these two factors is the source of the change in the nominal interest rate. Suppose that the domestic real interest rate increases so that the nominal interest rate iD rises while expected inflation remains unchanged. In this case, it is reasonable to assume that the expected future exchange rate is unchanged because expected inflation is unchanged. In this case, the increase in iD increases the relative expected return on dollar assets, raises the quantity of dollar assets demanded at each level of the exchange rate, and shifts the demand curve to the right. We end up with the situation depicted in the figure, which analyzes an increase in iD, holding everything else constant. Our model of the foreign exchange market produces the following result: When domestic real interest rates rise, the domestic currency appreciates. When the nominal interest rate rises because of an increase in expected inflation, we get a different result from the one shown in the figure. The rise in expected domestic inflation leads to a decline in the expected appreciation of the dollar, which is typically thought to be larger than the increase in the domestic interest rate iD.* As a result, at any given exchange rate, the relative expected return on domestic (dollar) assets falls, the demand curve shifts to the left, and the exchange rate falls from E1 to E2, as shown in Figure 15.7. Our analysis leads to this conclusion: When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates. Because this conclusion is completely different from the one reached when the rise in the domestic interest rate is associated with a higher real interest rate, we must always distinguish between real and nominal measures when analyzing the effects of interest rates, either domestic or foreign, on exchange rates. Why Are Exchange Rates So Volatile? The high volatility of foreign exchange rates surprises many people. The asset market approach to exchange rate determination that we have outlined here gives a straightforward explanation of volatile exchange rates. Because expected appreciation of the domestic currency affects the expected return on domestic assets, expectations about the price level, inflation, trade barriers, productivity, import demand, export demand, and future monetary policy play important roles in determining the exchange rate. When expectations about any of these variables change, as they do—and often at that—our model indicates that the expected return on domestic assets, and therefore on the exchange rate, will be immediately affected. Because expectations on all these variables change with just about every bit of news that appears, it is not surprising that the exchange rate is volatile. The interest parity condition The interest parity condition shows the relationship between domestic interest rates, foreign interest rates, and the expected appreciation of the domestic currency. Comparing Expected Returns on Domestic and Foreign Assets To illustrate further, suppose that dollar assets pay an interest rate of iD and do not have any possible capital gains, so that they have an expected return payable in dollars of iD. Similarly, foreign assets have an interest rate of iF and an expected return payable in the foreign currency, euros, of iF. To compare the expected returns on dollar assets and foreign assets, investors must convert the returns into the currency unit they use. First let us examine how François the foreigner compares the returns on dollar assets and foreign assets denominated in his currency, the euro. When he considers the expected return on dollar assets in terms of euros, he recognizes that it does not equal iD; instead, the expected return must be adjusted for any expected appreciation or depreciation of the dollar. If François expects the dollar to appreciate by 3%, for example, the expected return on dollar assets in terms of euros would be 3% higher than i^D because the dollar is expected to become worth 3% more in terms of euros. Thus, if the interest rate on dollar assets is 4%, with an expected 3% appreciation of the dollar, the expected return on dollar assets in terms of euros is 7%: the 4% interest rate plus the 3% expected appreciation of the dollar. Conversely, if the dollar were expected to depreciate by 3% over the year, the expected return on dollar assets in terms of euros would be only 1%: the 4% interest rate minus the 3% expected depreciation of the dollar. As the relative expected return on dollar assets increases, foreigners will want to hold more dollar assets and fewer foreign assets. Interest Parity Condition We currently live in a world in which there is capital mobility: Foreigners can easily purchase American assets, and Americans can easily purchase foreign assets. If there are few impediments to capital mobility and we are looking at assets that have similar risk and liquidity then it is reasonable to assume that the assets are perfect substitutes (that is, equally desirable). When capital is mobile and when assets are perfect substitutes, if the expected return on dollar assets is above that on foreign assets, both foreigners and Americans will want to hold only dollar assets and will be unwilling to hold foreign assets. Conversely, if the expected return on foreign assets is higher than on dollar assets, both foreigners and Americans will not want to hold any dollar assets and will want to hold only foreign assets. For existing supplies of both dollar assets and foreign assets to be held, it must therefore be true that there is no difference in their expected returns; that is, the relative expected return in the above equation must equal zero. This condition can be rewritten as This equation, which is called the interest parity condition, states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency. Equivalently, this condition can be stated in a more intuitive way: The domestic interest rate equals the foreign interest rate plus the expected appreciation of the foreign currency. If the domestic interest rate is higher than the foreign interest rate, there is a positive expected appreciation of the foreign currency, which compensates for the lower foreign interest rate. Stock funds, also known as equity funds, invest primarily in stocks and aim to provide long- term growth and capital appreciation. Bond funds invest primarily in bonds and aim to provide a steady income stream. They can invest in a range of bonds, including government bonds, corporate bonds, and municipal bonds. Hybrid funds are a combination of stock and bond funds, and they aim to provide a balance of growth and income. Money market funds invest primarily in short-term, low-risk securities, such as government bonds and certificates of deposit, and aim to provide a stable source of income and preservation of capital. Investors can choose the type of mutual fund that best aligns with their investment objectives, risk tolerance, and financial goals. By investing in a mutual fund, investors can gain access to a diversified portfolio of securities, professional management, and economies of scale, which can result in lower costs and better returns compared to investing in individual securities. Fee Structure of Investment Funds Originally, most shares of mutual funds were sold by brokers who received a commission for their efforts. Because this commission was paid at the time of the purchase and immediately subtracted from the redemption value of the shares, these funds were called load funds. If the fee is charged when the funds are deposited, it is a front-end load.If a fee is charged when funds are taken out (usually a declining fee over five years), it is a deferred load. Beginning in the 1980s, funds that did not charge a direct load (or fee) appeared. These are called no-load funds. Regardless of whether a load is charged, all mutual fund accounts are subject to a variety of fees. One of the primary factors that an investor should consider before choosing a mutual fund is the level of fees the fund charges. The fees are taken out of portfolio income before it is passed on to the investor. Since the investor is not directly charged the fees, many will not realize that they have even been subtracted. The usual fees charged by mutual funds are the following: • A contingent deferred sales charge imposed at the time of redemption is an alternative way to compensate financial professionals for their services. This fee typically applies for the first few years of ownership and then disappears. 
 • A redemption fee is a back-end charge for redeeming shares. It is expressed as a dollar amount or a percentage of the redemption price. 
 • An exchange fee may be charged when transferring money from one fund to another within the same fund family. 
 • An account maintenance fee is charged by some funds to maintain low balance accounts. 
 • 12b-1 fees, if any, are deducted from the fund’s assets to pay marketing and advertising expenses or, more commonly, to compensate sales professionals. By law, 12b-1 fees cannot exceed 1% of the fund’s average net assets per year. 
 Regulation of Mutual Funds Mutual funds are regulated under four federal laws designed to protect investors. The Securities Act of 1933 mandates that funds make certain disclosures. The Securities Exchange Act of 1934 set out antifraud rules covering the purchase and sale of fund shares. The Investment Company Act of 1940 requires all funds to register with the SEC and to meet certain operating standards. Finally, the Investment Advisers Act of 1940 regulates fund advisers. As part of this government regulation, all funds must provide two types of documents free of charge: a prospectus and a shareholder report. • A mutual fund’s prospectus describes the fund’s goals, fees and expenses, and investment strategies and risks; it also gives information on how to buy and sell shares. The SEC requires a fund to provide a full prospectus either before an investment or together with the confirmation statement of an initial investment. • Annual and semiannual shareholder reports discuss the fund’s recent performance and include other important information, such as the fund’s financial statements. By examining these reports, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund’s prospectus. In addition, investors are sent a yearly statement detailing the federal tax status of distributions received from the fund. Mutual fund shareholders are taxed on the fund’s income directly, as if the shareholders held the underlying securities themselves. Similarly, any tax-exempt income received by a fund is generally passed on to the shareholders as tax exempt. Mutual funds are the only companies in America that are required by law to have independent directors. The SEC believes that independent directors play a critical role in the governance of mutual funds. In January 2001, the SEC adopted substantive rule amendments designed to enhance the independence of investment company directors and provide investors with more information to assess directors’ independence. These rules require that: • Independent directors constitute at least a majority of the fund’s board of directors. 
 • Independent directors select and nominate other independent directors. 
 • Any legal counsel for the fund’s independent directors be an independent legal counsel. 
 • In addition, SEC rules require that mutual funds publish extensive information about directors, including their business experience and fund shares held. This system of overseeing the interests of mutual fund shareholders has helped the industry avoid systemic problems and contributed significantly to public confidence in mutual funds. 
