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: The Tyranny of Collateral
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.

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39 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global 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. We 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 two cases. The first examines the role of financial development on economic
growth and the second, whether China is a counter-example to the importance of financial development.
These cases fit in especially well with courses focusing on public policy since promoting economic growth is
one of the major issues for policymakers. 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
is higher than for an individual, while banks’ large scale allows them to keep legal and computing
costs per transaction low. Economies of scale which help financial intermediaries lower transaction
costs explains why financial intermediaries exist and are so important to the economy.
2. When a couple dates, they are (explicitly or implicitly) extracting information about the significant
other. At the same time, they are sharing information about themselves. This information flow helps
both individuals to make better decisions about a probable (or not) future life together. In this way,
one can think that this process is formally no different from the one in which the loan officer tries to
choose the right borrower.

3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able to
screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly,

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 Chapter 7: Why Do Financial Institutions Exist? 40

if the lender knows what the borrower is up to, then moral hazard will not be a problem because the
lender can easily stop the borrower from engaging in moral hazard.

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
principles make it easier for investors to screen out good firms from bad firms, thereby reducing the
adverse selection problem in financial markets. In addition, they make it harder for managers to
understate profits, thereby reducing the principal-agent (moral hazard) problem.
5. One would expect the group of countries with more efficient legal systems to exhibit higher living
standards. Legal systems are an important part in the lending process, precisely because they are part
of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow
and inefficient legal systems do not promote lending and thereby funding of investment opportunities.

6. One would expect corruption measures to be negatively correlated with living standards. Corruption
usually deters investment, since it undermines the legal system. Countries in which corruption is
prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects
living standards by undermining the efficiency of the legal system, thereby lowering investment, one
fundamental ingredient to economic growth, the basis of higher living standards.

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
production through regulation so that it is easier to screen out good from bad borrowers, thereby
reducing the adverse selection problem. The government can also help reduce moral hazard and
improve the performance of financial markets by enforcing standard accounting principles and
prosecuting fraud.

8. Yes. The person who is putting her life savings into her business has more to lose if the business
takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits.
So she will act more in the interest of the lender, making it more likely that the loan will be paid off.
9. The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general,
the bank does not “keep the house title”, but it places a lien on it instead to prevent the house owner
to sell the house without its supervision. In this case, the bank wants to make sure that you do not sell
the house, get the money and never pay back the loan.

10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because
the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe
a problem.

11. The free-rider problem means that private producers of information will not obtain the full benefit of
their information producing activities, and so less information will be produced. This means that there
will be less information collected to screen out good from bad risks, making adverse selection problems
worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.
12. The conflict of interest discussed in the chapter is of underwriting and research in investment banking.
A conflict of interest usually arises among banks when they own asset management companies, which
invest their clients’ funds in securities that match their declared financial objectives. In Europe, asset
management companies provide investors with more diversification and investing options than they
would have by themselves. When the banks issue mutual funds to the general public and then steer their
clients to the asset management companies that they own, there is a conflict of interest. Banks and asset
management companies should not be related to one another, especially when banks are issuing mutual
funds or hedge funds.

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41 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global Edition

13. Credit rating agencies try to mitigate the problem of adverse selection. By compiling information and
evaluating default risks, credit rating agencies help investors to decide which bonds have the highest
risks of default and which ones are relatively safer investments. The subprime mortgage crisis
undermined the trustworthiness of these agencies, since securities that were assigned good ratings
were in fact bad investments.

14. The “Chinese wall” is a term used in audit firms when a client might need two different services from
the same company. For example in PwC, client X might need accounts preparation services from the
Transaction Services department and audit services from the Audit and Assurance department at the
same time. This is legal in Europe but illegal in America. When faced with such a situation (where it
is legal), the two departments must put up a proverbial Chinese wall between each other to prevent
the sharing private information.
15. The principal–agent problem may occur in a multinational company where the owners or
shareholders do not run the business on a day-to-day basis. The shareholders or the owners are the
principal. The business is run by the agents—the board of directors, CEO, and CFO—which could
conflict with the interest of the owners. This is a common problem for MNCs as most are public
listed and run by the board, who are often not shareholders, so both principal and agent suffer from
goal incongruence which is detrimental to the overall financial health of a company.

16. a. Research analysts in investment banks might distort their research to please issuers of securities
so underwriters in the investment bank can get their business.
b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but
underpriced, IPOs to executives in return for their companies’ future business.
17. When prospective employers ask job applicants to go through a job interview, they are trying to solve
the adverse selection problem. Prospective employers want to know more about potential workers,
much in the same way loan officers want to know more about potential borrowers. As it is the case
with a loan transaction, the information asymmetry does not end here, since if hired, worker and
employer will have to solve the moral hazard problem. Usually employers try to solve this problem
with paying schemes that encourage workers to provide more effort.

