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. stocks are not the most important source of external financing for businesses.
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.
3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
4. Banks are the most important source of
external funds used to finance businesses.
5. The financial system is among the most
heavily regulated sectors of the economy.
6. Only large, well-established corporations have
access to securities markets to finance their
activities.
7. Collateral is a prevalent feature of debt
contracts for both households and businesses.
8. Debt contracts are typically extremely
complicated legal documents that place
substantial restrictions on the behavior of the
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.
3. 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. 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 markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms.
Financial crises occur when there is disruption in the financial system that causes such a sharp increase in adverse selection and moral hazard problems in financial market that the markets are unable to channel funds efficiently.
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. Increases in bad loans eroded banks’ net worth.
2. A rise in foreign interest rates.
3. Debt contracts have short duration.
4. Increases in uncertainty by political shocks.
5. Speculative attacks on the domestic currency.
6. A decline in the stock market.
7. Deterioration in households’ and firms’
balance sheets.