 Hedge Funds 
 A hedge fund is a type of investment fund that uses a variety of investment strategies and financial instruments to generate returns for its investors. Unlike traditional mutual funds, hedge funds are not required to adhere to strict regulations regarding the types of investments they can make, which gives them more flexibility and a wider range of investment opportunities. Hedge funds are often managed by investment professionals and are designed to generate high returns for their investors, usually through the use of leverage, short selling, and other aggressive investment strategies. The minimum investment required to participate in a hedge fund is usually high, and they are typically only open to accredited investors. Additionally, hedge funds are not subject to the same level of public disclosure as mutual funds, which makes it more difficult for investors to evaluate the risks and returns associated with these investments. 
 In the transaction, the managers did not care whether the overall bond market rose or fell. In this sense, the transaction was market-neutral. All that was required for a profit was that the prices of the bonds converge, an event that occurred as predicted. Hedge fund managers scour the world in their search for pricing anomalies between related securities. The figure shows a situation where hedge funds could invest. Securities A and B move in lockstep over time. At some point they diverge, creating an opportunity. The hedge fund would buy security B, because it is expected to increase relative to A, and would sell A short. The fund managers hope that the gain on security B will be greater than the loss on security A. At times, the search for opportunities leads hedge funds to adopt exotic approaches that are not easi ly avai lable elsewhere, f rom investing in distressed securities to participating in venture-capital financing. Hedge funds accumulate money from many people and invest on their behalf, but several features distinguish them from traditional mutual funds: • Hedge funds have a minimum investment requirement of between $100,000 and $20 million, with the typical minimum investment being $1 million. Long Term Capital Management required a $10 million minimum investment. • Most hedge funds are set up as limited partnerships. Federal law limits hedge funds to no more than 99 limited partners with steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes. Funds may have up to 499 limited partners if each has $5 million in invested assets. • Hedge funds are unique in that they usually require investors to commit their money for long periods of time, often several years. The purpose of this requirement is to give managers breathing room to attempt long-range strategies. • Hedge funds often charge large fees to investors. The typical fund charges a 1% annual asset management fee plus 20% of profits. Some charge significantly more. For example, Long Term Capital Management charged investors a 2% management fee and took 25% of profits. Despite the argument that the wealthy do not need regulatory protection from the risk incurred by hedge fund investments, the SEC passed regulation in 2006 requiring that hedge fund advisers register. The SEC cited two concerns prompting the new move. First, they were concerned about the growing incidence of fraudulent conduct by hedge fund advisers. Second, they expressed concern that more investors were participating in hedge funds through “retailization,” and that this justified increased oversight. By requiring advisers to register, the SEC can conduct on-site examinations. The SEC argues these examinations are necessary to protect the nation’s securities market as well as hedge fund investors. Conflicts of Interest in the Mutual Fund Industry Investor confidence in the stability and integrity of the mutual fund industry is critical. A large portion of the population is now responsible for planning their own retirement, and most of these investments are being funneled into various funds. If these funds take advantage of investors or fail to provide the returns they should, people will find themselves unable to retire or having to scale back their retirement plans. No one argues that mutual funds can or should guarantee any specific return. They should, however, treat all investors equally and accurately disclose risk and fees. They must also follow the policies and rules they publish as governing the management of each fund. Sources of Conflicts of Interest Conflicts of interest arise when there is asymmetric information and the principal’s and agent’s interests are not closely aligned. The governance structure of mutual funds creates Chapter 21: Insurance Companies and Pension Funds Insurance Companies Insurance companies are financial intermediaries. Insurance companies collect funds from policyholders in the form of premiums, and they invest these funds to generate returns. The returns from these investments are used to pay claims to policyholders and to cover the operating costs of the insurance company. In this sense, insurance companies act as intermediaries, taking in funds from one group of individuals (policyholders) and using these funds to provide financial protection to another group of individuals (claimants). By pooling resources in this way, insurance companies help to spread risk and make it easier for individuals to manage their financial risks. Why do people pay for insurance when they know that over the lifetime of their policy, they will probably pay more in premiums than the expected amount of any loss they will suffer? Because most people are risk-averse: They would rather pay a certainty equivalent (the insurance premium) than accept the gamble that they will lose their house or their car. Thus, it is because people are risk-averse that they prefer to buy insurance and know with certainty what their wealth will be (their current wealth minus the insurance premium) than to run the risk that their wealth may fall. Fundamentals of Insurance Although there are many types of insurance and insurance companies, all insurance is subject to several basic principles. 1. There must be a relationship between the insured (the party covered by insurance) and the beneficiary (the party who receives the payment should a loss occur). In addition, the beneficiary must be someone who may suffer potential harm. The reason for this rule is that insurance companies do not want people to buy policies as a way of gambling. 2. The insured must provide full and accurate information to the insurance company. 
 3. The insured is not to profit as a result of insurance coverage. 
 4. If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation. 
 5. The insurance company must have a large number of insurers so that the risk can be spread out among many policies. 
 6. The loss must be quantifiable. 7. The insurance company must be able to compute the probability of the loss. 
 The purpose of these principles is to maintain the integrity of the insurance process. Without them, people might be tempted to use insurance companies to gamble or speculate on future events. Taken to an extreme, this behavior could undermine the ability of insurance companies to protect persons in real need. In addition, these principles provide a way to spread the risk among many policies and to establish a price for each policy that will provide an expectation of a profitable return. Despite following these guidelines, insurance companies suffer greatly from the problems of asymmetric information. Adverse Selection and Moral Hazard in Insurance Recall that adverse selection occurs when the individuals most likely to benefit from a transaction are the ones who most actively seek out the transaction and are thus most likely to be selected. Adverse selection is a phenomenon that occurs when people who are more likely to file a claim are more likely to buy insurance. This can happen when individuals have more information about their own risk of loss than the insurance company does. For example, if an individual knows they are at a higher risk of getting into a car accident, they may be more likely to purchase car insurance than someone who is a safer driver. Insurance companies are aware of this phenomenon and try to mitigate it by using underwriting techniques to gather information about potential policyholders. However, even with these techniques, adverse selection can still occur. In addition to the adverse selection problem, moral hazard plagues the insurance industry. Moral hazard occurs when the insured fails to take proper precautions to avoid losses because losses are covered by insurance. For example, moral hazard may cause you not to lock your car doors if you will be reimbursed by insurance if the car is stolen. One way that insurance companies combat moral hazard is by requiring a deductible. A deductible is the amount of any loss that must be paid by the insured before the insurance company will pay anything. For example, if new canvas yacht covers cost $5,000 and the yacht owner has $1,000 deductible, the owner will pay the first $1,000 of the loss and the insurance company will pay $4,000. In addition to deductibles, there may be other terms in the insurance contract aimed at reducing risk. For example, a business insured against fire may be required to install and maintain a sprinkler system on its premises to reduce the loss should a fire occur. Selling Insurance Another problem common to insurance companies is that people often fail to seek as much insurance as they actually need. Human nature tends to cause people to ignore their mortality, for example. For this reason, insurance, unlike many banking services, does not sell itself. Instead, insurance companies must hire large sales forces to sell their products. A good sales force can convince people to buy insurance coverage that they never would have pursued on their own yet may need. The relationship between the agent and the company varies: Independent agents may sell insurance for a number of different companies. They do not have loyalty to any one firm and simply try to find the best product for their customer. Exclusive agents sell the insurance products for only one insurance company. Most agents, whether independent or exclusive, are compensated by being paid a commission. To keep control of the risk that agents are incurring on behalf of the company, insurance companies employ underwriters, people who review and sign off on each policy an agent writes and who have the authority to turn down a policy if they deem the risk unacceptable. If underwriters have questions about the quality of customers, they may order an independent inspector to review the property being insured or request additional medical information about a customer. Stock companies and mutual companies Insurance companies can be structured in two different ways: as stock companies or as mutual companies. A stock insurance company, also known as a stock insurance corporation, is a for-profit insurance company that is owned by shareholders. These shareholders own stocks in the company and receive dividends as a return on their investment. Stock insurance companies are driven by the pursuit of profits for their shareholders, and their business decisions are often influenced by the need to generate returns for their owners. On the other hand, a mutual insurance company is owned by its policyholders, who are also its customers. Instead of paying dividends to shareholders, mutual insurance companies return profits to their policyholders in the form of policyholder dividends or reduced premiums. The primary focus of a mutual insurance company is to provide insurance protection to its policyholders, rather than to generate profits for its owners. In general, both stock and mutual insurance companies offer insurance products, such as life insurance, health insurance, and property and casualty insurance. The choice between a stock or mutual insurance company often comes down to personal preference and the type of insurance coverage needed. Policyholders may prefer a mutual insurance company because of its customer-focused approach, while others may prefer a stock insurance company because of its potential for generating investment returns. Types of Insurance Insurance is classified by which type of undesirable event is insured. The most common types are health, life, and property and