Chapter 8
An Economic Analysis of
Financial Structure
This chapter provides an economic
analysis of how financial structure is
designed to promote economic efficiency.
It explains why financial contracts are
written as they are and why financial
intermediaries are more important than
securities markets for getting funds to
borrowers.
It explains how the performance of the
financial sector affects economic growth
and why financial crises occur.
Basic Puzzles about Financial
Structure Throughout the world
1. 1. stocks are not the most important source of stocks are not the most important source of
external financing for businesses. external financing for businesses.
2. Issuing marketable debt and equity 2. Issuing marketable debt and equity
securities is not the primary way in which securities is not the primary way in which
businesses finance their finance their operations.
3. Indirect finance, which involves the activities 3. Indirect finance, which involves the activities
of financial intermediaries, is many times more of financial intermediaries, is many times more
important than direct finance, in which important than direct finance, in which
businesses raise funds directly from lenders in businesses raise funds directly from lenders in
financial markets.
4. 4. Banks are the most important source ofBanks are the most important source of
external funds used to finance businesses. external funds used to finance businesses.
5. 5. The financial system is among the mostThe financial system is among the most
heavily regulated sectors of the economy. heavily regulated sectors of the economy.
6. Only large, well-established corporations have 6. Only large, well-established corporations have
access to securities markets to finance their access to securities markets to finance their
activities. activities.
7. Collateral is a prevalent feature of debt 7. Collateral is a prevalent feature of debt
contracts for both households and businesses. contracts for both households and businesses.
8. 8. Debt contracts are typically extremely Debt contracts are typically extremely
complicated legal documents that place complicated legal documents that place
substantial restrictions on the behavior of the substantial restrictions on the behavior of the
borrower. borrower.
An important feature of financial markets
is that they have substantial transaction
and information costs.
An economic analysis of how these costs
affect financial markets provides us with
solutions to the eight puzzles, which in turn
provides us with a much deeper
understanding of how our financial system
works.
Transaction Costs
Financial intermediaries reduce
transaction costs through economies
of scale and expertise.
Economies of scale
The reduction in transaction costs per
dollar of investment as the size of
transactions increases.
Economies of scale exist because the total
cost of carrying out a transaction in
financial markets increases only a little
as the size of the transaction grows.
Expertise
Financial intermediaries arise
because they are better able to
develop expertise to lower
transaction costs.
Asymmetric Information:
Adverse Selection and Moral
Hazard
Asymmetric information
One party has insufficient
knowledge about the other party
involved in a transaction to make
accurate decisions.
Adverse selection
A problem from asymmetric
information before the transaction
occurs.
The parties who are the most likely
to produce an undesirable outcome
are most likely to want to engage in
the transaction.
Moral Hazard
A problem from asymmetric information
after the transaction occurs.
The lender runs the risk that the
borrower will engage in activities that are
undesirable from the lender’s point of
view because they make it less likely that
the loan will be paid back.
Adverse selection and moral hazard
will reduce the desires of the lenders
for making loans to good credit risks.
How Adverse Selection
Influences Financial Structure
The Lemons Problem
Potential buyers of used cars can not tell the
quality of a used car.
The price that a buyer pays must therefore
reflect the average quality of the cars in the
market, somewhere between the low value
and the high value.
The owner of a used car is more likely to
know the quality of the car.
The owner is happy to sell his car if his car
is a lemon.
The owner will not sell his car if his car is a
peach.
As a result, very few good cars will be put
in the market for sale. Buyers therefore
are less likely to get good cars. The used
car market will function poorly.
The Lemons Problem in Stock
and Bond Markets
The securities market will not work well
because few firms will sell securities in it to
raise funds. So is the bonds market.
This explains puzzle 2---- why marketable
securities are not the primary source of
financing for business in any country; and
puzzle 1---- why stocks are not the most
important source of financing.
Tools to Help Solve Adverse
Selection Problems
In the absence of asymmetric
information, the lemons problem goes
away.
Private Production and Sale of
Information
The solution to the adverse selection
problem in financial markets is to furnish
people supplying funds with full details
about the individual or firms seeking to
finance their investment activities.
Private companies can collect and produce
information for that purpose.
The system of private production and sale of
information does not completely solve the
adverse selection problem because of the free
-rider problem.
The free-rider problem arises when people
who do not pay for information take
advantage of the information that other
people have paid for.
The free-rider problem reduces the profit of
the company that produces and sells
information and prevents it from producing
enough information for the market.
Government Regulation
The government could produce
information free of charge.
The government could require firms
selling their securities in public markets
to adhere to standard accounting
principles and to disclose information
about their operations.
This explains why financial markets are
among the most heavily regulated
sectors in the economy.
