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The Enron Implosion
Until 2001, Enron Corporation, a firm that special-
ized in trading in the energy market, appeared to be
spectacularly successful. It had a quarter of the
energy-trading market and was valued as high as
$77 billion in August 2000 (just a little over a year
before its collapse), making it the seventh-largest cor-
poration in the United States at that time. However,
toward the end of 2001, Enron came crashing
down. In October 2001, Enron announced a third-
quarter loss of $618 million and disclosed account-
ing “mistakes.” The SEC then engaged in a formal
investigation of Enron’s financial dealings with part-
nerships led by its former finance chief. It became
clear that Enron was engaged in a complex set of
transactions by which it was keeping substantial
amounts of debt and financial contracts off of its bal-
ance sheet. These transactions enabled Enron to hide
its financial difficulties. Despite securing as much as
$1.5 billion of new financing from J. P. Morgan
Chase and Citigroup, the company was forced to
declare bankruptcy in December 2001, the largest
bankruptcy in U.S. history.
The Enron collapse illustrates that government reg-
ulation can lessen asymmetric information problems,
but cannot eliminate them. Managers have tremen-
dous incentives to hide their companies’ problems,
making it hard for investors to know the true value
of the firm.
The Enron bankruptcy not only increased concerns
in financial markets about the quality of accounting
information supplied by corporations, but also led to
hardship for many of the firm’s former employees,
who found that their pensions had become worthless.
Outrage against the duplicity of executives at Enron
was high, and several were indicted, with some
being convicted and sent to jail.
144
Part 3 Fundamentals of Financial Institutions
Just as used-car dealers help solve adverse selection problems in the automo-
bile market, financial intermediaries play a similar role in financial markets. A finan-
cial intermediary, such as a bank, becomes an expert in producing information about
firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds
from depositors and lend them to the good firms. Because the bank is able to lend
mostly to good firms, it is able to earn a higher return on its loans than the interest
it has to pay to its depositors. The resulting profit that the bank earns gives it the
incentive to engage in this information production activity.
An important element in the bank’s ability to profit from the information it pro-
duces is that it avoids the free-rider problem by primarily making private loans rather
than by purchasing securities that are traded in the open market. Because a private
loan is not traded, other investors cannot watch what the bank is doing and bid up the
loan’s price to the point that the bank receives no compensation for the information
it has produced. The bank’s role as an intermediary that holds mostly nontraded loans
is the key to its success in reducing asymmetric information in financial markets.
Our analysis of adverse selection indicates that financial intermediaries in
general—and banks in particular, because they hold a large fraction of nontraded
loans—should play a greater role in moving funds to corporations than securities mar-
kets do. Our analysis thus explains facts 3 and 4: why indirect finance is so much more
important than direct finance and why banks are the most important source of exter-
nal funds for financing businesses.
Another important fact that is explained by the analysis here is the greater impor-
tance of banks in the financial systems of developing countries. As we have seen,
when the quality of information about firms is better, asymmetric information prob-
lems will be less severe, and it will be easier for firms to issue securities. Information
about private firms is harder to collect in developing countries than in industrial-
ized countries; therefore, the smaller role played by securities markets leaves a
greater role for financial intermediaries such as banks. A corollary of this analysis
is that as information about firms becomes easier to acquire, the role of banks should
decline. A major development in the past 20 years in the United States has been huge
improvements in information technology. Thus, the analysis here suggests that the
lending role of financial institutions, such as banks in the United States, should have
declined, and this is exactly what has occurred (see Chapter 18).
Our analysis of adverse selection also explains fact 6, which questions why large
firms are more likely to obtain funds from securities markets, a direct route, rather
than from banks and financial intermediaries, an indirect route. The better known
a corporation is, the more information about its activities is available in the market-
place. Thus, it is easier for investors to evaluate the quality of the corporation and
determine whether it is a good firm or a bad one. Because investors have fewer wor-
ries about adverse selection with well-known corporations, they will be willing to
invest directly in their securities. Our adverse selection analysis thus suggests that
there should be a pecking order for firms that can issue securities. The larger and
more established a corporation is, the more likely it will be to issue securities to
raise funds, a view that is known as the pecking order hypothesis. This hypothe-
sis is supported in the data and is what fact 6 describes.
Collateral and Net Worth
Adverse selection interferes with the functioning of finan-
cial markets only if a lender suffers a loss when a borrower is unable to make loan
payments and thereby defaults. Collateral, property promised to the lender if the
borrower defaults, reduces the consequences of adverse selection because it reduces
the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender
Chapter 7 Why Do Financial Institutions Exist?
145
can sell the collateral and use the proceeds to make up for the losses on the loan. For
example, if you fail to make your mortgage payments, the lender can take title to your
house, auction it off, and use the receipts to pay off the loan. Lenders are thus more
willing to make loans secured by collateral, and borrowers are willing to supply col-
lateral because the reduced risk for the lender makes it more likely they will get
the loan in the first place and perhaps at a better loan rate. The presence of adverse
selection in credit markets thus provides an explanation for why collateral is an
important feature of debt contracts (fact 7).
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