Chapter 16
Financial
System
Design
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Learning Objectives
• Analyze the stockholder-lender and managerstockholder conflicts
• Understand the different financial structures that
limit these conflicts
• Compare and contrast the financial system
design of Germany, Japan, the United Kingdom,
and the United States
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Introduction
• As Eastern European countries adopt capitalism, they
are faced with task of designing a financial system
• Two models in industrialized nations are:
– Markets-oriented—United States and United Kingdom
– Banking-oriented—Germany and Japan
• Chapter examines/contrasts the two models
• Ends with observations/recommendations for emerging
capitalistic countries
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Information and System Design
• All financial systems have things in common
– Payments system—processing of checks and
electronic transfers
– Specialized Financial Intermediaries —
organizations or activities designed to perform
specific functions within the financial system
– Deposit Insurance—protecting individual depositor
– Central Bank—responsible for issuing currency and
implementing monetary policy
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Information and System Design
(Cont.)
• However, there are significant differences
– Primarily related to how businesses obtain financing
– The private ownership of business leads to two
fundamental problems that are handled differently by
the financial sectors in the various systems
• Both are based on the issue of asymmetric information
• Stockholder-lender conflict
• Management-stockholder conflict
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Information and System Design
(Cont.)
• Stockholder-Lender Conflict
– Adverse selection—firm owners (stockholders)
have an incentive to understate their true riskiness to
obtain borrowing on a more favorable basis
– Moral hazard—firms have an incentive to become
riskier after their loans are funded
– Magnitude of these two problems is much less for
large companies because of large amounts of
publicly available information
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Information and System Design
(Cont.)
• Manager-Stockholder Conflict
– This conflict presents a much greater problem with
large companies
– Stockholders (owners) delegate the management to
professional managers
– Owners would like the manager to operate the firm
in their best interest—maximize value of the stock
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Information and System Design
(Cont.)
• Manager-Stockholder Conflict (Cont.)
– Unfortunately, the manager may have other
objectives
• Minimize their own effort and maximize their salaries and
perks
• May want to maximize the firm’s size to increase their
importance
• Want to preserve their jobs which suggests choosing
excessively safe strategies rather than value-maximizing
strategies that may involve more risk
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Information and System Design
(Cont.)
• Manager-Stockholder Conflict (Cont.)
– Firing the manager is one way to resolve the
differences between stockholders and managers
• This requires close monitoring of their performances
• Difficult to judge whether an activity is in the best interest
of the stockholders
• Might prove difficult and costly
• Since there are often a large number of stockholders, they
may be no incentive for any individual to monitor the
performance
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Information and System Design
(Cont.)
• Manager-Stockholder Conflict (Cont.)
– Small, closely held firms this conflict is less
• A significant amount of stock is held by one investor
• Major stockholder has a great incentive to monitor the manager’s
performance
• Potential gains of monitoring the performance is much greater than the
costs
• The owner in a closely held firm often has the power to control the
firm’s board of directors and fire managers
• In privately held firms, the owner is often the manager--eliminates the
stockholder-manager conflict
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Information and System Design
(Cont.)
• Conflict Resolution and Financial System
Design
– Figure 16.1 summarizes the relationship between
firm size and the two problems just discussed
– Stockholder-lender conflict (risk-shifting problem)
is significant for small firms, but not large ones
– Manager-stockholder conflict (corporation
governance)—does not arise for small firms, but
exists for large firms with professional managers
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FIGURE 16.1 Financial system
design: the problems.
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Information and System Design
(Cont.)
• Conflict Resolution and Financial System
Design (Cont.)
– These two conflicts are associated with external
financing—almost all firms raise funds from
outsiders in the form of debt or equity
– These two conflicts are dealt with differently in a
banking-oriented financial system as compared to a
markets-oriented financial system
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Information and System Design
(Cont.)
• Conflict Resolution and Financial System
Design (Cont.)
• Banking-oriented—banks actually own companies they
monitor, and the stock and bond markets are relatively
underdeveloped
• Markets-oriented—banks do not own companies and
public bond and stock markets are prominent institutions
• Figure 16.2 summarizes how banking-oriented systems
(a) and markets-oriented systems (b) solve the
stockholder-lender and manager-stockholder conflicts
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FIGURE 16.2 Financial system
design: conflict resolution.
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Information and System Design
(Cont.)
• Small Firms: Stockholder-Lender Conflict
– Both systems treat small firms similarly
– Small firms borrow from banks and other monitoringintensive financial intermediaries
– Banks are specialists in information--ideally suited to assess
borrower risk before making the loan
– Design loan contracts to minimize the incentive to become
riskier after the loan is made
• Small firms: Manager-Stockholder Conflict
– Not a problem in either financial system
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Information and System Design
(Cont.)