casualty insurance. In its simplest form, life insurance provides income for the heirs of the deceased. Many insurance companies offer policies that provide retirement benefits as well as life insurance. In this case, the premium combines the cost of the life insurance with a savings program. The cost of life insurance depends on such factors as the age of the insured, average life expectancies, the health and lifestyle of the insured, and the insurance company’s operating costs. Property and casualty insurance protects property (houses, cars, boats, and so on) against losses due to accidents, fire, disasters, and other calamities. Property and casualty premiums are based simply on the probability of sustaining the loss. That is why car insurance premiums are higher if a driver has had speeding tickets, has caused accidents, or lives in a high-crime area. Each of these events increases the likelihood that the insurance company will have to pay a claim. Life Insurance Life is assumed to unfold in a predictable sequence: You work for a number of years while saving for retirement; then you retire, live off the fruits of your earlier labor, and die at a ripe old age. The problem is that you could die too young and not have time to provide for your loved ones, or you could live too long and run out of retirement assets. Either option is very unappealing to most people. The purpose of life insurance is to relieve some of the concern associated with either eventuality. Although insurance cannot make you comfortable with the idea of a premature death, it can at least allow you the peace of mind that comes with knowing that you have provided for your heirs. Life insurance companies also want to help people save for their retirement. In this way, the insurance company provides for the customer’s whole life. The basic products of life insurance companies are life insurance proper, disability insurance, annuities, and health insurance. Life insurance pays off if you die, protecting those who depend on your continued earnings. As mentioned, the person who receives the insurance payment after you die is called the beneficiary of the policy. Disability insurance replaces part of your income should you become unable to continue working due to illness or an accident. An annuity is an insurance product that will help if you live longer than you expect. For an initial fixed sum or stream of payments, the insurance company agrees to pay you a fixed amount for as long as you live. If you live a short life, the insurance company pays out less than expected. Conversely, if you live unusually long, the insurance company may pay out much more than expected. Notice one curiosity among these various types of insurance: Although predicting any one individual’s life expectancy or probability of being disabled is very difficult, when many people are insured, the actual amount to be paid out by the insurance company can be predicted very accurately. Insurance companies collect and analyze statistics on life expectancies, health claims, disability claims, and other relevant matters. The law of large numbers says that when many people are insured, the probability distribution of the losses will assume a normal probability distribution, a distribution that allows accurate predictions. This distribution is important: Because insurance companies company follow the standards set by the state in which it is chartered, but it must also comply with the regulations set in any state in which it does business. The purpose of most regulations is to protect policyholders from losses due to the insolvency of the company. To accomplish this, insurance companies are restricted as to their asset composition and minimum capital ratio. All states also require that insurance agents and brokers obtain state licenses to sell each kind of insurance: life, property and casualty, and health. These licenses are to ensure that all agents have a minimum level of knowledge about the products they sell. Insurance Management In the case of an insurance policy, moral hazard arises when the existence of insurance encourages the insured party to take risks that increase the likelihood of an insurance payoff. Adverse selection holds that the people most likely to receive large insurance payoffs are the ones who will want to purchase insurance the most. Screening: To reduce adverse selection, insurance companies try to screen out poor insurance risks from good ones. Effective information collection procedures are therefore an important principle of insurance management. The insurance company uses the information you provide to allocate you to a risk class. Based on this information, the insurance company can decide whether to accept you for the insurance or to turn you down because you pose too high a risk and thus would be an unprofitable customer for the insurance company. Risk-Based Premium: Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance company is a time-honored principle of insurance management. Adverse selection explains why this principle is so important to insurance company profitability. Restrictive Provisions: Restrictive provisions in policies are another insurance management tool for reducing moral hazard. Such provisions discourage policyholders from engaging in risky activities that make an insurance claim more likely. One type of restrictive provision keeps the policyholder from benefiting from behavior that makes a claim more likely. Restrictive provisions may also require certain behavior on the part of the insured that makes a claim less likely. A company renting motor scooters may be required to provide helmets for renters in order to be covered for any liability associated with the rental. Prevention of Fraud: Insurance companies also face moral hazard because an insured person has an incentive to lie to the company and seek a claim even if the claim is not valid. Thus, an important management principle for insurance companies is conducting investigations to prevent fraud so that only policyholders with valid claims receive compensation. Cancellation of Insurance: Being prepared to cancel policies is another insurance management tool. Insurance companies can discourage moral hazard by threatening to cancel a policy when the insured person engages in activities that make a claim more likely. Deductibles: The deductible is the fixed amount by which the insured’s loss is reduced when a claim is paid off. Deductibles are an additional management tool that helps insurance companies reduce moral hazard. With a deductible, you experience a loss along with the insurance company when you make a claim. A deductible thus makes a policyholder act more in line with what is profitable for the insurance company; moral hazard has been reduced. And because moral hazard has been reduced, the insurance company can lower the premium by more than enough to compensate the policyholder for the existence of the deductible. Coinsurance: When a policyholder shares a percentage of the losses along with the insurance company, their arrangement is called coinsurance. Coinsurance works to reduce moral hazard in exactly the same way that a deductible does. A policyholder who suffers a loss along with the insurance company has less incentive to take actions, such as going to the doctor unnecessarily, that involve higher claims. Coinsurance is thus another useful management tool for insurance companies. Limits on the Amount of Insurance: Another important principle of insurance management is that there should be limits on the amount of insurance provided, even though a customer is willing to pay for more coverage. Pensions Pension funds are financial intermediaries. Pension funds typically receive contributions from employers and employees and then invest those funds in a variety of financial assets such as stocks, bonds, and real estate. The goal of the investment is to generate returns that can be used to pay out pensions to retirees in the future. By pooling the savings of many individuals, pension funds act as intermediaries between savers and investors, facilitating the flow of funds from savers to the financial markets. Types of Pensions Pension plans can be categorized in several ways. They may be defined-benefit or defined- contribution plans, and they may be public or private. Defined benefit pension plans and defined contribution pension plans are two different types of retirement savings plans that are offered by employers to their employees. Defined benefit pension plans, also known as traditional pension plans, are plans in which the employer promises to pay a specific benefit to the employee upon retirement, typically based on factors such as the employee's salary and years of service. The benefit amount is usually determined by a formula and is not tied directly to the employee's contributions or investment returns. The employer is responsible for funding the plan and managing the investments, and the employee is not typically involved in the investment decisions. Defined contribution pension plans, on the other hand, are plans in which the employee and employer both contribute a specific amount to the plan, typically on a regular basis. The benefit that the employee receives upon retirement is based solely on the balance of the account and the investment returns earned on the contributions. The employee typically has more control over investment decisions, and the risk and reward of the plan are shared between the employee and employer. In general, defined benefit pension plans provide a higher level of guaranteed benefits, but they also carry more risk for the employer, who must fund the plan and manage the investments. Defined contribution plans provide more control and flexibility for the employee, but they also carry more risk, as the benefit received upon retirement depends on the employee's contributions and investment returns. Private and Public Pension Plans The main difference between private and public pension plans is the entity that sponsors and manages the plan. Private pension plans are sponsored and managed by private sector employers, such as corporations and small businesses. They can take the form of defined benefit plans or defined contribution plans. In a defined benefit plan, the employer promises to pay a certain benefit to the employee upon retirement, usually based on a formula that takes into account the employee's salary and years of service. In a defined contribution plan, the employer sets aside money into an account for the employee, and the employee's benefit at retirement is determined by the balance in that account, which is invested in stocks, bonds, or other assets. Public pension plans, on the other hand, are sponsored and managed by government entities, such as state and local governments, or by government-affiliated organizations. They also can be defined benefit or defined contribution plans, with the difference that they are mandatory for the employees. Public pension plans are typically established by laws and regulations, and they are intended to provide retirement income security to public sector employees. Regulation of Pension Plans Employee Retirement Income Security Act The most important and most comprehensive legislation affecting pension funds is the Employee Retirement Income Security Act (ERISA), passed in 1974. ERISA set certain standards that must be followed by all pension plans. Failure to follow the provisions of the act may cause a plan to lose its advantageous tax status. The motivation for the act was that many workers who had contributed to plans for years were losing their benefits when plans failed. The principal features of the act are the following: • ERISA established guidelines for funding. 
 • It provided that employees switching jobs may transfer their credits from one employer plan to the next. 
 • Plans must have minimum vesting requirements. Vesting refers to how long an employee must work for the company to be eligible for pension benefits. The maximum permissible vesting period is seven years, though most plans allow for vesting in less time. Employee contributions are always immediately vested. 
 • It increased the disclosure requirements for pension plans, providing employees with more ample information about the health and investments of their pension plans. 
 • It assigned the responsibility of regulatory oversight to the Department of Labor. 
