162 PART 3 Fundamentals of Financial Institutions

MINI-CASE

Has Sarbanes-Oxley Led to a Decline

in U.S. Capital Markets?

There has been much debate in the United States in
recent years regarding the impact of Sarbanes-Oxley,
especially Section 404, on U.S. capital markets.
Section 404 requires both management and com-
pany auditors to certify the accuracy of their financial
statements. There is no question that Sarbanes-Oxley
has led to increased costs for corporations, and this is
especially true for smaller firms with revenues of less
than $100 million, where the compliance costs have
been estimated to exceed 1% of sales. These higher
costs could result in smaller firms listing abroad and
discourage IPOs in the United States, thereby shrinking
U.S. capital markets relative to those abroad. However,
improved accounting standards could work to encourage
stock market listings and IPOs because better informa-
tion could raise the valuation of common stocks.
Critics of Sarbanes-Oxley have cited it, as well as
higher litigation and weaker shareholder rights, as
the cause of declining U.S. stock listings and IPOs,
but other factors are likely at work. The European
financial system experienced a major liberalization
in the 1990s, along with the introduction of the
euro, that helped make its financial markets more
integrated and efficient. As a result, it became easier
for European firms to list in their home countries.
The fraction of European firms that list in their
home countries has risen to over 90% currently
from around 60% in 1995. As the importance of
the United States in the world economy has dimin-
ished because of the growing importance of other
economies, the U.S. capital markets have become
less dominant over time. This process is even more
evident in the corporate bond market. In 1995
corporate bond issues were double that of Europe,
while issues of corporate bonds in Europe now exceed
those in the United States.

The global settlement had measures to improve the quality of information in

financial markets:

t
It required investment banks to make their analysts’ recommendations public.

t
Over a five-year period, investment banks were required to contract with at
least three independent research firms that would provide research to their
brokerage customers.

The most controversial elements of the Sarbanes-Oxley Act and the Global
Legal Settlement were the separation of functions (research from underwriting, and
auditing from nonaudit consulting). Although such a separation of functions may
reduce conflicts of interest, it might also diminish economies of scope and thus
potentially lead to a reduction of information in financial markets. In addition, there
is a serious concern that implementation of these measures, particularly Sarbanes-
Oxley, is too costly and is leading to a decline in U.S. capital markets (see the Mini-
Case box “Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?”).

SUMMARY
1. There are eight basic facts about U.S. financial struc-
ture. The first four emphasize the importance of finan-
cial intermediaries and the relative unimportance of
securities markets for the financing of corporations;
the fifth recognizes that financial markets are among
the most heavily regulated sectors of the economy;
the sixth states that only large, well-established cor-
porations have access to securities markets; the sev-
enth indicates that collateral is an important feature
of debt contracts; and the eighth presents debt con-
tracts as complicated legal documents that place sub-
stantial restrictions on the behavior of the borrower.

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 CHAPTER 7 Why Do Financial Institutions Exist? 163

2. Transaction costs freeze many small savers and bor-
rowers out of direct involvement with financial mar-
kets. Financial intermediaries can take advantage of
economies of scale and are better able to develop
expertise to lower transaction costs, thus enabling
their savers and borrowers to benefit from the exis-
tence of financial markets.
3. Asymmetric information results in two problems:
adverse selection, which occurs before the transac-
tion, and moral hazard, which occurs after the trans-
action. Adverse selection refers to the fact that bad
credit risks are the ones most likely to seek loans,
and moral hazard refers to the risk of the borrower’s
engaging in activities that are undesirable from the
lender’s point of view.
4. Adverse selection interferes with the efficient func-
tioning of financial markets. Tools to help reduce
the adverse selection problem include private pro-
duction and sale of information, government regula-
tion to increase information, financial intermediation,
and collateral and net worth. The free-rider problem
occurs when people who do not pay for information
take advantage of information that other people have
paid for. This problem explains why financial inter-
mediaries, particularly banks, play a more important
role in financing the activities of businesses than
securities markets do.
5. Moral hazard in equity contracts is known as the
principal–agent problem because managers (the
agents) have less incentive to maximize profits than
stockholders (the principals). The principal–agent
problem explains why debt contracts are so much
more prevalent in financial markets than equity
contracts. Tools to help reduce the principal–agent
problem include monitoring, government regulation
to increase information, and financial intermediation.
6. Tools to reduce the moral hazard problem in debt
contracts include collateral and net worth, monitor-
ing and enforcement of restrictive covenants, and
financial intermediaries.
7. Conflicts of interest arise when financial service
providers or their employees are serving multiple
interests and have incentives to misuse or conceal
information needed for the effective functioning of
financial markets. We care about conflicts of interest
because they can substantially reduce the amount
of reliable information in financial markets, thereby
preventing them from channeling funds to parties
with the most productive investment opportuni-
ties. Three types of financial service activities have
had the greatest potential for conflicts of interest:
underwriting and research in investment banking,
auditing and consulting in accounting firms, and
credit assessment and consulting in credit-rating
agencies. Two major policy measures have been
implemented to deal with conflicts of interest: the
Sarbanes-Oxley Act of 2002 and the Global Legal
Settlement of 2002, which arose from a lawsuit by
the New York attorney general against the 10 larg-
est investment banks.

