Summary AFBI
Lecture 1 Introduction, functions of the financial system Ch.1
Functions of the financial system ⇒
Working of the financial system: allocation
Financial and economic development
- functioning of financial systems is vitally linked to economic growth: as well
functioning financial systems allocate funds to their most productive uses.
- some recent studies conclude that at intermediate levels of financial depth, there is a
positive relationship between the size of the financial system and economic growth.
- but at high levels of financial depth (private credit > 100% GDP), more finance is
associated with a higher likelihood of financial crises and less growth.
Main functions of financial system
1. reducing information costs: overcome an information asymmetry between borrowers
and lenders which can occur ex ante (adverse selection) and ex post (monitoring) -
e.g. banks, credit rating agencies
2. reducing transaction costs - e.g. by pooling funds
3. facilitating the trading, diversification, and management of risk: e.g. by providing
liquidity and through securitization
Example of information costs: credit rating agencies →
- a credit rating is a forward looking opinion on credit risk
- CRAs perform two key functions:
1. offer an independent assessment of the ability of issuers to meet their debt
1
, obligations
2. offer monitoring services through which they influence issuers to tale corrective
actions to avert downgrades
Concentrated market: the three largest CRAs share roughly 95% of the market
Regulation of credit rating agencies?
Discussion on the role of CRAs:
- conflicts of interest inherent to their business model: CRAs are mainly financed on
the basis of an issuer based compensation scheme, meaning that the agencies are
paid by the issuers of these instruments to publish rating
- underestimation of credit risk associated with structured credit products
- condemned for exacerbating the recent european debt crisis when they downgraded
various countries in the midst of the financial turmoil
Role of government
Government intervention (regulation, policy) is needed:
- to protect property rights and to enforce contracts
- to encourage proper information provision (transparency)
- in order to ensure soundness of financial institutions
- in order to ensure competition
Financial (de)liberalisation
- financial liberalization: opening up of domestic financial markets to foreign capital and
foreign financial intermediaries
- allowing foreign capital to freely enter domestic markets:
1. increase the availability of funds, stimulating investment and economic growth
2. enhances competition in the financial system
3. may lead to institutional reforms that stimulate financial development
But also, instability?
Bank versus market based
- direct finance: sector in need of funds borrows from another sector via a financial
market
- indirect finance: a financial intermediary obtains funds from savers and uses these
savings to make loans to a sector in need of finance
Do differences in financial systems affect macro economic outcomes? ⇒
https://www.youtube.com/watch?v=2AHgeVBz8G4
Banks conduct financial intermediation and bear risks on their own balance sheet, generally
on the basis of close relationships with their clients. By contrast, markets channel resources
2
,directly from savers to borrowers, serving as platforms where equity and debt securities are
priced, distributed and traded.
A case for bank based system
- atomistic markets (where each individual player is too small to affect outcomes) face
a free rider problem: when an investor acquires information about an investment
project and behaves accordingly, this reveals information to all investors
- banks, however, may exclusively benefit form information they acquire
- drawback: hold up problem
A second element →
- corporate governance, i.e. the set of mechanisms arranging the relationship between
stakeholders of a firm, notably holders of equity, and the management of the firm.
Corporate governance
Investors can use several tools to ensure that management of a firm acts in their interest: the
most important tools are →
1. appointment of the BoD
2. executive compensation
3. the market for corporate control: proxy contests, friendly managers and takeovers,
and hostile takeovers
4. Monitoring by financial intermediaries → argument for bank based system
Counterarguments:
1. banks are not necessarily better monitors than markets
2. problems created by powerful banks
3. governance of banks themselves
4. markets more flexible
Another view: complements
- Some authors argue that financial markets and financial intermediaries may provide
complementary growth-enhancing financial services to the economy.
- For instance: Allen and Santomero (1997): intermediaries reduce participation
costs, i.e. the costs of learning about effectively using financial markets as well as
participating in them on a day-to-day basis.
Law and finance view: focus on legal systems
- Financial system is a set of contracts that is defined and made more or less
effective by legal rights and enforcement mechanisms.