 ERISA also established the Pension Benefit Guarantee Corporation (PBGC or simply called Penny Benny), a government agency that performs a role similar to that of the FDIC. It insures pension benefits up to a limit (currently just over $57,000 per year per person) if a company with an underfunded pension plan goes bankrupt or is unable to meet its pension obligations for other reasons. Individual Retirement Plans The Pension Reform Act of 1978 updated the Self-Employed Individuals Tax Retirement Act of 1962 to authorize individual retirement accounts (IRAs). IRAs permitted people (such as those who are self-employed) who are not covered by other pension plans to contribute into a tax-deferred savings account. Legislation in 1981 and 1982 expanded the eligibility of these accounts to make them available to almost everyone. IRAs proved extremely popular, to the extent that their use resulted in significant losses of tax revenues to the government. That led Congress to include provisions in the Tax Reform Act of 1986 that sharply curtail eligibility. Keogh plans are a retirement savings option for the self-employed. Funds can be deposited with a depository institution, life insurance company, or securities firm. The owner of the Keogh is often allowed some discretion as to how the funds will be invested. On January 1, 1997, the Small Business Protection Act of 1996 went into effect. This act created simplified retirement plans with so-called SIMPLE IRAs and 401(k) plans for businesses with 100 or fewer employees. SIMPLE retirement plans are becoming significantly more popular, especially among the smallest businesses. 
 receive. The advantage to the investment banker of a best efforts transaction is that there is no risk of mispricing the security. There is also no need for the time-consuming task of establishing the market value of the security. The investment banker simply markets the security at the price the customer asks. If the security fails to sell, the offering can be canceled. Private Placements —> In a private placement, securities are sold to a limited number of investors rather than to the public as a whole. The advantage of the private placement is that the security does not need to be registered with the SEC as long as certain restrictive requirements are satisfied. Investment bankers are also often involved in private placement transactions. While investment bankers are not required for a private placement, they often facilitate the transaction by advising the issuing firm on the appropriate terms for the issue and by identifying potential purchasers. Equity Sales Another service offered by investment banks is to help with the sale of companies or corporate divisions. The first step in any equity sale will be the seller’s determination of the business’s worth. The investment banker will provide a detailed analysis of the current market for similar companies and apply various sophisticated models to establish company value. The company value is based on the use the buyer intends to make of it. If a buyer is interested only in the physical assets, the firm will be worth one amount. A buyer who sees the firm as an opportunity to take advantage of synergies between this firm and another will have a very different price. Despite the elasticity of the yardstick, investment bankers have developed a number of tools to give business owners a range of values for their firms. How much cash flows will have to be discounted depends very much on who will be bidding on the firm. Again, investment bankers help. They may make discreet inquiries to feel out who in the market may be interested. Additionally, they will prepare a confidential memorandum that presents the detailed financial information required by prospective buyers to make an offer for the company. All prospective buyers must sign a confidentiality agreement stipulating that they will not use the information to compete or share it with third parties. The investment bank will screen prospects to ensure that the information goes only to qualified buyers. The next step in an equity sale is the letter of intent issued by a prospective buyer. Once the letter of intent has been accepted by the seller, the due diligence period begins. This 20- to 40-day period is used by the buyer to verify the accuracy of the information contained in the confidential memorandum. The findings shape the terms of the definitive agreement. This agreement converts information gathered during the due diligence period and the results of subsequent negotiations into a legally binding contract. Mergers and Acquisitions A merger occurs when two firms combine to form one new company. Both firms support the merger, and corporate officers are usually selected so that both companies contribute to the new management team. Stockholders turn in their stock for stock in the new firm. In an acquisition, one firm acquires ownership of another by buying its stock. Often this process is friendly, and the firms agree that certain economies can be captured by combining resources. It is not unusual that a firm suffering financial stress will even seek out a company to acquire them. At other times, the firm being purchased may resist. Resisted takeovers are called hostile. In these cases, the acquirer attempts to purchase sufficient shares of the target firm to gain a majority of the seats on the board of directors. Board members are then able to vote to merge the target firm with the acquiring firm. Investment bankers serve both acquirers and target firms. Acquiring firms require help in locating attractive firms to pursue, soliciting shareholders to sell their shares in a process called a tender offer, and raising the required capital to complete the transaction. Target firms may hire investment bankers to help ward off undesired takeover attempts. The mergers and acquisitions markets require very specialized knowledge and expertise. Securities Brokers and Dealers A broker and a dealer are two different types of financial intermediaries that play distinct roles in the financial markets. A broker is an intermediary that helps clients buy or sell financial assets such as stocks, bonds, and commodities. Brokers act on behalf of clients, seeking to execute trades at the best possible price. Brokers are paid a fee or commission for their services, but they do not take ownership of the financial assets they trade. Instead, they act as intermediaries between buyers and sellers, connecting them and facilitating trades. A dealer, on the other hand, takes ownership of financial assets with the intention of reselling them at a profit. Dealers make a market in financial assets, meaning they are willing to buy and sell securities at quoted prices. Dealers profit from the difference between the prices at which they buy and sell financial assets, also known as the bid-ask spread. Dealers are often market makers, meaning they are willing to take the other side of a trade when a buyer or seller cannot be found. In short, brokers facilitate trades by connecting buyers and sellers, while dealers take ownership of securities and make a market in them, earning profits from the spread between the bid and ask prices. Brokerage Services Securities brokers offer several types of services. Securities Orders —> If you call a securities brokerage house to buy a stock, you will speak with a broker who will take your order. You have three primary types of transactions available: market orders, limit orders, and short sells. The two most common types of securities orders are the market order and the limit order. When you place a market order, you are instructing your agent to buy or sell the security at the current market price. When placing a market order, there is a risk that the price of the security may have changed significantly from what it was when you made your investment decision. An alternative to the market order is the limit order. Here, buy orders specify a maximum acceptable price, and sell orders specify a minimum acceptable price. What can be done if an investor is convinced that a stock will fall in the future? The solution is to sell short. A short sell requires that the investor borrow stocks from a brokerage house and sell them today, with the promise of replacing the borrowed stocks by buying them in the future. Of course, if you are wrong and the price rises, you will suffer a loss. Market and limit orders allow you to take advantage of stock price increases, and short sells allow you to take advantage of stock price decreases. Analysts track the number of short positions taken on a stock as an indicator of the number of investors who feel that a stock’s price is likely to fall in the future. Other Services —> In addition to trading in securities, stockbrokers provide a variety of other services. Investors typically leave their securities in storage with the broker for safekeeping. If the securities are left with the broker, they are insured against loss by the Securities Investor Protection Corporation (SIPC), an agency of the federal government. This guarantee is not against loss in value, only against loss of the securities themselves. Brokers also provide margin credit. Margin credit refers to loans advanced by the brokerage house to help investors buy securities. Full-Service vs. Discount Brokers —> Full-service brokers provide research and investment advice to their customers. Full-service brokers will often mail weekly and monthly market reports and recommendations to their customers in an effort to encourage them to invest in certain securities. Full-service brokers attempt to establish long-term relationships with their customers and to help them assemble portfolios that are consistent with their financial needs and risk preferences. Of course, this extra attention is costly and must be paid for by requiring higher fees for initiating trades. Discount brokers simply execute trades on request. If you want to buy a particular security, you call the discount broker and place your request. No advice or research is typically provided. Because the cost of operating a discount brokerage firm is significantly less than the cost of operating a full-service firm, lower transaction costs are charged. These fees may be a fraction of the fees charged by a full-service broker. Securities Dealers Securities dealers hold inventories of securities, which they sell to customers who want to buy. They also hold securities purchased from customers who want to sell. It is impossible to overemphasize the importance of dealers to the smooth functioning of the U.S. financial markets. They stand ready to make a market in the security at any time—that is, they make sure that an investor can always sell or buy a security. For this reason, dealers are also called market makers. When an investor wishes to sell a thinly traded stock (one without an active secondary market), it is unlikely that another investor is simultaneously seeking to buy that security. This nonsynchronous trading problem is solved when the dealer buys the security from the investor and holds it in inventory until another investor is ready to buy it. The knowledge that dealers will provide this service encourages investors to buy securities that would be otherwise unacceptable. Regulation of Securities Firms Many financial firms engage in all three securities market activities, acting as brokers, dealers, and investment bankers. The largest in the United States is Merrill Lynch; other well- known firms include Morgan Stanley and Salomon Smith Barney (a division of Citigroup). The SEC not only regulates the firms’ investment banking operations but also restricts brokers and dealers from misrepresenting securities and from trading on insider information, unpublicized facts known only to the