• Large firms: Stockholder-Lender Conflict
– The two financial systems treat large firms significantly
differently
– Markets-Oriented System
• Large firms tend to borrow short term in commercial paper market
and borrow long term in the bond market
• Production of information about business risk is delegated to bond
rating agencies
• Widespread availability of public information, plus credit ratings,
enables large firms to develop reputation for not becoming too risky
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Information and System Design
(Cont.)
• Large firms: Stockholder-Lender Conflict (Cont.)
– Banking-Oriented Systems
• When lender and stockholders are the same (the bank), as is often the
situation, this problem does not exists
• No incentive for stockholder to exploit themselves
• However, it is generally not the case that banks own all of the firm’s
equity
• Nevertheless, consolidation of ownership is often large enough that
the bank owns a controlling interest
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Information and System Design
(Cont.)
• Large Firms: Manager-Stockholder Conflict
– Banking-Oriented Systems
• Solution is driven principally by the bank’s ownership of
the business
• Bank has the incentive to monitor the behavior of the
firm’s management
• Bank also has control over management so it can fire an
incompetent manager
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Information and System Design
(Cont.)
• Large Firms: Manager-Stockholder Conflict (Cont.)
– Markets-Oriented Systems
• Because of diffuse ownership, little incentive for individual
stockholders to monitor performance of managers
• Often the CEO will influence who is selected to serve on the board of
directors, which results in ignoring the CEO’s poor performance
• Creates a distinct possibility that inefficient managers become
entrenched and the firm becomes manager-controlled
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Information and System Design
(Cont.)
• Large Firms: Manager-Stockholder Conflict (Cont.)
– Markets-Oriented Systems (Cont.)
• Often this situation is resolved through a corporate takeover and new
owners replace previous managers
• Managers will actively resist such a takeover effort
• Hostile takeover—attempts to takeover a company against current
management’s wishes
• To minimize the conflict, management’s compensation packages are
structured to link compensation to performance desired by
stockholders
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Financial System Design: Summary
of Four Countries
• Germany
– A strong banking-oriented financial system
– Hausbank
• A single bank that is the primary source of external financing, both
debt and equity
• The relationship between a business firm and their Hausbank is a very
powerful one
• This relationship fosters bank participation in the strategic activities of
the firm through stock ownership and control, and sitting on company
supervisory boards
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16-22
Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
– Hausbank (Cont.)
• Bank ownership participation is both direct and indirect
– Direct—bank owns a large share of the stock
– Indirect—individuals and institutions deposit stock holdings in a
trust account with a bank and voting rights are conveyed to the
bank
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Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
– Organization of the banking system
• Commercial banks
– Comprised of three major banks and a number of regional and
private banks
– Active participants in the international markets
• Savings banks
– Typically owned by regional or town government which operate
locally
– Initially organized as mortgage lenders but now offer full
commercial banking services
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Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
– Organization of the banking system (Cont.)
• Cooperative banks
– First established to collect savings and extend credit to
individuals
• Specialized banks
– Mortgage, consumer lending, small business loan guarantees,
export financing, and industry-specific financing
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Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
– Dominance of banks in Germany comes at the
expense of the securities markets
• Stock, bond, and commercial paper markets are not very
important
• Eight regional stock exchanges, dominated by the
Frankfurt exchange
• Less than a quarter of the largest German companies are
listed, and a large proportion are not actively traded
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16-26
Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
• Corporate bond and commercial paper market is very
small, largely due to taxes and regulations prior to 1992
making it very expensive to issue these securities
• Therefore, most German companies are highly
dependent on their banks for credit
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Financial System Design: Summary
of Four Countries (Cont.)
• Germany (Cont.)
– Dominance of banking system is aided by regulations that
permits universal banking
• Can engage in a variety of financial service activities
• Permitted to own nonfinancial companies and underwrite corporate
securities and insurance
• Those who advocate giving U.S. banks full underwriting privileges
cite German universal banking as model of success
• However, this success might be a result of a poorly developed stock
and bond market which is not the case in the United States
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Financial System Design: Summary
of Four Countries (Cont.)
• Japan
– Keiretsu form of industrial organization
• A group of companies that are controlled through
interlocking ownership—companies own stock in each
other
• Encourages strong loyalty among the companies,
including favoritism in customer-supplier relationships
• Each keiretsu has a main bank that typically owns stock in
other members of the keiretsu
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Financial System Design: Summary
of Four Countries (Cont.)
• Japan (Cont.)
– Japanese banks may own equity in nonfinancial companies,
although this is now limited to 5 percent in any single firm
– Organization of the banking system
• City banks—represent a disproportionately large fraction of the
world’s biggest banks
• Regional banks
• Special-purpose financial institutions—include long-term credit
banks, specialized small business and industrial institutions
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Financial System Design: Summary
of Four Countries (Cont.)
• Japan (Cont.)
– Historically corporate debt markets have been suppressed,
further enhancing power of banks
– The result is a vast majority of debt financing that comes
from the banking system
– Unlike Germany, stock market is quite large, however
extensive cross ownership masks high degree of
concentration of ownership
– Adopted laws that separate commercial banking from
investment banking, however, this separation has been eroded
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16-31
Financial System Design: Summary
of Four Countries (Cont.)