18. Adverse selection occurs where one party in a transaction has complete knowledge of a situation that
the other party lacks, which can be detrimental to the economy in the long run. In the subprime
mortgage crisis, the banks awarded mortgages to people who were generally incapable to pay off the
loans keeping in view what they earned. The mortgage sellers knew that the future homeowners could
not afford to pay back later but still insisted that they take out the mortgage as they wanted the
commission from each transaction. The reason why they could do so was because the mortgages were
then securitized: once packaged and sold, they were not on the books of the banks. The problem of
adverse selection also occurred with the investors of the securitized loans who thought that real estate
prices would continue to rise and with that the demand for securitized mortgages. However, the banks
knew very well that real estate prices would not rise indefinitely.

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
entities. This mandatory disclosure improves the quality of information, but has the disadvantage of
being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB
which can help stop conflicts of interest in the accounting industry. Also by making the audit committee
independent of management, audits are likely to be more reliable, an important benefit. However,
Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them
from providing auditing and consulting services to the same client.

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 Chapter 7: Why Do Financial Institutions Exist? 42

20. Cecilia and Julia are free-riders. Even though they have provided no effort, they had accepted the
reward of a good grade. Looking into the future, Lucia now has no incentive to work hard, if
everybody gets the same grade regardless of their effort. One can expect that Lucia will either not
participate or decide to provide no effort at all, with the result that the project will most probably be a
failure. It is very difficult to completely eliminate the free rider problem, both in financial markets
and in our everyday lives.

 Quantitative Problems
1. Sam is in the market for a used motorbike. At a used bike shop, Sam roughly knows that the price of
a used motorbike is between $40,000 and $48,000. If Sam believes that the dealer knows as much
about the bikes as him, how much do you think that Sam is willing to pay? Explain. Assume that he
only cares about the expected value of the bike he buys and that the bike values are symmetrically
distributed.
Solution: Sam is willing to pay the average price. If the distribution of used motorbike values is
symmetric, Sam will be willing to pay $44,000 for a randomly selected used motorbike.

2. Sam now decides to go to a different town to search for a used motorbike and believes that the dealer
knows more about the used motorbikes than him. How much do you think that Sam is willing to pay?
Discuss. How can this be resolved in a competitive market?
Solution: Sam is willing to pay the average price upfront: $44,000. However, the dealer will know
this, and only sell him a used motorbike worth between $40,000 and $44,000. Fortunately,
Sam also knows this. So, Sam will only pay $42,000. And so on. This ends with Sam
paying $40,000, and the bike being worth $40,000.
This is alright for Sam, but the dealer can never sell motorbikes worth more than $40,000.
The resolution, of course, is to get more information. This may include a test drive,
mechanical inspection, warranty, etc.

3. You wish to hire Melissa to manage your Kansas operations. The profits from the operations depend
partially on how hard Melissa works, as follows:

Probabilities
Profit  $20,000 Profit  $100,000
Lazy Worker 65% 35%
Hard Worker 30% 70%

If Melissa is lazy, she will surf the Internet all day, and she views this as a zero cost opportunity.
However, Melissa would view working hard as a “personal cost” valued at $2,000. What fixed-
percentage of the profits should you offer Melissa? Assume Melissa only cares about her expected
payment less any “personal cost.”
Solution: Let P be the percent of profits you pay Melissa.
If Melissa is lazy, her expected payment is
0.65  20,000 P + 0.35  100,000 P = 48,000 P
If Melissa works hard, her expected payment is
0.30  20,000 P + 0.70  100,000 P − 2,000 = 76,000 P − 2,000
To induce Melissa to work hard, you need

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43 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition, Global Edition

76,000 P − 2,000 > 48,000 P

28,000 P > 2,000
P > 0.0714
So, offer Melissa 7.14% of the profits, and this should induce her to work hard.

4. You own a house worth $800,000 on a river. If the river floods moderately, the house will be
completely destroyed. This happens about once every 80 years. If you build a seawall, the river
would have to flood heavily to destroy your house, and this only happens about once every 400 years.
What would be the annual premium for an insurance policy that offers full insurance? For a policy
that only pays 80% of the home value? What are your expected costs with and without a seawall? Do
the different policies provide an incentive to be safer (build the seawall)?
Solution: With full insurance:
Without a seawall, the expected loss is
800,000  0.0125 = 10,000
With a seawall, the expected loss is
800,000  0.0025 = 2,000
The insurance company will charge the expected loss as a premium. Your expected cost
under either scenario each year is the premium.
With partial insurance:
Without a seawall, the expected loss is
640,000  0.0125 = 8,000
With a seawall, the expected loss is
640,000  0.0025 = 1,600
The insurance company will charge the expected loss as a premium. Your expected cost
each year is:
Without a seawall:
[0.0125 (640,000 − 800,000) + 0.9875 (0)] − 8,000 = −6,000
With a seawall:
[0.0025  (640,000 − 800,000) + 0.9975 (0)] − 1,600 = −1,200
Unfortunately, neither insurance policy is better or worse. Although the premiums under
the partial insurance policy are lower, the expected cost each year is the same as with full
insurance. In either scenario, you will build the seawall if the annual cost of building and
maintaining a seawall is less than $4,800/year.

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