KEY TERMS
agency theory, p. 141
audits, p. 143
collateral, p. 146
conflicts of interest, p. 157
costly state verification, p. 148
economies of scope, p. 157
equity capital, p. 146
free-rider problem, p. 143
incentive compatible, p. 151
initial public offerings (IPOs), p. 158
net worth (equity capital), p. 146
pecking order hypothesis, p. 146
principal–agent problem, p. 147
restrictive covenants, p. 138
secured debt, p. 138
spinning, p. 158
state-owned banks, p. 154
unsecured debt, p. 138
venture capital firm, p. 149

QUESTIONS
1. How can economies of scale help explain the exis-
tence of financial intermediaries?
2. Explain why dating can be considered a method to
solve the adverse selection problem.
3. Would moral hazard and adverse selection still arise
in financial markets if information were not asym-
metric? Explain.
4. How do standard accounting principles help financial
markets work more efficiently?
5. Suppose you have data about two groups of coun-
tries, one with efficient legal systems and the other
with slow, costly, and inefficient legal systems. Which
group of countries would you expect to exhibit higher
living standards?
6. Which relationship would you expect to exist between
measures of corruption and living standards at the
country level? Explain by which channel corruption
might affect living standards.

M07_MISH9265_09_SE_C07.indd 163 11/10/16 2:48 PM

 164 PART 3 Fundamentals of Financial Institutions
7. How can the existence of asymmetric information
provide a rationale for government regulation of
financial markets?
8. Would you be more willing to lend to a friend if she
put all of her life savings into her business than you
would if she had not done so? Why?
9. Suppose you are applying for a mortgage loan. The
loan officer tells you that if you get the loan, the bank
will keep the house title until you pay back the loan.
Which problem of asymmetric information is the bank
trying to solve?
10. “The more collateral there is backing a loan, the less
the lender has to worry about adverse selection.” Is
this statement true, false, or uncertain? Explain your
answer.
11. How does the free-rider problem aggravate adverse
selection and moral hazard problems in financial mar-
kets?
12. Explain how the separation of ownership and con-
trol in American corporations might lead to poor
management.
13. Which specific asymmetric information problem do
credit-rating agencies help to reduce in the bond
market? Explain the effect of the subprime mortgage
crisis on the trustworthiness of these agencies and on
the quality of information.
Q U A N T I TAT I V E P R O B L E M S
1. You are in the market for a used car. At a used car
lot, you know 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 care only about the expected value
of the car you buy and that the car values are sym-
metrically 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?
3. You wish to hire Ricky to manage your Dallas opera-
tions. The profits from the operations depend par-
tially on how hard Ricky works, as follows.
Probabilities
Profit = Profit =
$10,000 $50,000
Lazy 60% 40%
Hard worker 20% 80%
M07_MISH9265_09_SE_C07.indd 164
14. How does the provision of several types of financial
services by one firm lead to conflicts of interest?
15. Suppose that in a given bond market, there is cur-
rently no information that can help potential bond
buyers to distinguish between bonds. Which bond
issuers have an incentive to disclose information
about their companies? Explain why.
16. Describe two conflicts of interest that occur when
underwriting and research are provided by a single
investment firm.
17. Which problem of asymmetric information are pro-
spective employers trying to solve when they ask
applicants to go through a job interview. Is that the
end of the information asymmetry?
18. Describe two conflicts of interest that occur in
accounting firms.
19. Which provisions of Sarbanes-Oxley do you think are
beneficial, and which are not?
20. Lucia, Cecilia, and Julia have to do a midterm project.
While Lucia works hard on the project for two weeks,
Cecilia and Julia do not even answer the phone. The
project is a success and everybody gets an A. How
would you refer to Cecilia and Julia? What do you
think might happen if the same three classmates are
assigned to do a final project?
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 cares only about his
expected payment less any “personal cost.”
4. You own a house worth $400,000 that is located on
a river. If the river floods moderately, the house
will be completely destroyed. This happens about
once every 50 years. If you build a seawall, the river
would have to flood heavily to destroy your house,
which happens only about once every 200 years.
What would be the annual premium for an insur-
ance policy that offers full insurance? For a policy
that pays only 75% of the home value, what are your
expected costs with and without a seawall? Do the
different policies provide an incentive to be safer
(i.e., to build the seawall)?
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WEB EXERCISES
Why Do Financial Institutions Exist?
1. In this chapter we discuss the lemons problem and its
effect on the efficient functioning of a market. This
theory was initially developed by George Akerlof.
Go to http://www.nobelprize.org/nobel_prizes/
economic-sciences/laureates/2001/. This site
reports that Akerlof, Spence, and Stiglitz were awarded
the Nobel Prize in economics in 2001 for their work.
Read this report down through the section on George
Akerlof. Summarize his research ideas in one page.
CHAPTER 7 Why Do Financial Institutions Exist? 165
2. This chapter discusses how an understanding of
adverse selection and moral hazard can help us
better understand financial crises. The greatest
financial crisis faced by the United States was the
Great Depression from 1929 to 1933. Go to www
.amatecon.com/greatdepression.html. This site
contains a brief discussion of the factors that led to
the Great Depression. Write a one-page summary
explaining how adverse selection and moral hazard
contributed to the Great Depression.