1. Agency theory: how asymmetric information affects economic behavior
Asymmetric Information in Finance
 Financial Structure
Adverse selection: Before a transaction
Lemons Problem
Moral hazard: After the transaction
Principal – Agent Problem
Debtor & Risk
Conflicts of Interest
No Bank Left Behind

2. The Trouble With Lending:
The Mantra:
...A healthy, vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities…
The Trouble With Lending:
Worst risks line up first
Borrowers won’t do what they “promised”
The Trouble With Buying a Share:
If it’s such a good deal, why offer it to me?
Management might ripoff, not share with shareholders
So how can a financial system “move funds” from savers to entrepreneurs?

3. Financing business: Eight Facts
Stocks are not most important source of external financing
Issuing marketable securities (debt and equity) not the main way businesses finance operations
Indirect finance is much more important than direct finance
Financial intermediaries  the most important source of external funds
The financial system is (supposed to be) heavily regulated
Only large, well-established corporations have (had) easy access to securities markets to finance their activities  need reputation and net worth
Debt contracts: trust … but collateral
Debt contracts: trust … but restrictive covenants

5. Why Intermediaries? … Transaction Costs
Economies of scale
Expertise: information specialists to handle adverse selection and moral hazard problems
What went wrong? … Perverse incentives
Asymmetric Information Problems
Adverse selection before a transaction
“Lemons problem”
Moral hazard after the transaction
Managers and principal - agent problem
Debt & risky behavior…insurance & risky behavior
Conflicts of interest

6. Countering Adverse Selection
Private production and sale of information
Free-rider problem
Perverse incentives: who pays Moody’s?
Government regulation to increase information
Regulatory capture…the revolving door
Financial intermediation: information specialists?!?
Collateral and net worth…skin in the game
Countering Moral Hazard: Principal - Agent
Align manager incentives with owners’
Stock/stock options/bonuses/bonus claw-backs
Monitor  venture capital firms
Avoid being owner: debt not equity

7. Moral Hazard in Debt Markets
Borrowers have incentives to take on risk
Heads they win
Tails you lose
Countering Moral Hazard in Debt Contracts
Net worth and collateral…skin in the game
Incentive compatible … loss is borrower’s, not lenders
Enforce Restrictive Covenants
Keep collateral valuable
Provide information

8. Incentives leading to the subprime-triggered crisis
The Players
Homebuyer…live free…or default
Appraiser…fee
Mortgage broker…commission
Originate and sell
Securitizer: Investment banks/commercial banks
Fees, bonuses
Moving, not storage
Ratings agency…fee
“Investors”/GSEs…return
Government role
Regulation/supervision
Deposit insurance
Lender of last resort
TBTF…Too Interconnected to Fail

10. Economies of Scope and Conflicts of Interest
Underwriting and Research in (what was) Investment Banking
Investment bank research used to underwrite securities serves sellers and buyers of the securities at same time
…do not make negative or controversial comments about clients
Jack Klugman/Citi dotcom research/pre-school recommendations
Spinning: investment bank can allocate hot, underpriced, IPOs to executives of other companies in return for their companies’ future business
Auditing and Consulting in Accounting Firms  INCEST
Auditors may skew opinions to get consulting business
May audit information systems or tax and financial plans put in place by their consulting counterparts
May provide an overly favorable audit to retain business
Sarbanes-Oxley Act of 2002: SEC Oversight/CPA independence
Audit committee independence/CEO-CFO signoff/…
Global Legal Settlement of 2002: Separate research & underwriting

11. Chapter 8 Questions
Would the lemons problem be more severe for stocks traded on the New York Stock Exchange, where only large-cap(italization) companies are listed, or stocks traded over-the-counter?
Hint: Bernie Madoff once headed NASDAQ
Which firms are most likely to use bank financing rather than issue bonds or stocks to finance their activities? Why?
How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?
Why can the provision of several types of financial services by one firm lead to lower costs of information production?
Why can the provision of several types of financial services by one firm lead to conflicts of interest?