management of a corporation. When discussing regulation, it is important to recognize that the public’s confidence in the integrity of the financial markets is critical to the growth of our economy and the ability of firms to continue using the markets to raise new capital. If the public believes that there are other powerful players with superior information who can take advantage of smaller investors, the market will be unable to attract funds from these smaller investors. Ultimately, the markets could fail entirely. Due to asymmetric information, investors will not know as much about securities being offered for sale by firms as firm insiders will. If an average price is set for all securities based on this lack of information, good securities would be withdrawn and only poor and overpriced securities would remain for sale. With only these securities offered, the average price would fall. Now any securities worth more than this new average would be withdrawn. Eventually, the market would fail as the average security offered drops in quality and market prices fall as a result. One solution to the lemons problem is for the government to regulate full disclosure so that asymmetric information is reduced. Investing —> Once commitments have been received, the venture fund can begin the investment phase. Venture funds either may specialize in one or two industry segments or may generalize, looking at all available opportunities. It is not uncommon for venture funds to focus investments in a limited geographic area to make it easier to review and monitor the firms’ activities. Frequently, venture capitalists invest in a firm before it has a real product or is even clearly organized as a company. This is called seed investing. Investing in a firm that is a little further along in its life cycle is known as early-stage investing. Finally, some funds focus on later-stage investing by providing funds to help the company grow to a critical mass to attract public financing. Typically, about 60% of venture capital funds go into seed investments, 25% into early-stage investments, and 15% into later-stage investments. Exiting —> The goal of a venture capital investment is to help nurture a firm until it can be funded with alternative capital. Venture firms hope that an exit can be made in no more than 7 to 10 years. Later-stage investments may take only a few years. Once an exit is made, the partners receive their share of the profits and the fund is dissolved. A venture fund can successfully exit an investment in a number of ways. The most glamorous and visible is through an initial public offering. At the public stock offering, the venture firm is considered an insider and receives stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years. Once the stock is freely tradable, usually after two years, the venture fund distributes the stock to its limited partners, who may then hold the stock or sell it. While not as visible, an equally common type of successful exit for venture investments is through mergers and acquisitions. In these cases, the venture firm receives stock or cash from the acquiring company. These proceeds are then distributed to the limited partners. The number of venture-backed merger and acquisition deals peaked at 269 in 2000. Venture Fund Profitability —> Venture investing is extremely high-risk. Most start-up firms do not succeed. Despite the careful monitoring and advice provided by the venture capital firm, there are innumerable hurdles that must be jumped before a new concept or idea yields profits. If venture investing is high-risk, then there must also be the possibility of a high return to induce investors to continue supplying funds. Private Equity Buyouts In the last section, we learned that new start-up companies often fund their growth by raising capital from venture capital firms. The private company is allowed to mature and then, with profitability ensured, it sells shares to the public. In a private equity buyout, instead of a private company going public, a public company goes private. In a typical private equity buyout, the publicly traded shares of a company are purchased by a limited partnership formed for that purpose. Since the public shares are then retired, the firm is no longer subject to the controls and oversight required of publicly held companies, nor does it have to answer to diverse stockholders. Advantages to Private Equity Buyouts Private equity partners and the managers of privately held firms cite a number of advantages to the private equity ownership structure. First, as private companies they are not subject to the controversial regulations included in the 2002 Sarbanes- Oxley Act. Many managers and CEOs complain that meeting the requirements of Sarbanes-Oxley is frustrating and takes valuable time away from more productive activities. Second, CEOs of publicly held firms often feel under pressure to produce quarterly profits. In a private equity scenario, CEOs frequently have more time and flexibility to enact the changes needed to turn around subpar companies. Instead of trying to convince thousands of diverse investors of the wisdom of a particular course of action, the CEO of a privately held company need convince only the managing partners of the private equity firm. One reason top CEOs have been attracted to privately held firms is that they can be compensated more easily with an ownership interest in the firms. Typically, executives are recruited with a small cash salary and an opportunity to invest their own money in the firm, often taking as much as a 20% ownership position. Some believe this more closely aligns the executive’s interest with those of the private equity partnership. Life Cycle of the Private Equity Buyout In a typical private equity buyout, a partnership is formed and private equity investors are contacted to pledge participation. Each investor usually pledges at least $1 million of capital and agrees to leave the funds under the partnership’s control for an extended period of time, often five years or more. The partnership now identifies an underperforming company that it believes can be turned around by new management. Using the equity contributed by the partners, the firm buys the outstanding public shares of the troubled company. A new CEO and board are elected to run the company. The managing partners tend to be active participants in the management of the firm. Once the company is revived and showing improved revenues and profitability, it will be either sold to another firm or taken public in an IPO. This is where the investors in the private buyout earn their return. Because the company is now stronger, it is expected to sell for much more than it did when initially purchased and taken private. Economic Sciences Nobel Prize - Financial Intermediation and the Economy by Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig Financial intermediaries such as traditional banks and other bank like institutions facilitate loans between lenders and borrowers, and thereby play a key role for the allocation of capital. Financial intermediaries also play a key role during times of significant economic distress. The fact that banks and other financial intermediaries perform important functions but at the same time can be associated with devastating crises poses a critical challenge to policymakers. Two parallel projects originated in the early 1980s, both motivated by the experiences of the banking sector during the Great Recession, have significantly advanced our understanding of the role of banks in the economy. Diamond and Dybvig (1983) presented a theory of maturity transformation and showed that an institution using demand deposits to finance long-term projects is the most efficient arrangement, but that, at the same time, this arrangement has an inherent vulnerability: bank runs may arise. Diamond (1984) developed a theory of a bank’s provision of delegated monitoring services and showed that banks can ensure that projects with high (but risky) long-run returns obtain funding by monitoring borrowers on behalf of lenders. Bernanke (1983) provided historical documentary evidence and empirical data to uncover the importance of the credit channel for the propagation of the depression. Bernanke (1983) showed that the downturn became so deep and so protracted in large part because bank failures destroyed valuable banking relationships, and the resulting credit supply contraction left significant scars in the real economy. —> this was a new insight: earlier economic historians had viewed bank failures merely as a consequence of the downturn, or mattering to the rest of the economy only by contracting the money supply, rather than directly damaging investments through severed credit arrangements. The theoretical and empirical findings of Bernanke, Diamond, and Dybvig thus reinforce each other. Together they offer important insights into the beneficial role that banks play in the economy, but also into how their vulnerabilities can lead to devastating financial crises. The findings have proven extremely valuable for policymakers: the actions taken by central banks and financial regulators around the world in confronting two recent major crises – the Great Recession and the economic downturn that was generated by the COVID-19 pandemic – were in large part motivated by the laureates’ research. The role of financial intermediaries Institutions such as banks and similar financial intermediaries exist arguably because financial markets fundamentally channel savings toward real investment. In the aggregate economy, savings must equal investments, but investment opportunities and the willingness and ability to save usually don’t coincide at the individual level. The role of financial markets is to solve the problem of coincidence of saving and investment, while taking into account the needs of different savers and investors. To solve this problem, financial intermediaries exist. These institutions channel funds from savers to investors, receiving funds from some customers and using the funds to finance others. They also make it possible for the borrower to have a long term financing agreement at the same time as lenders can withdraw the money they lent on demand. This is exactly the maturity transformation. Thus, financial intermediaries perform essential functions for society but, as history demonstrated, they can also be very fragile, admitting phenomena such as bank runs. These occur when depositors panic and rush to withdraw their funds, leaving the bank without sufficient assets. Bank runs can be contagious, driving large parts of financial intermediation to a halt. Such systemic financial crises are typically followed by deep economic downturns. Three complementary insights The laureates’ research can be said to have generated three complementary insights. generated major new insights into how economies work. In particular, we have learned about a number of weaknesses in market economies and how to handle them with regulation and economic policy; Keynesian macroeconomics grew out of these insights. —> Keynes (1936) argued that recessions were primarily due to drops in aggregate demand, moving economic output below the production capacity of the economy. According to this view, governments should counter recessions through an expansionary fiscal policy that boosts aggregate demand. Economic historians paid less attention to the role of banks and imperfectly functioning credit markets during the Great Depression. In the subsequent research on the Great Depression, bank failures were typically viewed as a consequence of the depression rather than as an important element in explaining its evolution. One notable exception was Friedman and Schwartz (1963), who argued that the bank failures