Question

1. Assume that countries A and B are of similar size, that they have similar economies, and that the government debt levels of both countries are within reasonable limits. Assume that the regulations in country A require complete disclosure of financial reporting by issuers of debt in that country, but that regulations in country B do not require much disclosure of financial reporting. Explain why the government of country A is able to issue debt at a lower cost than the government of country B.
2. Financial institutions are subject to regulations to ensure that they do not take excessive risk and they can safely facilitate the flow of funds through financial markets. Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to facilitate their financial transactions. Why do you think the existing regulations were ineffective at ensuring a safe financial system

Answer 1

Complete disclosure of financial reporting by issuers of debt in a country allows the general public and stakeholders to understand issuer’s macro policy and dynamic guidelines. It reduces information asymmetry between the public and the government and helps in improving the image and credibility of a government. This in turn helps government to attract external debt and outside investment by increasing investors’ trust. It helps the investors to evaluate the government’s resource allocation and behavior. It also sends out positive signals to outside investors during financial crisis. Complete disclosure of financial reporting can reduce moral hazard costs which could arise from conflicts among various stakeholders in the firm. So a higher level of disclosure of government financial reporting is associated with a lower cost of issuing a debt.

During the credit crisis in 2008, initially some financial institutions failed which caused concerns in the market that others financial institutions might also fail. This concern caused disruption of flow of funds in financial markets. The reason behind financial institution’s failure was that they experienced massive mortgage defaults. They were not able to recognized that subprime mortgages, (which includes low down payment, unqualified borrowers) may default. So regulators could have imposed regulations to limit an institution's exposure to subprime mortgages.