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Financial Structure in Debt Markets - Banking - Lecture Slides, Slides of Banking and Finance

Bhupendra Narayan Mandal UniversityBanking and Finance

Banking is an ever green field of study. In these slides of Banking, the Lecturer has discussed following important points : Financial Structure In Debt Markets, Debt Contracts, Advantages, Financial Structure, Debt Markets, Moral Hazard Risks, Risky Investment, Strong Incentive, Riskier Investment, Financial Intermediation

Typology: Slides

2012/2013

Uploaded on 07/29/2013

sathyanarayana
sathyanarayana 🇮🇳

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How Moral Hazard Influences
Financial Structure in Debt Markets
•Debt Contracts are still subject to
moral hazard even with the advantages
•Borrowers have an incentive to take on
investment projects that are riskier than
lenders would like.
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Download Financial Structure in Debt Markets - Banking - Lecture Slides and more Slides Banking and Finance in PDF only on Docsity!

How Moral Hazard Influences

Financial Structure in Debt Markets

  • Debt Contracts are still subject to moral hazard even with the advantages
  • Borrowers have an incentive to take on investment projects that are riskier than lenders would like.

Moral Hazard Risks

  • It’s a very risky investment but if Steve is successful then he has a strong incentive to take on the riskier investment.
  • You on the other hand, would be unhappy because if Steve were unsuccessful, then you would lose all your money you lent him.

Net Worth and Collateral

  • When borrowers have more at stake because their net worth is high or the collateral they have pledged to the lender is valuable

A Solution that High Net Worth and

Collateral Provides to the Moral

Hazard Problem

  • Make the debt contract incentive compatible
  • incentive-compatible : having the incentives of both parties to a contract in alignment

Forms of Covenants

  1. to discourage undesirable behavior
  2. to encourage desirable behavior
  3. to keep collateral valuable
  4. to provide information

Covenants to discourage undesirable

behavior

  • Function in two forms:
    • restricting the use of money so that it can only be used on certain criteria
    • barring the use of the capital so it can not be used for certain purposes.

Covenants to keep collateral valuable

  • Require proper protection of the asset, an example would be homeowners insurance as part of a mortgage

Covenants to provide information

  • Require the provision of information by the borrower to the lender, making it easier to monitor the firm.

Characteristics

  • Agent: Greedy CEOs and CFOs
  • Principal: corporate workers and investors
  • Lax Monitoring: insufficient auditing
  • Lack of leadership
  • Strong incentives for committing fraud
  • Consider their companies as piggy banks

International Tyco

  • CEO Kozlowski was accused of looting $ million for extravagant lifestyle from Tyco and obtaining $430 million by fraud in the sale of company shares.
  • Often asked the board for loan and forgiven later.
  • Both CEO and CEFO conspired to falsify the financial statements to inflate stock.

Consequences

  • Stocks became worthless
  • Thousand of workers were out of job and lost pension
  • Investors lost money
  • CEOs and CFOs were convicted for fraud and theft, each was sentenced 25 years or more
  • Corporate oversight and accounting reforms were initiated and enforced
  • Other example: Enron, Adelphi, Global Crossing, etc.