Money and Banking

1. Modigliani-Miller and Financial Structure Money and Banking Mr. Vaughan

2. Financial-Structure Puzzles Eight, interrelated puzzles, about financial structure: • Financial system boasts a broad array of marketable securities and financial intermediaries—and heterogeneity is increasing. * • Internal finance is more important than external finance for firms—not just in U.S., but all over developed world. * • Firms seeking external finance rely more heavily on banks than securities markets—not just in U.S. but all over developed world. • Only large, well-established corporations can tap securities markets to finance operations—not just in U.S. but all over developed world. * Not listed in Mishkin.

3. Financial-Structure Puzzles(continued) Eight, interrelated puzzles, about financial structure: • U.S. firms selling securities rely more heavily on bonds than on stocks. (Common, but not universal, pattern in developed world. • Debt contracts typically are extremely complicated legal documents placing substantial restrictions on borrowers. • Collateral is a common feature of debt contracts. • As financial markets have grown more sophisticated, financial intermediation has become more important economically. * • Financial system is heavily regulated—not just in U.S., but all over developed world. * Not listed in your text.

4. Sources of External FinanceCross-Country Comparisons

5. Understanding Financial StructureModigliani-Miller Theorem Theorem: In frictionless capital markets, firm value depends solely on cash flows from assets. Capital structure—i.e., how assets are financed—plays no role. Corollary: NPV of investment projects doesn’t depend on financing. Definition: Frictionless capital market • Perfect Competition • No transactions costs • No information asymmetries • No tax/regulatory distortions

6. Understanding Financial StructureModigliani-Miller Theorem Intuition: • Cash flows from assets determine the size of pie. • Capital structure—debt/equity mix—merely slices pie. • Firm cannot make pie larger by slicing it differently. Debt Equity

7. Modigliani-Miller TheoremLogic Consider two firms with identical cash flows from assets: • One has debt (levered firm) in capital structure; other (un-levered firm) does not. • Investors can borrow privately on same terms as levered firm. • Total value of firm is defined as market value of debt plus the market value of equity. So: • Total value of un-levered firm = total value of outstanding shares • Total value of levered firm = total value of outstanding debt + total value of outstanding shares.

8. Modigliani-Miller Theorem:Logic Un-levered Firm: Cash Flows from Assets = Dividends - Private Debt Service = Net Cash Flows Levered Firm: Cash Flows from Assets - Firm’s Debt Service Dividends = Net Cash Flows • Net cash flows are identical. • Investors care only about net cash flows. • Arbitrage guarantees total value of levered firm will equal total value of un-levered firm.

9. Explanations for Financial-Structure Puzzles MM identifies frictions that make financing choices important: • Transactions costs • Asymmetric information costs • Taxation and Regulation • Financing arrangements reflect efforts to minimize transactions costs, information costs, tax burden, and regulatory burden.

10. Transactions Costs Definition:Time/money spent channeling funds from surplus units to deficit units. Forms: • Search costs • Negotiation costs • Enforcement costs Implication: Small firms and large firms needing small amounts of financing will rely on internal finance or bank finance.

11. Transactions Costs Another Form:Bankruptcy costs Definition: Loss of firm value arising from financial distress • Explicit bankruptcy costs: lawyers and accountants fees, etc. • Implicit bankruptcy costs: loss of sales, loss of trade credit, key employees, etc. Implication: Firms with intangible assets and attractive growth opportunities will shy away from debt financing.

12. Asymmetric-Information Costs Definition:Costs of overcoming two types of information problems: • Adverse selection: separating good from bad risks before execution of financial contract. • Moral hazard: insuring economic agents with delegated authority live up to contract terms.

13. Asymmetric-Information Costs:Adverse Selection Example: Lemon’s Problems • If investors can't distinguish good and bad securities, they will offer only average value. • Good securities will be undervalued, so firms won't issue them; bad securities will be overvalued, so too many will be issued. • Investors do not want bad securities, so market falls apart.