- A well-functioning legal system facilitates the operation of both financial markets
and intermediaries.
- Some argue that distinguishing between efficiency of legal system more useful than
categorizing in bank-based or market-based system.
3
, Law families →
- La Porta et al. (1997): financial systems offer different levels of creditor and
shareholder protection depending on the origin of the legal rules in place.
- Differences in law families:
1. English: protect shareholders and creditors the most
2. French: protect shareholders and creditors the least
3. German, Scandinavian: in between
- Both corporate governance and private law are diverse (not harmonized) across
European Union (see Table 1.1)
Recent changes: sustainable finance, non bank intermediations, securitization ⇒
1. resource allocation and sustainable finance
2. rise of non bank financial intermediation
3. securitization
Resource allocation and sustainable finance (1)
“...the transition to a low-carbon economy consistent with the objectives of the Paris
agreement requires a radical shift of resource allocation and, thus, a seminal response by
the financial sector”
1. Role of government: Social-Cost Benefit Analysis. Internalize all costs and benefits
to society of economic activities (externalities)
- e.g. carbon tax.
2. Role of finance: Integrate climate-related risks into strategic decision-making and
risk management (and thereby pricing).
- Physical risks: effects of extreme weather events / effects of higher temperatures
and sea level rises.
- Transition risks: losses from the process of adjustment towards a low-carbon
economy.
Finance does not internalize environmental risks →
- Allocation role of finance important in transition to sustainable economy
1. Resource scarcity and climate change may reach planetary boundaries
2. Sustainable finance includes social and environmental factors (LT)
- But finance is short-term and focus on economic/financial factors
- Mark Carney (2015): Tragedy of the Horizon
- Challenges to integrate other factors in decision-making
1. Socially responsible investing (SRI); evidence on performance is mixed
2. Integrated reporting, whereby annual report explains impact of corporate strategy
and performance on external environment
3. Task Force on Climate-Related Financial Disclosures (TCFD)
We see a rise of non bank financial intermediation. (2)
Securitization (3)
4
Lecture 1 Introduction, functions of the financial system Ch.1
Functions of the financial system ⇒
Working of the financial system: allocation
Financial and economic development
- functioning of financial systems is vitally linked to economic growth: as well
functioning financial systems allocate funds to their most productive uses.
- some recent studies conclude that at intermediate levels of financial depth, there is a
positive relationship between the size of the financial system and economic growth.
- but at high levels of financial depth (private credit > 100% GDP), more finance is
associated with a higher likelihood of financial crises and less growth.
Main functions of financial system
1. reducing information costs: overcome an information asymmetry between borrowers
and lenders which can occur ex ante (adverse selection) and ex post (monitoring) -
e.g. banks, credit rating agencies
2. reducing transaction costs - e.g. by pooling funds
3. facilitating the trading, diversification, and management of risk: e.g. by providing
liquidity and through securitization
Example of information costs: credit rating agencies →
- a credit rating is a forward looking opinion on credit risk
- CRAs perform two key functions:
1. offer an independent assessment of the ability of issuers to meet their debt
1
, obligations
2. offer monitoring services through which they influence issuers to tale corrective
actions to avert downgrades
Concentrated market: the three largest CRAs share roughly 95% of the market
Regulation of credit rating agencies?
Discussion on the role of CRAs:
- conflicts of interest inherent to their business model: CRAs are mainly financed on
the basis of an issuer based compensation scheme, meaning that the agencies are
paid by the issuers of these instruments to publish rating
- underestimation of credit risk associated with structured credit products
- condemned for exacerbating the recent european debt crisis when they downgraded
various countries in the midst of the financial turmoil
Role of government
Government intervention (regulation, policy) is needed:
- to protect property rights and to enforce contracts
- to encourage proper information provision (transparency)
- in order to ensure soundness of financial institutions
- in order to ensure competition
Financial (de)liberalisation
- financial liberalization: opening up of domestic financial markets to foreign capital and
foreign financial intermediaries
- allowing foreign capital to freely enter domestic markets:
1. increase the availability of funds, stimulating investment and economic growth
2. enhances competition in the financial system
3. may lead to institutional reforms that stimulate financial development
But also, instability?
