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Lecture 2
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Lecture Preview
A vibrant economy requires a
financial system that moves funds ?
from savers to borrowers. But how
does it ensure that your hard- ?
?
earned dollars are used by those ?
with the best productive investment ?
opportunities? ?
? ?
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Basic Facts About Financial Structure
Throughout the World
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Sources of Foreign External Finance
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Facts of Financial Structure
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Facts of Financial Structure
3. Indirect finance, which involves the
activities of financial intermediaries, is
many times more important than direct
finance, in which businesses raise funds
directly from lenders in financial
markets.
4. Financial intermediaries, particularly
banks, are the most important source of
external funds used to finance
businesses.
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Facts of Financial Structure
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Facts of Financial Structure
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Transactions Costs
Transactions costs influence financial
structure
E.g., a HK$5,000 investment only allows you to
purchase 100 shares @ $50 / share (equity)
Minimum brokerage commission HK$100
No diversification
Bonds even worsemost have a HK$100,000
size or larger
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Transactions Costs
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Asymmetric Information: Adverse
Selection and Moral Hazard
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Asymmetric Information: Adverse
Selection and Moral Hazard
Adverse Selection
1. Occurs when one party in a transaction
has better information than the other
party
2. Before transaction occurs
3. Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek loan and be selected
Used mobile phones (Why?)
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Asymmetric Information: Adverse
Selection and Moral Hazard
Moral Hazard
1. Occurs when one party has an
incentive to behave differently once
an agreement is made between
parties
2. After transaction occurs
3. Hazard that borrower has incentives
to engage in undesirable (immoral)
activities making it more likely that
won't pay loan back
The admission for bachelor program in CUHK?
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Asymmetric Information: Adverse
Selection and Moral Hazard
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The Lemons Problem
Price Goods Price Bads
Sg
Dg
Sb
Dm
Dmb Dm
Db Dmb
Db
Quantity Quantity
g: good
m: mean
b: bad 17
The Lemons Problem: How Adverse
Selection Influences Financial Structure
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Tools to Help Solve Adverse Selection
(Lemons) Problems
3. Financial Intermediation
Analogy to solution to lemons problem
provided by used car dealers
Avoid free-rider problem by making
private loans (explains Fact # 3 and # 4)
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How Moral Hazard Affects the Choice
Between Debt and Equity Contracts
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How Moral Hazard Affects the Choice
Between Debt and Equity Contracts
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How Moral Hazard Influences Financial
Structure in Debt Markets
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Asymmetric Information Problems and
Tools to Solve Them
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What Are Conflicts of Interest
and Why Are They Important?
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Ethics and Conflicts of Interest
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Conflicts of Interest: Underwriting and
Research in Investment Banking
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Conflicts of Interest: Underwriting and
Research in Investment Banking
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Conflicts of Interest: Auditing and Consulting
in Accounting Firms
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Conflicts of Interest: Credit Assessment and
Consulting in Rating Agencies
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What Is a Financial Crises?
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What Is a Financial Crises?
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What Is a Financial Crises?
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Dynamics of Financial Crises in
Advanced Economies
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Sequence of Events in U.S.
Financial Crises (a)
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Sequence of Events in U.S.
Financial Crises (b)
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Stage One: Initiation
Increase in Uncertainty
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Stage One: Initiation
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Stage One: Initiation
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Stage One: Initiation
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Stage One: Initiation
Finally, a financial crisis can begin with an
increase in uncertainty:
Periods of high uncertainty can lead to crises,
such as stock market crashes or the failure of
a major financial institution.
E.g., 2008, when AIG, Bear Sterns, and Lehman
Bros. failed
With information hard to obtain, moral hazard
and adverse selection problems increase,
reducing lending and economic activity
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Stage Two: Banking Crisis
Deteriorating balance sheets lead financial
institutions into insolvency. If severe enough,
these factors can lead to a bank panic.
Panics occur when depositors are unsure which
banks are insolvent, causing all depositors to
withdraw all funds immediately
As cash balances fall, FIs must sell assets quickly,
further deteriorating their balance sheet
Adverse selection and moral hazard become
severe it takes years for a full recovery
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Stage Three: Debt Deflation
If the crisis also leads to a sharp
decline in prices, debt deflation can
occur, where asset prices fall, but debt
levels do not adjust, increasing debt
burdens.
This leads to an increase in adverse
selection and moral hazard, which is
followed by decreased lending
Economic activity remains depressed
for a long time
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Stock Market Prices During
The Great Depression
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Credit Spreads During
The Great Depression
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The Great Depression
The deflation during the period lead to
a 25% decline in price levels.
The prolonged economic contraction
lead to an unemployment rate around
25%.
The Depression was the worst
financial crisis ever in the U.S. It
explains why the economic
contraction was also the most severe
ever experienced by the nation.
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The Global Financial Crisis of
2007-2009
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The Global Financial Crisis of
2007-2009
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Housing Prices: 20022010
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The Global Financial Crisis of
2007-2009
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Credit Spreads: 20022009
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The Global Financial Crisis of
2007-2009
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Assignment 1.2
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