where of first-order importance through their effect on money supply. Since the money stock consists both of outstanding currency and bank deposits, the dramatic drop in deposits caused by the bank panics caused a drop in money supply that in turn led to deflation that exacerbated the economic downturn. They also argue that the actual credit losses of banks going into the panics were relatively small, but that the subsequent run on bank deposits was the main reason for the dramatic contraction of the money stock. A new perspective, however, came about with Bernanke’s fundamental paper, published in American Economic Review in 1983. Similar to Friedman and Schwartz, he argued that banks and banking panics stood in the center of why the recession became so deep and so long-lived, but not only because of its effect on money supply. According to his narrative and empirical analysis, supported with documentary evidence from the period, he argues that the contraction of banking activity was detrimental because it disrupted the intermediation of credit between lenders and borrowers. Since bank relationships where not easy to replace, this lead to severe credit constraints for bank-dependent borrowers which depressed economic activity and contributed to a deeper and longer downturn. Contemporary financial markets Today’s financial markets include several institutions aside from banks that, broadly speaking, channel savers’ money to investors, and some of them also engage in maturity transformation. Stock markets provide direct links whereby savers fund publicly traded companies; publicly traded stocks are liquid in that they can be sold quickly, but they do not offer a safe return. Another source of investor funding is bond issuance; bonds of larger companies can often also be traded in centralized markets and thus offer a degree of liquidity. A more recent phenomenon is the growth of venture capital and private equity firms that offer funding for companies that are not publicly traded, but these firms do not engage in maturity transformation and are typically not accessible to most individual savers. Today there are also a number of intermediaries – such as securitization vehicles and money market mutual funds – that provide debt-financing like banks do but operate largely outside of the regulated banking system. By financing long-term illiquid investment with shorter-term and more liquid instruments, these non-bank intermediaries also engage in maturity transformation. Because of this similarity, they are often referred to as shadow banks. Finally, commercial banks have developed in a number of ways, not least of which is their reliance on “wholesale funding,” a significant new liability item on their balance sheet: short-term borrowing in money markets from financial institutions. Banks and the economy Banking research before the laureates’ contributions While banks have been discussed by economists since at least the 18th century, in particular by David Humen and Adam Smith, this discourse has taken place mostly in the context of monetary economics. Since not all depositors would need to withdraw their deposits at the same time, banks only needed to hold relatively little currency (or “reserves”) in order to create a much larger quantity of deposits. Based on statistical theory, Edgeworth (1888) provided the first formal model of this mechanism, which inspired a separate literature on cash inventory management. Bagehot (1873) argued for the role of the central bank as a “lender of last resort” in cases when there was not enough reserves to cover withdrawals. In contrast, relatively few of the early economists emphasized the role of banks for the allocation of capital in the economy. Important exceptions were Böhm-Bawerk (1911) and Schumpeter (1911), who argued that the services provided by financial intermediaries are essential for technological innovation and economic development. In the decades before Bernanke’s (1983) contribution, the macroeconomic discussion on financial intermediation was dominated by the question of whether the inside money creation of banks was desirable. On one side of the debate, some economists were in favor of the real bills doctrine (going back to Adam Smith, 1776). They argued that banks should be allowed to freely create inside money and market forces would prevent excessive “credit creation” by private banks. On the other side, proponents of the quantity theory of money argued that a real bills regime permits excessive fluctuations in the supply of money and, hence, in the price level, which amplified business cycle fluctuations. Milton Friedman, one of the main proponents of the quantity theory, went as far as to argue in favor of 100% reserve banks, i.e., that banks should only be allowed to invest deposits in cash or risk-free government debt. A few economists, such as Brainard and Tobin, criticize this view for ignoring the role of financial intermediaries for transferring savings to investment: “Intermediation permits borrowers who wish to expand their investments in real assets to be accommodated at lower rates and easier terms than if they had to borrow directly from the lenders. If the creditors of financial intermediaries had to hold instead the kinds of obligations that private borrowers are capable of providing, they would certainly insist on higher rates and stricter term”. The view of banks in the microeconomics and finance literature during this time was very much influenced by the seminal insights of Miller and Modigliani. They show that in a world without frictions, the way firms were financed was irrelevant. Their theorem turned out to have far- reaching consequences: in the absence of frictions, financial intermediation would not affect firm value either, and would thus be irrelevant for capital provision. As long as an investment project is valuable, firms would be able to obtain capital for it in a competitive capital market. In order to generate a role for financial intermediation, then, there had to exist some capital market friction that intermediaries were able to overcome. The banking literature that emerged in the 1970s explained banks as having a cost advantage relative to direct lending by savers, and as being able to efficiently intermediate the maturity mismatch between borrowers and lenders. One branch of the literature focused on banks having access to technology that enables them to reduce transaction costs when matching borrowers and savers. Specifically, they can issue higher yielding securities (e.g., deposits) than alternatives because they have an advantage in finding profitable investments. Banks were also thought to have special credit evaluation skills, enabling them to make loans at lower costs than savers if they were to make loans directly to borrowers. Together, these features implied that banks had a special appeal not just to savers but also to borrowers. Maturity transformation Diamond and Dybvig show how government regulation, such as deposit insurance or lender of last resort policies, can help avoid such coordination failures. Delegated monitoring Diamond (1984) provided one important reason for this: banks collect valuable information from their borrowers, which makes their loans more valuable within the banking relationship compared to if they are sold to outsiders. Delegated monitoring, debt, and diversification Diamond (1984) argued that delegated monitoring is a central economic role of financial intermediaries: investors delegate their investment decisions to financial institutions, who invest in multiple investment projects/borrowers on their behalf. In their signaling model of financing, Leland and Pyle (1977) also argued informally that financial intermediaries have economies of scale in information production, and that intermediated finance can thus reduce the cost of asymmetric information. Diamond (1984) provided the first formal model of this mechanism and has become a seminal paper in the financial intermediation literature. A key insight is that diversification across many loans makes it possible for banks to finance risky projects through close-to-riskless debt, thus providing another mechanism for banks to funnel less risky and more liquid savings to riskier and less liquid productive investment. The ability to create liquidity in this way is unique to the lending bank, due to the monitoring of borrowers it performs on behalf of savers. This makes banking relationships valuable, and provides an explanation for why bank loans are illiquid if banks are forced to sell them to outsiders who do not have this information. The focus is on showing that banks optimally perform monitoring of risky projects and are able to promise depositors a riskless, high return. Financial intermediation during the Great Depression The insights from Bernanke (1983) were also very important in their own right and led to a deeper understanding of the importance of leverage among banks, firms, and households in exacerbating economic shocks. The Cost of Credit Intermediation (CCI) Bernanke defined the CCI as the “cost of channeling funds from the ultimate savers/lenders into the hands of good borrowers. The CCI includes screening, monitoring, and accounting costs, as well as the expected losses inflicted by bad borrowers. Banks presumably choose operating procedures that minimize the CCI. This is done by developing expertise at evaluating potential borrowers; establishing long- term relationships with customers; and offering loan conditions that encourage potential borrowers to self-select in a favorable way”. In addition to emphasizing direct effects on credit supply when financial intermediaries cannot perform their screening and monitoring services, Bernanke also pointed to an indirect financial channel working through demand. An increase in CCI increases the effective cost of credit and can even make credit unavailable for some potential borrowers. While the increase in CCI might be less important for large, cash-rich firms, it becomes binding for bank-dependent borrowers, including farms, small firms, and households, which cut back on consumption and investment. The resulting decrease in demand dampens economic activity and leads to lower prices and deflationary pressures. Fisher (1933) argued that during the Great Depression, deflation was particularly damaging to already leveraged firms and households, since their outstanding debt was nominal, and they thus became even more leveraged in real terms. In turn, this caused an increase in insolvency and financial distress, which led lenders to liquidate borrower assets, further depressing prices and exacerbating the feedback loop. The seriousness of the problem in the Great Depression was not only deflation but the fact that debt deflation disproportionately hit small and bank-dependent borrowers, such as households, farms, and small businesses, which had increased their leverage significantly in the years before of the Great Depression. As a result, debt deflation had a particularly large effect in terms of reducing consumer demand, distorting capital allocation across firms, and causing further losses to the financial intermediaries lending to households and small businesses. Evidence on the CCI and on aggregate output Bernanke (1983) presented several pieces of evidence to corroborate the CCI channel. He shows that bank failures were followed not only by a decrease in bank credit but also by a widening of credit spreads. He also showed that the credit contraction was particularly harmful for borrowers that were more bank-dependent, such as small firms, farmers, and households, while large firms with access to public equity and bond markets seem to have been much less credit constrained. Based on this evidence, Bernanke (1983) argued that the bank failures during the Great Depression caused the reduction in credit, which in turn reduced economic activity. The persistence of the Great Depression After having provided evidence that the CCI channel can explain the depth of the Great Depression, Bernanke (1983) argued that it can also better explain its persistence compared to Diamond (1984) argue that the unique information the bank obtains about the borrower through their screening and monitoring makes it difficult for firms to replace their bank with a new lender. The failure of shadow banks did not only affect credit supply indirectly through the spillovers on commercial banks, but also directly affected access to credit in the real economy. Policy responses The panic in short-term debt markets following the demise of Lehman Brothers in 2008 prompted the Fed and the U.S. Department of Treasury (U.S. Treasury) to intervene, acting as a “lender of last resort” not only for commercial banks but also extending support to important shadow banks (such as large investment banks). To support the flow of credit to households and firms, the Fed launched a series of programs targeting different financial intermediation functions. In an effort to ensure that mortgage financing would remain available to creditworthy borrowers, the U.S. Treasury made an initial pledge of $200 billion (which was later increased to $400 billion) when Fannie Mae and Freddie Mac were placed into conservatorship. The Fed also intervened by conducting large purchases of agency mortgage-backed securities with aim to reduce the cost of mortgages by expanding central bank intermediation to offset the contraction in credit provision by financial intermediaries. Finally, the U.S. Treasury launched the Troubled Asset Relief Program (TARP), which involved purchasing $250 billion of preferred equity in the nine largest U.S. commercial banks. These interventions, coupled with a temporary public guarantee on the debt of these banks, helped stabilize the markets, especially the short-term funding market, and many observers believe they helped restore investor and creditor confidence in the solvency and viability of financial institutions. Similarly, the European Central Bank (ECB) took a number of steps to support the smooth functioning of the euro area interbank markets in response to the Global Financial Crisis. These non-standard measures became known as enhanced credit support, and helped secure the flow of credit to households and firms. They focused primarily on commercial banks, as these are the main source of funding for households and business in the euro area (about 70% of the funding comes from banks). The ECB policy interventions included: “the full accommodation of banks’ liquidity requests at fixed interest rates; the expansion of the list of assets eligible as collateral; the lengthening of the maturities of refinancing operations, up to one year; the provision of liquidity in foreign currencies, notably the U.S. dollar; and, finally, outright purchases of euro-denominated covered bonds issued in the euro area.” Individual European governments also adopted measures to support their financial markets, thus safeguarding the stability of the European financial system. The measures included increasing deposit insurance ceilings, guarantees for bank liabilities, and bank recapitalizations. Central banks around the world took similar steps using a battery of policies to avoid runs and to keep credit flowing to households and firms. Banking regulation Supporting financial institutions during a financial crisis comes at a cost. That taxpayers bear this cost may be particularly controversial if the crisis is considered to have arisen from excessive risk taking in the banking sector. Governments bailing out banks that have taken excessive risks produces incentives for risk-taking at the expense of taxpayers (moral hazard). Requirements that a bank keep a certain capital ratio (equity capital divided by assets) are supposed to mitigate excessive risk taking and ensure that sufficient equity capital is available to support banks’ lending activities also in bad times, but policymakers are aware that these requirements may increase credit costs during normal times. The capital requirements in place at the time clearly failed to prevent the Global Financial Crisis, arguably because they did not sufficiently mitigate excessive risk-taking. The international financial regulation since the Global Financial Crisis has made capital requirements more stringent, including the introduction of counter-cyclical capital buffers and “absolute” caps on bank leverage that complement the risk-based ones that were already in place. In addition to capital requirements, post–Global Financial Crisis regulation has introduced new liquidity requirements that depends on the illiquidity of the bank’s assets and the extent of maturity transformation that it undertakes. Moreover, existing bank capital requirements prior to the Global Financial Crisis addressed risk- taking by an individual bank. If a bank’s capital ratio falls below the required level, it can restore it by raising more equity or shrinking its balance sheet by reducing lending. However, if several large banks’ capital ratios fall below the required level at the same time, and they respond by shrinking their balance sheets, a credit crunch will ensue. If banks try to sell assets urgently (so called fire sales), asset values market-wide may fall even further, leading to additional reduction of lending activity by banks seeking to shrink the balance sheet (deleveraging). The result is a harmful reduction in credit supplied to households and firms, curtailing real activity such as consumer spending and business activities. Hence, it became clear that bank regulation solely focusing on risk-taking by individual banks was inadequate. The Global Financial Crisis also made it clear that it was insufficient to focus prudential policies simply on traditional banks when much of the solvency problems were in the shadow-banking system. Policymakers needed updated tools to address the evolving landscape of financial intermediation – “a ‘macroprudential’ approach that recognizes general equilibrium effects, and seeks to safeguard the financial system as a whole”. Thus, macroprudential policy has now become widespread language to cover this broad range of policy and regulatory interventions. These are aimed at striking a balance between the negative consequences of disrupted credit networks emphasized in Bernanke (1983) and the various costs of intervention. The regulatory response to the Global Financial Crisis came in the form of the July 2010 Wall Street Reform and Consumer Protection Act, or “Dodd–Frank,” in the U.S., and the recommendations made by the Basel Committee on Banking Supervision in September 2010, the “Basel III” process. The former focuses on consumer protection, regulation of over-the-counter derivatives, and resolution authority, while the latter addresses some of the deficiencies in the pre–Global Financial Crisis bank capital requirements. Banking regulators around the world now also require large banks to conduct stress tests, analyses to determine whether a bank has enough capital to absorb losses during stressful conditions while meeting obligations to creditors and counterparties, and continuing to be able to lend to households and businesses. In other words, the stress tests help ensure that large banks can support the economy during economic downturns. The COVID-19 pandemic Also during our most recent economic crisis, caused by the COVID-19 pandemic, it is clear that policymakers understand that it is imperative to safeguard the viability of the financial system to minimize disruptions to credit supply. As first shown by Bernanke (1983) and emphasized in the present document, the Great Depression started as a “normal” recession but developed into something much worse due to disruptions in the financial system, particularly bank failures. The steps taken by federal, state, and local officials to mitigate the spread of the virus during the pandemic led to a sudden and very deep reduction in economic activity. Through a battery of measures, central banks all over the world ensured that credit continued to flow to households and firms, preventing financial market disruptions from intensifying the economic damage. The Fed intervened directly in the markets for corporate and municipal bonds to ensure that key players could raise funds to pay workers and avoid bankruptcy. The Fed also provided unlimited liquidity to financial institutions so they could meet credit drawdowns and make new loans to businesses and households. These measures were aimed to help firms survive the crisis and resume hiring and production once the pandemic receded. In Europe, the ECB responded to the COVID-19 crisis by dramatically increasing its purchases of government bonds, regional and local authorities’ bonds, corporate bonds, asset-backed securities, and covered bonds under its existing programs, and significantly expanded the scope of bond-buying activity by launching the €750 billion Pandemic Emergency Purchase Program (PEPP), which also covered commercial paper issued by non-financial corporations. Furthermore, the ECB incentivized banks to lend by expanding its targeted long-term refinancing operations (TLTROs —> these offered banks cheap (with negative interest rate, banks actually get paid to borrow money), long-term loans with additional incentives to use the funds to lend to euro area consumers and businesses). Finally, the ECB launched several other initiatives to encourage banks to lend to consumers, business, and other banks, including temporarily relaxing capital requirements; relaxing the rules around the classification of non-performing loans; easing collateral restrictions; providing support for bank funding and money markets; and established international swap lines. While the root cause for the crises we describe in this section differs, they share a common feature: policymakers around the world realize the importance of maintaining market participants’ faith in the ability of not just traditional banks, but also in other financial intermediaries such as shadow banks, to channel savings toward investment without disruption. Conclusion Banks and bank-like institutions have existed for thousands of years. Today they are active in every country around the world. Banks obviously perform important functions, but they have also been at the epicenter of some of history’s most devastating economic crises such as the Great Depression. Nevertheless, it was not until the work of this year’s laureates, Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig, that we had a comprehensive theory of why banks exist in the form we observe, what role they play in the economy, why they are fragile, and an empirical account of how devastating and long-lasting the consequences of massive bank failures can be. Diamond and Dybvig (1983) showed that an institution using demand deposits to finance long- term lending is perfectly suited to satisfy the conflicting needs of savers and borrowers. The former need liquid assets to satisfy random spending needs, while the latter need long-term commitments to be able to finance investments that cannot be prematurely liquidated without large costs. Banks do this by transforming illiquid assets into liquid assets. The theory of Diamond and Dybvig (1983) also implies that maturity transformation naturally is a fragile business. A rumor that a bank is about to fail can lead to a bank run, where the expectations that other people will demand their deposits will lead all savers to run to the bank to withdraw their funds. Even healthy banks may get into trouble