Lecture 10 Flashcards
Trade-Offs in Financial Systems
- Trade-off 1 (Innovation vs. Volatility)
* Trade-off 2 (Deregulation vs. Risk-taking)
Trade-off 1 (Innovation vs. Volatility) - explain
Innovative development of new instruments and new markets for risk handling creates rapidly growing possibilities to efficiently reallocate ever more specific risks, but also new challenges regarding market volatility
Trade-off 1 (Innovation vs. Volatility) - example
The structured products that were designed to make the banking system more stable, ultimately led to a decline in lending standards and an unprecedented credit expansion in 2007-08 (Brunnermeier, 2009). The unique and worrisome feature of this crisis was the spillover of financial system problems to real economy (not the other
way around as during the previous crises).
• Zingales (2015) proposes a contention that the size of the U.S. financial system has outgrown its benefits.
• Trade-off 2 (Deregulation vs. Risk-taking) - explain
Dynamic development of globally integrated, highly competitive financial markets andderegulation are pivotal factors behind the very high growth rates, but it
may create financial instability through excessive risk-taking by financial institutions
Trade-off 2 (Deregulation vs. Risk-taking) - examples
- The legal origins determine the scope of regulation. It is largely argued that common law seeks to support private market outcomes and to limit state intervention, while civil law seeks to impose statedesired allocations and more regulation (La Porta et al., 2008).
- Rajan and Zingales (2003) argue that economic growth is higher in competitive and open economies.
Traditional View
“Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. These functions are common to the financial systems of most developed economies. Yet the form of these financial systems varies widely.» (Allen and Gale, 2001, «Comparing Financial Systems»)
Who is A New Market Participant
Algorithmic traders
Two Types of Financial Systems
Market oriented financial system
Bank oriented financial system
Market oriented financial system
- many large corporations obtain their financing through issuance of securities on financial markets
• arm’s length financing – US and UK
Bank oriented financial system
- commercial banks are dominant in the provision of capital to corporation
• relationship financing – Germany, Japan
Difference between Market oriented financial system and Bank oriented financial system
Bank oriented system - investors are control oriented - dominant agency conflict - universal banking Market oriented system - well-developed, large financial markets with high liquidity - investors are portfolio oriented - dominant agency conflict - separation of investment banking from commercial banking
What does it mean by not very developed and relatively small financial markets with low liquidity
- low market capitalization
- few IPOs
- few SEO
• rights issues
• private placements
What does it mean by well-developed, large financial markets with high liquidity
- strong emphasis on liquidity provision
- high market cap
- many IPOs
- many SEOs
• public offerings
What does it mean that investors are control oriented
• concentrated ownership • private owners and family controlled corporations are not uncommon • cross-holdings • dual-class shares • no hostile takeovers • relatively few but very large corporations
What does it mean that investors are portfolio oriented
- dispersed ownership
- institutional investors dominate
- one share-one vote
- hostile takeovers not uncommon
- many large but few giant corporations
