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Agency theory : how asymmetric information affects economic behavior

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.

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Agency theory : how asymmetric information affects economic behavior

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  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 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

  4. Why Intermediaries? … Transaction Costs • Economies of scale • Expertise: information specialists to handle adverseselection 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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?

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