Chapter 7
Why Do Financial Institutions Exist?
Basic Facts About Financial Structure Throughout the World
Transaction Costs
How Transaction Costs Influence Financial Structure
How Financial Intermediaries Reduce Transaction Costs
Asymmetric Information: Adverse Selection and Moral Hazard
The Lemons Problem: How Adverse Selection Influences Financial Structure
Lemons in the Stock and Bond Markets
Tools to Help Solve Adverse Selection Problems
Mini-Case Box: The Enron Implosion
How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Moral Hazard in Equity Contracts: The Principal-Agent Problem
Tools to Help Solve the Principal-Agent Problem
How Moral Hazard Influences Financial Structure in Debt Markets
Tools to Help Solve Moral Hazard in Debt Contracts
Summary
Case: Financial Development and Economic Growth
Mini-Case Box: Should We Kill All the Lawyers?
Case: Is China a Counter-Example to the Importance of Financial Development?
Conflicts of Interest
What are Conflicts of Interest and Why Do We Care?
Why Do Conflicts of Interest Arise?
Mini-Case Box: The Demise of Arthur Andersen
Mini-Case Box: Credit Rating Agencies and the 2007-2009 Financial Crisis
What Has Been Done to Remedy Conflicts of Interest?
Mini-Case Box: Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?
◼ Overview and Teaching Tips
The development of a new literature in finance on asymmetric information and financial structure in recent
years now enables financial institutions to be taught with basic principles rather than placing emphasis on
a set of facts that students may find boring and so will forget after the final exam. This chapter provides an
outline of this literature to the student and provides him or her with an understanding of why our financial
system is structured the way it is. In addition it emphasizes the ideas of adverse selection and moral
hazard, which are basic concepts that are useful in understanding conflicts of interest in this chapter,
financial regulation in Chapter 18, principles of insurance management in Chapter 21, and principles of
credit risk management in Chapter 23.
34 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
The chapter begins with a discussion of eight basic facts about financial structure. Students find some of
these facts to be quite surprising—the relative unimportance of the stock market as a source of financing
investment activities, for example—which piques their interest and stimulates them to want to understand
the economics behind our financial structure. The next two sections then solve these facts by providing an
understanding of how transaction costs and asymmetric information affect financial structure. My experience
with teaching this material is that it is very intuitive and so is easy for students to learn. Furthermore,
students find the material inherently exciting because it explains phenomena that they know are important
in the real world. I have also found that it helps students to learn facts about the financial system because
they now have a framework to make sense out of all these facts.
The chapter then discusses four cases. The first two examine the role of financial development on economic
growth and whether China is a counter-example to the importance of financial development. The second
two focus on financial crises: One examines the role of financial development on economic growth, while
the other focuses on financial crises. These cases fit in especially well with courses focusing on public policy
since promoting economic growth and avoiding financial crises is one of the major issues for policymakers.
Students find these cases to be very stimulating, because there is something inherently exciting about
economic growth and financial crises. These cases can be skipped without loss of continuity, especially
for courses focusing on financial institutions.
The chapter contains a final section on “Conflicts of Interest,” which discusses what conflicts of interest
are and why we should care about them. Recent corporate and accounting scandals due to conflicts of
interest have received tremendous public attention and are thus highly interesting to students because
resulting bankruptcies have cost employees of these firms their jobs and their pensions, and because the
scandals may have hampered the efficient functioning of the financial system. In addition, the growing
concerns about the proliferation and effects of conflicts of interest have resulted in the decision of many
business schools to add business ethics courses to their curriculums. This chapter allows the instructor to
discuss ethical issues but with the analysis grounded on the asymmetric information concepts featured so
prominently in this book.
It is important to emphasize to students that conflicts of interest occur when people who are supposed to
act in the interests of the investing public by providing them with reliable information instead have
incentives (conflicting interests) to deceive the public to benefit themselves and their corporate clients.
The section ends by providing a survey of the different types of conflicts of interest in the financial
industry and discusses policies to remedy them.
The chapter has been designed to keep the textbook very flexible. The concepts of adverse selection and
moral hazard were explained in Chapter 2 and are explained again in Chapters 18, 21, and 23 so that
Chapter 7 does not have to be covered in order to teach these or later chapters.
◼ Answers to End-of-Chapter Questions
1. Financial intermediaries can take advantage of economies of scale and thus lower transaction costs.
For example, mutual funds take advantage of lower commissions because the scale of their purchases
2. Financial intermediaries develop expertise in such areas as computer technology so that they can
Chapter 7: Why Do Financial Institutions Exist? 35
3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able to
4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and
moral hazard problems in financial markets, hence making them operate better. Standard accounting
5. The lemons problem would be less severe for firms listed on the New York Stock Exchange because
6. Smaller firms that are not well known are the most likely to use bank financing. Since it is harder for
7. Because there is asymmetric information and the free-rider problem, not enough information is
available in financial markets. Thus there is a rationale for the government to encourage information
8. Yes. The person who is putting her life savings into her business has more to lose if the business
9. Yes, this is an example of an adverse selection problem. Because a person is rich, the people who are
10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because
11. The free-rider problem means that private producers of information will not obtain the full benefit of
12. The separation of ownership and control creates a principal-agent problem. The managers (the agents)
do not have as strong an incentive to maximize profits as the owners (the principals). Thus the
Copyright © 2015 Pearson Education, Inc.
14. Conflicts of interest arise because higher profits might arise in providing one kind of service if the
15. Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric
16. a. Research analysts in investment banks might distort their research to please issuers of securities
17. Spinning makes financial markets less efficient because it might influence executives to not use the
18. a. Clients may be able to pressure auditors into skewing their opinions in order to get fees for other
accounting services.
19. Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the
firm and requires disclosure of off-balance sheet transactions and relationships with special purpose
20. The Global Settlement has increased disclosure of analysts’ recommendations which can help
increase information in financial markets. Also it requires increased disclosure of potential conflicts
Chapter 7: Why Do Financial Institutions Exist? 37
◼ Quantitative Problems
1. You are in the market for a used car. At a used car lot, you known that the blue book value for the
cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much
about the car as you, how much are you willing to pay? Why? Assume that you only care about the
expected value of the car you buy and that the car values are symmetrically distributed.
2. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay?
Why? How can this be resolved in a competitive market?
Solution: You are willing to pay the average price upfront: $22,000. However, the dealer will know
3. You wish to hire Ricky to manage your Dallas operations. The profits from the operations depend
partially on how hard Ricky works, as follows:
Probabilities
Profit = $10,000
Profit = $50,000
Lazy Worker
60%
40%
Hard Worker
20%
80%
If Ricky is lazy, he will surf the Internet all day, and he views this as a zero cost opportunity.
However, Ricky would view working hard as a “personal cost” valued at $1,000. What fixed–
percentage of the profits should you offer Ricky? Assume Ricky only cares about his expected
payment less any “personal cost.”
Solution: Let P be the percent of profits you pay Ricky.
If Ricky is lazy, his expected payment is