• United Kingdom
– Financial system is very much markets-oriented,
although banks play a very important role
– London serves as both a domestic financial center as
well as the center of the Eurobond market
– Regulatory environment encourages foreign
participation and competition in financial markets
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Financial System Design: Summary
of Four Countries (Cont.)
• United Kingdom (Cont.)
– Organization of the banking system
• Clearing banks—universal banks, securities activities through
subsidiaries, extensive branch networks
• Merchant banks—provide wholesale banking services to large
corporations
• “other” British banks—consisting of institutions similar to merchant
banks and specialized banks
• “other” deposit-taking institutions—mostly building societies
which are similar to savings and loan associations in U.S.
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Financial System Design: Summary
of Four Countries (Cont.)
• United Kingdom (Cont.)
– Banks in the United Kingdom generally do not own
nonfinancial corporations
• While not explicitly prohibited, this practice is discourage by The
Bank of England to promote a safer banking system
– The Bank of England supervises banks on an informal basis,
relying on the English tradition—“Old boy network” and
applying moral suasion to influence the banking system
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Financial System Design: Summary
of Four Countries (Cont.)
• United States
– Financial system in the United States has been extensively
examined in Chapters 11-15
– Very large stock, bond, and commercial paper markets-model of the markets-oriented system
– Securitization of residential mortgages and other financial
assets has further strengthened the traded securities markets
– Banks play a key role in external financing for small and
midsize companies, not for large firms
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Financial System Design and
Conflict Resolution
• Measure differences between banking-oriented and
markets-oriented systems
– Figure 16.3 shows the size of the banking market and stock
market in each of the four countries
– Banking dominates in Germany and Japan, while financial
markets dominate in the U.K. and U.S.
– Large degree of ownership by banks in banking-oriented
system, much less in markets-oriented
– Quantitative evidence strongly supports labeling Germany
and Japan as banking-oriented and the U.S. and U.K. as
markets-oriented
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FIGURE 16.3 Size of banking and stock
markets (percentage of GDP), 2007.
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Financial System Design and
Conflict Resolution (Cont.)
• Conflict Resolution in the Big Four
– How is financial distress managed within the two major
orientations of the financial system
– When a company is in financial distress it cannot meet its
financial obligations
• For markets-oriented system, during these periods, stockholderbondholder (lender) conflict is extreme since owners have very little
stake left in their firm and cannot agree on a strategy short of
bankruptcy
• In banking-oriented systems it is easier for company to deal with
conflict under protective wing of its main bank.
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Financial System Design and
Conflict Resolution (Cont.)
• Conflict Resolution in the Big Four (Cont.)
– Dealing with manager-stockholder conflict varies between the
two systems
• Concentration of ownership in the banking-oriented system gives
banks a major incentive to monitor corporate management
• Due to diffusion of concentration in the markets-oriented system, little
incentive for the individual stockholder to monitor performance
• Predictably, there is a much larger volume of mergers and acquisitions
under the markets-oriented system
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Financial System Design and
Conflict Resolution (Cont.)
• And the Winner is. . .
– Each system has advantages and disadvantages
– A few conclusions:
• Banks with substantial ownership are better at solving the
stockholder-lender or management-stockholder conflict than rating
agencies or individual stockholders
• This requires intensive monitoring which is expensive
• Stocks and bonds issued by firms in banking-oriented systems are
much less liquid because of poorly developed markets
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16-40
Financial System Design and
Conflict Resolution (Cont.)
• And the Winner is. . . (Cont.)
– A few conclusions:
• This raises the cost of raising capital in Germany and
Japan
• Therefore, there is a trade-off between the two systems
– Financial innovations and developments in all four
countries suggest that there might be a good
compromise between extremes of the two systems
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Financial System Design for Eastern
Europe and other Emerging Economics
• An initial development in these countries was to
develop privatization programs which transforms
government-owned companies into privately
owned firms
• Typically involve distribution of shares to major
stockholders (employees, managers, and creditors)
• Privatization initially focused on small and
midsize companies
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Financial System Design for Eastern
Europe and other Emerging Economics
(Cont.)
• Privatization must occur with developments
of new securities markets—primarily equity
markets
• However, it is likely a banking-oriented
system may make more sense for these
formerly planned economies that are
accustomed to strict governmental control
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16-43
Financial System Design for Eastern
Europe and other Emerging Economics
(Cont.)
• At present, Eastern Europe can be regarded as
an information-poor environment, with little
public information about large firms
– Rating agencies do not exist
– Reputation building is extremely difficult
– Lack of managerial talent and experience suggests
that monitoring will be especially critical
• All these factors indicate that a bankingoriented system may be more suitable
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TABLE 16.1 Estimated Ownership
Patterns (percentage)
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TABLE 16.2 Merger and Acquisition
Activity: 2002
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