Chapter 8: Financial Structure, Transaction Costs, and Asymmetric Information
So much attention is paid to investment markets that it is often forgotten that the basis of all investments is the need of companies to obtain financing for their operations. An entrepreneur who has the capital to finance his own operations has no need of investors, but one who does not have the capital must either borrow the money (by issuing bonds) or getting others to contribute to his undertaking for a share of the profits (by selling stocks). The same thing applies to an existing operation in need of capital to expand its operations. In that sense, the capital markets are debt markets - and all investments are essentially based on the entreprenuers' ability to make productive use of borrowed capital. Banks, insurance companies, investment bankers, stockbrokers, and all the other players are merely intermediaries between those who have capital to lend and those who wish to borrow it.
It's also mentioned that not every business seeks to participate in capital markets directly. Most businesses manage their finances by obtaining loans from their local bank. The bank may choose to hold these loans and collect the payments, or it may sell the loans to others. The author estimates that the majority of financial arrangements are made in this manner, between business owners and their banks. As evidence, he cites that in the world's most advanced economies, the stock market supplies no more than 12% of funding to nonfinancial businesses, and the bond market provides about 10% - meaning that 78% of funding is not provided directly by financial markets.
So while the financial press seems to be exclusively focused on stocks and bonds, recognize that these represent a small percentage (about one-fifth) of business financing. Most of the finance is done at the local bank, and most of the loans are held rather than securitized by the banks that hold them.
The Necessity and Advantages of Intermediaries
The main reason that banks, rather than private individuals, are involved in financing operation is efficiencies of scale. The investor with $10,000 to lend will make about $500 if he loans that money to a business at a rate of 5%. But five hundred dollars is not sufficient to cover the transaction costs - to research a borrow to assess creditworthiness, to write the loan contract, to manage payments and collections, and so forth. The cost and effort simply aren't worth the return. It is much more efficient for the small investor to purchase stocks and bonds than to be a direct participant in capital lending.
There are very few investors whose personal fortunes enable them to invest tens or hundreds of millions of dollars in commercial lending, to hire the staff and maintain offices to do all of the things necessary to manage those investments so that it doesn't consume all of the interest earned on the loans. And in those instances, the super-rich investor generally starts a bank or an investment company, which eventually goes public (this is the history of Berkshire Hathaway).
He does mention peer-to-peer banking in which Web sites provide a forum for small investors to lend directly to small businesses. These sites are effectively playing the role of banks and brokerages, and their services involve screening applicants, collecting payments, and all the other operations. It is arguable whether this is actually peer-to-peer banking at all, but merely a clever arrangement in which the "bank" provides no security for its depositors, who assume the risk that its creditors will default. That is, it is not direct person to person lending, but lending through an intermediary.
In addition to having greater economies of scale, financial intermediaries also benefit from their expertise and access to information about borrowers that is not available to the public (asymmetric information). Small companies who borrow from banks do not disclose their financials to the SEC or to the public, and little is known about them - but when they apply to banks, the bank conducts its own investigation to determine and validate the borrower's creditworthiness, and this information remains the bank's possession, kept well out of the public's view.
It's also implied that when banks are in need of cash and securitize or sell their loans to raise capital, they do not offer their most profitable and least risky paper to buyers and markets. Quite the opposite: they keep their best and most profitable loans to themselves and "float" the less creditworthy and less profitable ones as commercial paper. And this provides the potential for abuse and outright fraud: it is the issuing bank who assesses the creditworthiness of borrowers whose papers they float - while there is the potential to audit and certain regulatory disclosure requirements, these are apparently easily skirted, as evidenced by the recent financial meltdown in which mortgages held by thoroughly uncreditworthy borrowers were securitized as "A+" investment vehicles.
The author mentions three problems (adverse selection, moral hazard, and agency) that he will discuss in turn in the sections that follow.
Adverse Selection
The author chases down a rather long analogy about the used car market. If a vehicle is mechanically sound and serviceable, chances are the person who owns it is quite happy with it and wishes to continue driving it. But if a vehicle is unreliable, the owner is eager to get rid of it and buy a better one. And so, buyers in the used-car market should be highly suspicious of the inventory: most sellers are simply trying to dump problem vehicles and will go to great lengths to hide their deficiencies so that someone will buy their lemons.
This is largely analogous to the capital markets: the bankers who hold a variety of loans are eager to securitize the bad ones to shield themselves from risk, and must offer a higher return (interest rate) to get buyers to assume the risk for them. This is adverse selection: the loans that are least likely to be repaid are the ones that bankers are most interested in passing on to someone else.
In both markets, the buyers are motivated by greed and blinded by stupidity. The used car buyer wants to pay less money to have a car than if he bought one new (and backed by the manufacturer) - he knows that there is a risk that the used car is a lemon, but accepts this risk in order to have more money. The aggressive investor likewise wants to get more return on his investment, but knows that the only way he can get a higher return is to take on more risk, and the investor must accept this risk to get a better return.
Intermediaries can usually help to mitigate the risk: a bank is beholden to protect its depositors' funds, and any loss that is taken on loans detracts from the bank's capital. Even those who act as brokers and do not assume the risk must defend their reputations to continue to attract investors. But where there is greed and competition between lenders, then they will often be less scrupulous in screening clients or decrease their lending standards across the board. At this point, their investors become subject to a disproportionate level of risk.
Another common service provided to the financial industry are the third-party screening services. Companies such as Standard and Poor, Moody's, and the like issue ratings for large borrowers - but their business models have changed. They were once paid by investment firms for rating borrowers, but because these firms often shared ratings these agencies lost revenue and switched to being paid by the borrowers for rating them - which naturally puts them in a precarious position of being paid by the borrowers to present them as creditworthy. The author asserts that "after every major financial crisis" it was found that the rating agencies had been far too lenient in granting high ratings to questionable borrowers.
