Which Of The Following Is An Example Of A Source

Which Of The Following Is An Example Of A Sourc

The assignment requires identifying an example of a source of internal finance for companies. Additionally, the task involves discussing techniques lenders use to alleviate information asymmetry and moral hazard problems, the purpose of Sarbanes-Oxley, methods banks use to increase reserves and manage interest rate risk, and the nature and implications of various banking practices and financial market concepts. The discussion extends to the roles of the SEC and FDIC, the characteristics of derivatives, the liquidity of financial markets, and the concept of lender of last resort. Furthermore, the assignment addresses the causes and potential consequences of financial crises, especially during housing bubbles, and examines policies such as "too big to fail." Critical analysis of these topics will be supported by credible academic sources to illustrate understanding of financial systems and crises.

Paper For Above instruction

Financial systems serve as the backbone of economic activity by facilitating the allocation of resources, risk management, and payment mechanisms. Central to these systems are sources of finance for companies, risk mitigation techniques employed by lenders, regulatory frameworks, and the functioning of various financial markets. An understanding of these elements is essential in explaining the stability and efficiency of financial markets and the potential for crises.

Sources of Internal Finance for Companies

Internal finance refers to funds generated within a company for its operations without relying on external sources. Examples include retained earnings, which are profits reinvested into the company after dividends are paid, and depreciation funds, which are non-cash charges that provide a reserve for future investments. Retained earnings are the most significant internal source because they do not incur additional costs and reflect the profitability of the company. Unlike external sources such as loans or issuing shares, internal financing does not lead to increased debt or dilution of ownership, making it an attractive option, especially during uncertain economic conditions (Brealey, Myers, & Allen, 2017).

Techniques to Reduce Asymmetric Information and Moral Hazard

Lenders face information asymmetry when they lack complete information about borrowers' creditworthiness, which can lead to adverse selection and moral hazard. Techniques such as checking credit ratings, which assess the borrower's credit history and risk, help mitigate asymmetric information. To combat moral hazard—the tendency of borrowers to engage in risky behavior after obtaining a loan—lenders often enforce covenants, conduct regular monitoring, and establish collateral requirements. Collateral acts as a safety net, ensuring that lenders can seize assets if borrowers default, thus aligning incentives and reducing risky behavior (Myers & Majluf, 1984; Stiglitz & Weiss, 1981).

The Purpose of Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002 was enacted to improve corporate governance and restore investor confidence following high-profile accounting scandals such as Enron and WorldCom. By implementing stricter financial reporting standards, enhancing internal controls, and increasing accountability of corporate executives, Sarbanes-Oxley aims to reduce financial misconduct, improve transparency, and prevent fraudulent activities that could destabilize financial markets (Coates, 2007).

Bank Reserve Management and Interest Rate Risk

Banks can increase their reserves by holding more excess reserves or by borrowing from other banks or the central bank. Effective reserve management allows banks to meet withdrawal demands and regulatory requirements. To deal with interest rate risk, banks use strategies such as asset-liability matching, interest rate swaps, and hedging through derivatives. These techniques help mitigate potential losses from fluctuating interest rates that could affect the bank’s net interest margin and overall stability (Saunders & Cornett, 2018).

Creating Mortgages and Bank Operations

When a bank transforms demand deposits into mortgages, it is engaging in long-term lending based on short-term liabilities. This process creates a mismatch known as maturity transformation, which can amplify liquidity risk but is vital for funding long-term investments. Unit banks, which operate in a single locality and do not engage in branch banking, typically focus on community-based lending and are more susceptible to local economic fluctuations.

Interest Rate Risk for ARMs and Banking Risks

Adjustable-rate mortgages (ARMs) transfer interest rate risk from lenders to borrowers. Borrowers assume this risk, which can lead to increased defaults if interest rates rise sharply. Banks focusing on ARMs must employ risk management strategies to hedge against rate fluctuations, such as floating-rate bonds or derivatives. Concentrations of risk and potential bank failures are exacerbated by practices like bank consolidation, which can lead to "too big to fail" scenarios.

Financial Markets and Crises

The creation of the SEC was intended to increase transparency and investor confidence in U.S. financial markets, thereby reducing fraudulent activities and systemic risks. The FDIC was established to protect depositors and maintain confidence during banking crises. Derivatives, such as options and futures, are financial instruments derived from underlying assets, used for hedging and speculation. Among markets, those that are less liquid, such as over-the-counter (OTC) derivatives markets, pose higher risks during financial distress.

Derivatives, Liquidity, and Market Risks

Financial derivatives are contracts whose value derives from underlying assets. They serve critical functions in risk management but can also amplify systemic risks during crises. The liquidity of markets influences their stability; markets like the secondary bond market tend to be more liquid, whereas specialized OTC markets are less so. The true nature of derivatives is that they enable hedging but also have the potential to cause contagion if not properly managed (Hull, 2017).

Lenders of Last Resort and Financial Crises

Lenders of last resort, typically central banks, provide emergency liquidity to prevent bank failures and systemic collapse. This role is crucial during financial crises, especially when liquidity dries up. Activities that could trigger a crisis include excessive leverage, rapid asset price inflation (bubbles), and inadequate regulation. During housing bubbles, continued buying is driven by speculative behavior, which inflates prices beyond fundamental values, increasing the risk of a crash.

The 'Too Big to Fail' Policy

The "too big to fail" doctrine exacerbates moral hazard because large institutions assume they will be rescued if they fail, encouraging risky behavior. This creates a moral hazard problem between the government and large banks, potentially leading to reckless risk-taking at the expense of taxpayers (Acharya, 2018). The policy underscores the necessity of regulation and supervision but also highlights the need for reforms to mitigate systemic risks.

Concluding Remarks

In conclusion, understanding sources of internal finance, risk management techniques, regulatory frameworks, and the behavior of financial markets is critical for assessing stability and preventing crises. While facilities like the SEC and FDIC have improved transparency and deposit security, ongoing challenges such as moral hazard, complex derivatives, and market liquidity continue to pose systemic risks. Effective regulation, prudent risk management, and awareness of behavioral dynamics are essential to safeguard the integrity of financial systems.

References

• Acharya, V. V. (2018). The End of Lehman Brothers: A Review of the 2008 Financial Crisis. Journal of Economic Perspectives, 32(1), 49–72.
• Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
• Coates, J. C. (2007). The Goals and Promise of the Sarbanes-Oxley Act. Journal of Economic Perspectives, 21(1), 91–116.
• Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson Education.
• Myers, S. C., & Majluf, N. S. (1984). Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have. Journal of Financial Economics, 13(2), 187–221.
• Saunders, A., & Cornett, M. M. (2018). Financial Markets and Institutions. McGraw-Hill Education.
• Stiglitz, J. E., & Weiss, A. (1981). Credit Rationing in Markets with Imperfect Information. The American Economic Review, 71(3), 393–410.