if bank runs become widespread. However, the theory also implies that deposit insurance and central banks promising to stand in as lender of last resort can be a remedy for this fragility. Diamond (1984) showed that the way banks are constructed is key for their ability to act as delegated monitors. In practice, small lenders could not themselves undertake the monitoring of all final users of their savings – it needs to be delegated. But who should then monitor the bank? Diamond (1984) showed that a debt contract between lenders and the bank, along with diversification, provides the bank with the right incentive to monitor. According to the theories of Diamond and Dybvig, banks are middlemen between savers and borrowers. But this situation does not impose costs on society. On the contrary, maturity transformation and borrower monitoring are socially productive activities that reduce the cost of credit and minimize wasteful bankruptcy costs. Thus, the economy works better with banks than without them, provided their inherent fragility can be managed. Bernanke analyzed the Great Depression. In his seminal work on the subject, Bernanke (1983) showed that the key mechanism behind the depth and in particular the length of the depression was bank failures and fear of bank runs. Banks could not fulfill the important tasks described theoretically by Diamond and Dybvig. The consequence was the largest economic crisis in modern history. The monitoring task described by Diamond (1984) requires knowledge about the borrower. This informational capital takes time to build, it is difficult to transfer to other banks and thus often gets destroyed in a bank failure. This, according to Bernanke, explains why the Great Depression and other financial crises have been so protracted. The research from the 1980s for which this year’s Prize in Economic Sciences is awarded obviously does not provide us with final policy recommendations. Deposit insurance does not always work as intended. It can lead to perverse incentives for banks and their owners to gamble to take the profit if things go well and let taxpayers pay the bill if not (moral hazard). Runs on new financial intermediaries, engaging in profitable maturity transformation like banks, but operating outside of bank regulation, were arguably key for the financial crisis 2007–2009 leading to the Great Recession. When central banks act as lenders of last resort, this can lead to large and unintended wealth redistribution and have negative moral hazard effects on banks who may increase reckless lending, potentially leading to future crises. Fundamentals of the leverage ratio measure: -simple fall-back complementary measure (it is complementary to TREA) -non-risk based measure (because, as t h e G l o b a l F i n a n c i a l C r i s i s demonstrated, risk based measures can be procyclical): physical or financial collateral, guarantees or other credit risk mitigation techniques on exposures are not taken into account; no netting recognit ion between assets and liabilities as a general rule (few exceptions exist). The Leverage Ratio requirement is a way for regulators to ensure that banks have a minimum level of capital to support their assets, regardless of the inherent risk of those assets. This requirement helps to ensure that a bank can absorb unexpected losses and maintain the solvency and stability of the institution.   Constituents of TEM: On-balance sheet exposures (other than SFTs and derivatives & off-balance sheet items) Starting point: accounting value (“cash receivables”) after specific credit risk adjustments (provisions/impairments), and fair value adjustments and additional value adjustments (AVAs). General principles: Physical or financial collateral, guarantees or credit risk mitigation purchased shall not reduce exposures assets shall not be netted with deposits Off-balance sheet exposures Contribution to TEM of off-balance sheet exposures is computed following the general rules set out in the CRR: nominal value after specific credit risk adjustments multiplied by the credit conversion factor (CCF) Credit conversion factors (CCF) established by risk category: • Full risk = 100% CCF • Medium risk = 50% CCF • Medium/low risk = 20% CCF • “Low risk” off-balance sheet items are subject to 10% credit conversion factor under LR (instead of 0% under risk-based framework) Securities Financing Transactions (SFTs) SFTs: repurchase transactions, securities lending/borrowing, margin lending transactions. Contribution of SFTs to TEM based on the rules set out in Article 429b of CRR Starting point: accounting value (“cash receivables”=assets, “cash payable”= liabilities) . Netting of cash receivables and cash payables permitted under following conditions: Same counterparty and final settlement date Legally enforceable right of set-off across different transactions (net or simultaneous settlement) Netting of collateral (Art 429e of CRR) Difference between fair value of cash or securities lent and fair value of cash or securities received from same counterparty. Netting across transactions with same counterparty permitted if included in netting agreement. Derivatives Derivatives: contracts listed in Annex II of CRR and credit derivatives. Positions in derivatives are collateralised via exchange of initial and variation margins. Variation margins are received (usually in cash)) if the derivatives positions “win” (have positive value, are assets) or are paid if the derivatives “lose” (have negative value, become liabilities). Variation margins are recognised as exposure-reducing for the purposes of the calculation of the LR denominator (Total Exposure Measure) under Art 429c(3) CRR. Credit derivatives (credit default swaps, CDS) are: i)“purchased”, if the institution receives insurance/protection from a party against the default of a third party, or are ii)“sold, or written”, where the institution is providing protection/insurance to a party against the default of a third party. Offsetting of written credit derivatives with purchased credit derivatives is possible under the conditions established in Article 429d(3) of CRR, which include: same or longer maturity of purchased credit derivatives, same or more conservative material terms (including reference name of the bought credit protection). Article 429d CRR: additional treatment for exposures to written credit derivatives ‘written credit derivative’ means any financial instrument through which an institution effectively provides credit protection including credit default swaps, total return swaps and options where the institution has the obligation to provide credit protection under conditions specified in the options contract.   Inclusion of written credit derivatives in the total exposure measure at effective (leverage-adjusted) notional amount. Offsetting of effective notional amounts of written credit derivatives permitted with effective notional amounts of purchased credit derivatives that meet conditions of Article 429d(3) of CRR. These include same or longer maturity of purchased credit derivatives, same or more conservative material terms (including reference name of the bought credit protection). Constituents of TEM: Summary of on & off-balance sheet items On-balance sheet assets, starting point is the accounting value, after specific credit risk adjustments (e.g. impairments/provisions on loans) General principles (Article 429 of CRR2): • physical or financial collateral, guarantees or credit risk mitigation purchased shall not reduce exposures • assets shall not be netted with deposits or other liabilities from same counterparties (cannot reduce a loan with a deposition from the same firm) Off-balance sheet items (Article 429f of CRR2) Treatment generally follows Article 111(1) of CRR, i.e. nominal value after specific credit risk adjustments (e.g. impairments/provisions on loans) multiplied by “credit conversion factor” List of off-balance sheet items by risk category in Annex I of CRR “low risk” off-balance sheet items are subject to 10% “credit conversion factor” for calculation of LR total exposure measure (instead of 0% for calculation of TREA under the “risk-based” framework) Pillar II  Capital Requirements The Pillar 2 requirement (P2R) is a bank-specific capital requirement which applies in addition to, and covers risks which are underestimated or not covered by, the minimum capital requirement (known as Pillar 1). A bank’s P2R is determined on the basis of the Supervisory Review and Evaluation Process (SREP). That requirement is legally binding, and if institutions fail to comply with it they can be subject to supervisory measures (including sanctions). Pillar II is an administrative actor: it is a letter, an obligation to comply with specific requirements. They differ from bank to bank. Prudential Supervisor (ECB for largest banks in EU —> Banking Union) can impose own funds requirements in addition to those set out in Art 92 of the CRR in order to: A. cover the risks that are not covered at all by the capital requirements set out in the law B. cover the risks that are not appropriately covered by the capital requirements set out in the law C. cover the risk of excessive leverage Additional own funds (P2R) required to cover risks identified and assessed in the Supervisory Review and Evaluation Process (SREP) performed annually by the Supervisor. The SREP aims at evaluating all risks to which the institution is or might be exposed, including: • other elements (sub-risk factors) of the risk categories mentioned in Art 92 (Pillar I risks) of the CRR • other risks not mentioned in the CRR (Pillar II risks) • the results of internal or supervisory stress testing exercises The SREP shall verify/assess compliance with all requirements set out by the CRD and CRR (including regarding governance, internal organization/risk management, remuneration, etc…). Example. Covid —> supply shocks —> government —> not many defaults have occurred —> models do not react that much. There’s a risk that a bank is not capitalized enough: the risk is that pillar 1 is not good enough to comply with all risks. The prudential supervisor has the power to step in and increase the requirements. Additional capital requirements: pillar II not written in the law, in addition to the 8% (risk weighted asset) you have to hold another requirement in terms of leverage ratio (due to a risk in excess of leverage).  Requirements which are additional requirements are meant to address all the additional risks the banks are exposed to (eg additional market risk, additional credit risk. Additional credit risk is concentration risk which is not fully covered in Pillar I or another one is the banking risk in the banking book, the pension risk etc.). Risk of excessive leverage which has to be tackled with an additional requirement regarding the leverage ratio (the others were only about TREA). For instance,  imagine that a bank has decided to issue mortgages in Swiss francs. If the franc jumps, the mortgage borrowers default. Indeed, you have given money to somebody that doesn’t earn Swiss francs and thus, if the Swiss franc appreciates, the value of the mortgage in national currency increases. In such case, the borrower can default. However, in the standardized approach, mortgages carry a very low risk weight. The SREP can identify such risk and impose an higher risk weight or higher capital requirement. For instance, the credit Risk is assessed in SREP not only as regards default risk (already capitalised in Pillar I) but also: concentration risk (e.g. by sectors, obligors/clients, geographical areas), non-performing loans (NPL) and coverage (provisions/impairment), credit policies and controls (e.g. lending policies, internal reporting, loans approval processes, assessment of collateral ect..).