Naturally, government seeks to impose regulation to keep everyone honest, but this has a limited effect. Cheaters are very innovative in seeking ways to cheat, exploiting loopholes in the regulations or simply covering up their misdeeds, and the SEC is often too slow and to overburdened to regulate them effectively. It is generally not until a financial crisis occurs that they investigate, fine, and refine legislation - and within a few years the cheaters have found new ways to cheat.
Moral Hazard
Another common problem in financial markets is moral hazard. Under normal circumstances, a person benefits or suffers from their own actions, and is motivated to do the right thing by fear of the consequences of failing to do it. When two or more people are involved, there is often the opportunity for one person to do the wrong thing, knowing that the negative consequences will be inflicted on someone else. This situation is known as moral hazard.
The insurance industry is fraught with moral hazard. While insurance ostensibly provides coverage against unforeseen tragedies, it is argued that insured persons are less careful than they need to be - they may leave their car unlocked or lets a fire burn unattended in their house because "it's insured." While they believe that no-one is harmed by their behavior, all those insured pay higher premiums as a consequence. This is not quite the same as insurance fraud, as it is not an intent to deceive the insurer, but it is simply indifference and abdication of personal responsibility.
The same is true in financial markets. Where a bank makes a loan to a borrower, the bank must be diligent in making sure that the borrower has the means and the intent to repay because the bank will lose out if the borrower defaults. But when the bank can sell or securitize the loan and pass along default risk to the buyer, then there is less incentive for them to carefully screen borrowers - because they will not suffer harm as a consequence when the borrower defaults.
Where it comes to encouraging the moral behavior of customers, the main defense of an insurance provider or a bank are the restrictive covenants in contracts. An insurance contract may stipulate that the insured must take certain precautions to safeguard property in order to be paid for a loss - hence the insured person is encouraged to act responsibly. Likewise, a lender may be required to take certain actions (or refrain from others) in order to qualify for a loan, or become immediately liable for the full balance if the lender detects that the borrower is not doing as promised.
Collateral property is a common example of a penalty to borrowers who fail to repay, but this is often negated by consumer protectionism. For example, it is a very lengthy and difficult process to evict someone from their home, even when they are severely delinquent in their payments. For that reason, mortgage underwriters are often left holding the bag - unable to seize the property that secured the loan that is no longer being repaid.
In the insurance industry, deductibles are often used to mitigate loss and discourage risk: a person whose car is insured cannot insist that the insurance company pay for every little scratch and dent because there is a deductible on the policy that exceeds the amount of minor repairs. (EN: Zero-deductible policies are available, but the premiums become extremely high simply because the insurance company pays for so many more minor repairs. And people who want zero-deductible are the type who generally file a lot of minor claims and don't want to pay deductibles.)
Where it comes to encouraging the moral behavior of lenders, the best defense would be to forbid the selling of commercial paper at all - but this would be devastating to economic activity, as it would severely limit the amount of capital available to entrepreneurs and businesses. Various regulations are in place the ensure that banks keep some skin in the game, and to balance moral hazard so that capital is available to maintain and grow the economy.
When it comes to reducing moral hazard, lenders are advantaged over borrowers when there is a high demand for capital: if one borrower seems too risky, the lender can refuse to loan to him and seek a more creditworthy borrower. But when the demand for capital is less than supply, lenders tend to take on more risk rather than having their funding lie fallow - and it is during these periods, when interest rates are low, that lenders tend to take on more and more risk in order to loan out their capital. This also reduces the lender's profit margin to the point where they look to reduce expenses - such as the costly screening process - which amplifies the problem.
Agency Problems
In this context, the author is referring to employees, people hired to act on behalf of others, such as the professional managers hired to run a business or the investment banker who is hired to obtain funding for a firm.
The main problem of agency is distance from the principal. The top layer of management is hired and appointed by the board, and is carefully screened and monitored to ensure that they pursue the interest of the owners. But those managers hire subordinate managers, and they hire another level of subordinates, and so on. The front-line employee is often anonymous and unknown, has no relationship with the owners, and are often delinquent in their duties. Where employees steal, slack off, act rudely toward customers, and otherwise behave in ways that harm the company, they are seldom held to account. And they often do not have any personal connection to the owners whom they represent, and quite often regard them with antipathy and spite. People would not dream of stealing from a friend or family member, but are much less scrupulous about stealing from the faceless owners of their company.
In general, monitoring and discipline are used to ensure employees behave. There are supervisors, cameras, and other mechanisms for monitoring activity and detecting misconduct as well as a formal disciplinary system to punish those who misbehave - but all of this is reactive. It is generally accepted that a more effective way to discourage misbehavior is to provide incentives: offer fair wages, provide commissions and bonuses, grant employees stock in the company, and in other ways align their personal interests with those of the organization. However, these programs are often ill-conceived and dispense rewards regardless of whether employees actually act in a beneficial way - or worse, they lead employees to game the system in order to get financial rewards (the salesman who sabotages his colleagues in order to win "top performer" in his department).
Such behavior is not limited to the rank-and-file employees on the assembly line and sales floor - the problems are far worse when a badly conceived incentive program is offered to those in positions of authority. Consider what happens when management is given incentives based on the price of the company's stock. They often act in ways that boost the short-term performance of the firm while damaging its long-term interests, or even engage in behavior such as forging the numbers to make the firm look more profitable than it actually is.