• This PPP #2 based on chapter 8 of the textbook ( pp.173-190) will be reviewed again in PPP #3 in “Review of Chapters 2 and 8, and Advanced Discussion”.

• However, at the end of this Chapter 8, pp.191-200 of the textbook, there is a description of new development of Government Regulations in the U.S. (Sarbanes-Oxley Act) and Canada (Bill 198).

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Revised Revised Chapter 8Chapter 8

An Economic Analysis of Financial Structure

Eco 2154 PPP #2

Eight Basic Facts1. Stocks are not the most important sources of

external financing for businesses.

2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.

3. Indirect finance is many times more important than direct finance.

4. Financial intermediaries are the most important source of external funds.

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Eight Basic Facts (Cont’d)

5. The financial system is among the most heavily regulated sectors of the economy.

5. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers.

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Sources of External FundsSources of External Funds

Transaction Costs

• How can Financial intermediaries reduce transaction costs of financing?– Economies of scale(quantity)– Expertise(quality)

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Asymmetric Information• Adverse selection occurs before the transaction

• Moral hazard arises after the transaction• Private production and sale of information

– Information Free-rider problem

• Government regulation to increase information

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*Moral Hazard in Equity Contracts

• Called the Principal-Agent Problem• Separation of ownership and control

of the firm

– Managers pursue personal benefits and power rather than the profitability of the firm.

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Moral Hazard: Solutions• Net worth and collateral

– Incentive compatible

• Monitoring and Enforcement of Restrictive Covenants– Discourage undesirable behavior– Encourage desirable behavior– Keep collateral valuable– Provide information

• Financial Intermediation

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Asymmetric InformationAsymmetric Information

Latest Examples of

Government Regulations aiming at Disclosure – Public Information Production,

Which may decrease Information Asymmetry and Moral Hazards.

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U.S. Side• Sarbanes-Oxley Act of 2002 (Public Accounting Return

and Investor Protection Act)– Increases supervisory oversight to monitor and prevent

conflicts of interest.

– Establishes a Public Company Accounting Oversight Board.

– Increases the SEC’s budget.

– Makes it illegal for a registered public accounting firm to provide any nonaudit service to a client contemporaneously with an impermissible audit.

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• Sarbanes-Oxley Act of 2002 (cont’d)– Beefs up criminal charges for white-collar crime

and obstruction of official investigations.

– Requires the CEO and CFO to certify that financial statements and disclosures are accurate.

– Requires members of the audit committee to be independent.

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• Global Legal Settlement of 2002– Requires investment banks to sever the link between research

and securities underwriting.– Bans ‘Spinning’ , which is ‘Selling Underpriced IPD shares to its

customers as bribe’– Requires investment banks to make their analysts’

recommendations public.– Over a 5-year period, investment banks are required to

contract with at least three independent research firms that would provide research to their brokerage customers.

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Control Attestation in Canada

• In October 2002, the Ontario government introduced Bill 198 in response to reforms in the United States.

• Similar to Sarbanes-Oxley Act, this bill made several reforms to security laws including auditor independence, CEO and CFO accountability for financial reporting, enhanced penalties for illegal activities and faster public disclosure.

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Financial Crises and Aggregate Economic Activity

We are skipping this part for now (from pp. 201-207). Why? We do not bite too big a topic for now in this course; We will do so later as we have got enough knowledge.

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