Bank versus market based
- direct finance: sector in need of funds borrows from another sector via a financial
market
- indirect finance: a financial intermediary obtains funds from savers and uses these
savings to make loans to a sector in need of finance
Do differences in financial systems affect macro economic outcomes? ⇒
https://www.youtube.com/watch?v=2AHgeVBz8G4
Banks conduct financial intermediation and bear risks on their own balance sheet, generally
on the basis of close relationships with their clients. By contrast, markets channel resources
2
,directly from savers to borrowers, serving as platforms where equity and debt securities are
priced, distributed and traded.
A case for bank based system
- atomistic markets (where each individual player is too small to affect outcomes) face
a free rider problem: when an investor acquires information about an investment
project and behaves accordingly, this reveals information to all investors
- banks, however, may exclusively benefit form information they acquire
- drawback: hold up problem
A second element →
- corporate governance, i.e. the set of mechanisms arranging the relationship between
stakeholders of a firm, notably holders of equity, and the management of the firm.
Corporate governance
Investors can use several tools to ensure that management of a firm acts in their interest: the
most important tools are →
1. appointment of the BoD
2. executive compensation
3. the market for corporate control: proxy contests, friendly managers and takeovers,
and hostile takeovers
4. Monitoring by financial intermediaries → argument for bank based system
Counterarguments:
1. banks are not necessarily better monitors than markets
2. problems created by powerful banks
3. governance of banks themselves
4. markets more flexible
Another view: complements
- Some authors argue that financial markets and financial intermediaries may provide
complementary growth-enhancing financial services to the economy.
- For instance: Allen and Santomero (1997): intermediaries reduce participation
costs, i.e. the costs of learning about effectively using financial markets as well as
participating in them on a day-to-day basis.
Law and finance view: focus on legal systems
- Financial system is a set of contracts that is defined and made more or less
effective by legal rights and enforcement mechanisms.
- A well-functioning legal system facilitates the operation of both financial markets
and intermediaries.
- Some argue that distinguishing between efficiency of legal system more useful than
categorizing in bank-based or market-based system.
3
, Law families →
- La Porta et al. (1997): financial systems offer different levels of creditor and
shareholder protection depending on the origin of the legal rules in place.
- Differences in law families:
1. English: protect shareholders and creditors the most
2. French: protect shareholders and creditors the least
3. German, Scandinavian: in between
- Both corporate governance and private law are diverse (not harmonized) across
European Union (see Table 1.1)
Recent changes: sustainable finance, non bank intermediations, securitization ⇒
1. resource allocation and sustainable finance
2. rise of non bank financial intermediation
3. securitization
Resource allocation and sustainable finance (1)
“...the transition to a low-carbon economy consistent with the objectives of the Paris
agreement requires a radical shift of resource allocation and, thus, a seminal response by
the financial sector”
1. Role of government: Social-Cost Benefit Analysis. Internalize all costs and benefits
to society of economic activities (externalities)
- e.g. carbon tax.
2. Role of finance: Integrate climate-related risks into strategic decision-making and
risk management (and thereby pricing).
- Physical risks: effects of extreme weather events / effects of higher temperatures
and sea level rises.
- Transition risks: losses from the process of adjustment towards a low-carbon
economy.
Finance does not internalize environmental risks →
- Allocation role of finance important in transition to sustainable economy
1. Resource scarcity and climate change may reach planetary boundaries
2. Sustainable finance includes social and environmental factors (LT)
- But finance is short-term and focus on economic/financial factors
- Mark Carney (2015): Tragedy of the Horizon
- Challenges to integrate other factors in decision-making
1. Socially responsible investing (SRI); evidence on performance is mixed
2. Integrated reporting, whereby annual report explains impact of corporate strategy
and performance on external environment
3. Task Force on Climate-Related Financial Disclosures (TCFD)
We see a rise of non bank financial intermediation. (2)
Securitization (3)
4