14. Asymmetric-Information CostsAdverse Selection Solutions to Lemon’s Problems • Information production by disinterested third party • Limited by free-rider problem • Signaling • collateral • net worth • reputation (a form of collateral) • Government regulation • Financial intermediation

15. Financial Frictions in ActionPecking Order Theory of Financing Adverse selection make some financing vehicles much more expensive than others. Example: • Managers want to issue new stock only when it is overvalued. • Stock issuance is “bad” signal. • Stock issuance causes price of outstanding stock to fall. • Decline in stock price is part of cost of external finance.

16. Financial Frictions in Action:Pecking Order Theory of Financing Firms use financing with smallest adverse selection costs (i.e., smallest information asymmetries) first. Pecking order: • Internal Funds • Bank Debt • Public Debt • Public Equity

17. Financial Frictions in Action:Pecking Order Theory of Financing Implications: • Financial slack is valuable. • Observed capital structures reflect availability of positive net present value projects. • No optimal debt/equity mix.

18. Asymmetric-Information CostsMoral Hazard Principal-Agent Problem: Principal designates agent to act on his behalf. Because monitoring/ disciplining are costly, agent has scope to pursue his own interest at the expense of principal. Examples: • Separation of ownership from control allows managers to use firm resources to pursue personal interests instead of maximizing shareholder value. • Separation of savers/investors allows investors to use surplus funds to pursue personal interests rather than accepting capital projects with highest NPV.

19. Asymmetric-Information Costs:Moral Hazard Solutionsto moral-hazard problems: • Debt finance • Motivates managers to maximize shareholder value by absorbing “free cash flow” • Reduces costs of monitoring investors • Government regulation • Financial intermediation

20. Asymmetric-Information CostsMoral Hazard Features of debt contracts that reduce moral-hazard problems: • Restrictive covenants • Collateral requirements • Net worth requirements • Reputation (a form of collateral or net worth)

21. Catalysts in Financial Markets Economic and Political “Shocks” Δ Technology Δ Transactions Costs Δ Information Costs Δ Relative Return from Granting Rents Δ Taxation and Regulation Δ Shape of financialintermediaries and markets

22. Catalysts in Financial Markets Technological improvements: • Advances in finance and statistical theory • Advances in computing speed, power, and storage space • Advances in transportation and telecommunication

23. Market failure! Regulation of Financial Markets Justification (according to Mishkin): 1. Increase Information to Investors • Decreases adverse selection/moral hazard problems 2. Ensuring Soundness of Financial Intermediaries • Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competition measures. 3. Improving Monetary Control • Reserve requirements • Deposit insurance

24. Regulation of Financial Markets Two better reasons (in MDV’s view) • Hysterical political reaction to real/ perceived crisis • “Rent” seeking • Use of government power to secure return above opportunity cost (economic rents) Technological and political/economic shocks alter returns to taxing/regulating.

25. Regulation of Financial MarketsGlass-Steagall Act (1933) Example of hysterical political reaction to real or perceived crisis plus rent seeking: Glass-Steagall (1933): • Established firewall between investment and commercial banking. • Based on idea that investment banking would increase risk of commercial banking and conflict of interest existed.

26. Mistake not fixed until 1999 Regulation of Financial MarketsGlass-Steagall Act (1933) But... • Portfolio theory indicates combining commercial and investment banking actually reduces risk. • Evidence from 1920s indicates bonds underwritten by investment bank subs of commercial banks performed well (no evidence of massive fraud). • Public benefits from economies of scope available by combining commercial and investment banking.

27. Recent Trends in Financial Markets • Financial entrepreneurship • Globalization • Democratization • Deregulation • Evolution of financial intermediation All these trends have their roots in technological or political/economic shocks!

28. Modigliani-Miller and Financial Structure Questions over Money and Banking Mr. Vaughan