Although government regulation
lessens the adverse selection problem, it
does not eliminate it because bad firms
have an incentive to make themselves
look like good firms.
Financial Intermediation
Financial intermediaries become experts in
the production of information about firms
and make profits by making loans to good
firms.
The ability of financial intermediaries to
profit from the information they produce is
that they avoid the free-rider problem by
primarily making private loans rather than
by purchasing securities that are traded in
the open market.
This explains puzzle 3 and 4: why indirect
finance is so much more important than
direct finance and why banks are the most
important source of external funds for
financing businesses.
It also explains puzzle 6: The larger and
more mature a corporation is, the more
information investors have about it, and the
more likely it is that the corporation can
raise funds in securities markets.
Collateral and Net Worth
Collateral reduces the consequences of
adverse selection because it reduces the
lender’s losses in the event of a default.
Lenders are more willing to make loans
secured by collateral.
This explains puzzle 7: Why collateral
is an important feature of debt
contracts.
Net worth, also called equity capital,
the difference between a firm’s assets
and its liabilities, can perform a similar
role to collateral.
How Moral Hazard Affects the
Choice Between Debt and
Equity Contracts
Moral Hazard in Equity
Contracts: The Principal-Agent
Problem
Equity contracts are subject to a particular
type of moral hazard called the principal-
agent problem.
The separation of ownership and control
involves moral hazard in that the managers
in control may act in their own interest
rather than in the interest of the
stockholders.
The owners (principal) of the firm are not
the same people as the managers (agent) of
the firm.
The principal-agent problem would not arise
if the owners of a firm had complete
information about what the managers were
up to.
The principal-agent problem would not arise
if there were no separation of ownership and
control.
Tools to Help Solve the Principal
-Agent Problem
Production of Information:
Monitoring
The owners can engage in a particular type
of information production, the monitoring of
the firm’s activities.
The monitoring can be costly state
verification.
Costly state verification makes the equity
contract less desirable.
The free-rider problem decreases the
amount of information production.
Government Regulation to
Increase Information
Governments have laws to force
firms to adhere to standard
accounting principles and impose
stiff criminal penalties on people
who commit the fraud of hiding
and stealing profits.
However these measures can only
be partly effective.
Financial Intermediation
Financial intermediaries have the
ability to avoid the free-rider problem
in the face of moral hazard.
Venture capital firm is able to reduce
the moral hazard arising from the
principal-agent problem by
participating the managing body of the
firm for monitoring .
It can eliminate the free-rider problem
because when a venture capital firm
supplies start-up funds, the equity in
the firm is not marketable to anyone
but the venture capital firm. The other
investors are unable to take a free ride
on the venture capital firm’s
verification activities.
Debt contracts
The debt contract is more attractive
than the equity contract in the sense
that it can reduce the need to monitor
managers.
Debt contract is a contractual
agreement by the borrower to pay the
lender fixed dollar amounts at periodic
intervals.
The advantage of a less frequent need to
monitor the firm, and thus a lower cost of
state verification, helps explain why debt
contracts are used more frequently than
equity contracts to raise capital.
The concept of moral hazard helps explain
puzzle 1, why stocks are not the most
important source of financing for businesses.
How Moral Hazard Influences
Financial Structure in Debt
Markets
Debt contracts are still subject to moral
hazard.
Borrowers have an incentive to take on
investment projects that are riskier than
the lenders would like.
Tools to Help Solve Moral
Hazard in Debt Contracts
Net Worth
When borrowers have more at stake
because their net worth is high, the risk
of moral hazard will be reduced.
High net worth makes the debt contract
incentive-compatible; that is, it aligns
the incentives of the borrower with
those of the lender.
Monitoring and Enforcement
of Restrictive Covenants
Restrictive covenants are directed at
reducing moral hazard either by ruling
out undesirable behavior or by
encouraging desirable behavior.
Four types of restrictive covenants
that achieve this objective.
1. Covenants can be designed to lower
moral hazard by keeping the borrower
from engaging in the undesirable
behavior of undertaking risky investment
projects.
2. Covenants can encourage the borrower
to engage in desirable activities that make
it more likely that the loan will be paid
off.
. Covenants can encourage the borrower
to keep the collateral in good condition
and make sure that it stays in the
possession of the borrower.
4. 4. Covenants require the borrower to
provide information about its activities
periodically, thereby making it easier for
the lenders to monitor the firm.
This explains puzzle 8 that debt
contracts require complicated
restrictive covenants to lower moral
hazard.
Financial Intermediation
Restrictive covenants can not eliminate
moral hazard completely.
It is almost impossible to write covenants
that rule out every risky activity.
Because monitoring and enforcement of
restrictive covenants are costly, the free-
rider problem arises in the debt contract.
Financial intermediaries have the ability to
avoid the free-rider problem as long as they
primarily make private loans.
Financial Development and
Economic Growth
The financial systems in developing and
transition countries face several difficulties
that keep them from operating efficiently.
In many developing countries, the legal
system functions poorly, making it hard to
make effective use of these tools: collateral
and restrictive covenants.
Governments in developing and
transition countries have often
decided to use their financial
system to direct credit to
themselves or to favored sectors of
the economy. Their directed credit
programs may not channel funds to
sectors that will produce high
growth for the economy.
Banks in many developing and
transition countries have been
nationalized by their governments.
Nationalized banks have little
incentive to allocate their capital to
the most productive uses.
Many developing and transition
countries have an underdeveloped
regulatory apparatus that retards
the provision of adequate
information to the marketplace.
Financial Crisis and Aggregate
Economic Activity
Financial Crises: Major disruptions in financial Financial Crises: Major disruptions in financial
markets that are characterized by sharp declines in markets that are characterized by sharp declines in
asset prices and the failures of many financial and asset prices and the failures of many financial and
nonfinancialnonfinancial firms. firms.
Financial crises occur when there is disruption in Financial crises occur when there is disruption in
the financial system that causes such a sharp the financial system that causes such a sharp
increase in adverse selection and moral hazard increase in adverse selection and moral hazard
problems in financial market that the markets are problems in financial market that the markets are
unable to channel funds to channel funds efficiently.
Economic activity will contract sharply. Economic activity will contract sharply.
Factors Causing Financial
Crises
Increases in interest rates
If market interest rates are driven up
sufficiently, good credit risks are less likely
to want to borrow while bad credit risks are
still willing to borrow.
The increase in adverse selection will induce
lenders not to make loans.
The substantial decline in lending lead to a
substantial decline in investment and
aggregate economic activity.
Increases in uncertainty
A dramatic increase in uncertainty in
financial markets makes it harder for
lenders to screen good from bad credit risks.
The resulting inability of lenders to solve the
adverse selection problem makes them less
willing to lend.
The substantial decline in lending lead to a
substantial decline in investment and
aggregate economic activity.
Asset market effects on balance
sheets
A sharp decline in the stock market is one
factor that can cause a serious deterioration
in firm’s balance sheets that can increase
adverse selection and moral hazard
problems.
A sharp decline in the stock market reduces
the net worth of a corporation or the value
of collateral.
This reduces the incentive of lenders to make
loans.
A sharp decline in the stock market will also
increase moral hazard problem by providing
incentives for borrower to engage in risky
investment.
Unanticipated declines in the aggregate price
level also decrease the net worth of firms.
An unanticipated in the price level raises the
real value of firm’s liabilities but does not
raise the real value of assets.
The net worth in real terms declines.
This increases adverse selection and moral
hazard problems facing lenders, thus which
leads to a drop in lending and economic
activity.
Because of uncertainty about the future
value of the domestic currency in developing
countries, many debt contracts are
denominated in foreign currencies.
When there is an unanticipated depreciation
or devaluation of the domestic currency, the
debt burden of domestic firms increases.
Since assets are typically denominated in
domestic currency, there is a resulting
deterioration in firms’ balance sheets and a
decline in net worth.
Increases in interest rates and therefore in
households’ and firms’ interest payments
decreases firms’ cash flow. The decline in
cash flow causes a deterioration in the
balance sheet.
The decreases in liquidity makes it harder
for lenders to know whether the firm or
household will be able to pay its debts.
Problems in the banking sector
If banks suffer a deterioration in
their balance sheets and so have a
substantial contraction in their
capital, they will have fewer
resources to lend, and bank lending
will decline.
If the deterioration in bank balance
sheets is severe enough, banks will
start to fail.
Bank Panic
The multiple bank failures are known as
bank panic. Many banks going out of
business reduces the amount of financial
intermediation undertaken by banks and
leads to a decline in investment and
aggregate economic activity.
The decrease in bank lending during a
financial crisis will decrease the supply of
funds to borrows, which in turn leads to
higher interest rates.
Mexican financial crisis
(1994-1995)
Causes
1. 1. Increases in bad loans eroded banks’ net Increases in bad loans eroded banks’ net
.
2. 2. A rise in foreign interest rates. A rise in foreign interest rates.
3. 3. Debt contracts have short contracts have short duration.
4. 4. Increases in uncertainty by political in uncertainty by political shocks.
5. 5. Speculative attacks on the domestic attacks on the domestic currency.
6. 6. A decline in the stock decline in the stock market.
7. Deterioration in households’ and firms’ 7. Deterioration in households’ and firms’
balance sheets. balance sheets.
