Chapter 8: An Economic Analysis
of Financial Structure
_____________________________
BASIC FACTS ABOUT
THE GLOBAL FINANCIAL
STRUCTURE
●​ The financial system includes many
different types of institutions: banks,
insurance companies, mutual funds,
stock and bond markets all of which
are regulated by government
1.​ Stocks are not the most important
source of external financing
-​ stock market accounted for
only a small fraction of the
external financing of
businesses
2.​ Issuing marketable securities is
not the primary source of
financing
-​ Marketable securities supply
less than one half of external
funds
3.​ Indirect finance is many times
more important than direct
finance.
-​ Less than 5% of corporate
bonds and less that ⅓ of
stocks are sold directly
-​ Securities are bought
primarily by financial
intermediaries
4.​ Banks are the most important
source of external funds.
-​ primary source of external
funds for businesses
throughout the world is loans
made by banks and other
nonbank financial
intermediaries
5.​ The financial system is heavily
regulated.
-​ Regulated by government to
promote provision of
information and stability
6.​ Only large, well-established firms
have access to securities
markets.
-​ Smaller businesses obtain
financing from banks rather
than marketable securities
7.​ Collateral is prevalent in debt
contracts.
-​ Collateral is property that is
pledged to a lender to
guarantee payment in the
event that the borrower is
unable to make debt
payments
8.​ Debt contracts have numerous
restrictive covenants.
-​ Contracts that restrict and
specify certain activities that
the borrower can engage in
TRANSACTION COSTS
●​ Major problem in financial markets,
preventing many small savers and
borrowers from direct involvement in
the financial market
●​ Most are restricted to few number of
investments and an inability to
diversify
●​ 1/5 of American households own
securities
●​ Around 1.3% of Filipinos engage in
the stock market
How Financial Intermediaries Reduce
Transaction Costs
-​ Reduced transaction costs and
allow small savers and borrowers to
benefit from the existence of
financial markets
●​ Economies of Scale
-​ Reduction in transaction
costs per dollar of investment
as the size (scale) of
transactions increases
-​ A mutual fund is a financial
intermediary that sells shares
to individuals and then
invests the proceeds in
bonds or stocks
-​ Telecommunications system
can be used for a huge
number of transactions at a
low cost per transaction
●​ Expertise
-​ Financial intermediaries are
better able to develop
expertise that can be used to
lower transaction costs
ASYMMETRIC INFORMATION
●​ When one party’s insufficient
knowledge about the other involved
in a transaction makes it impossible
to make accurate decisions in a
transaction
Adverse Selection
-​ asymmetric information problem that
occurs before a transaction occurs
-​ Ex: A lender not knowing a borrower
is a big risk taker or not.
Moral Hazard
-​ asymmetric information problem that
occurs after a transaction occurs
-​ Ex: A borrower possibly engaging in
activities that makes it less likely that
the loan will be paid back
ADVERSE SELECTION
The Lemons Problem
➢​ Buyers are unable to assess quality
of cars
➢​ Buyers will only pay the price that
reflects the average
➢​ Sellers know if the car is a peach
(good quality) or a lemon (low
quality)
➢​ Sellers are willing to sell bad cars at
the average price greater than the
actual car’s value
➢​ Good cars are no longer sold since it
is undervalued
➢​ Because of adverse selection, the
market is left with low quality cars,
leading to fewer sales
A similar problem arises in the securities
market
-​ investors will only pay an average
price for a stock since they can’t
distinguish between good and bad
firms
-​ lenders will not be able to
differentiate the good and bad firms,
leading to good firms not borrowing
-​ Both lead to lower participation in
the securities market
Tools to Help Solve Adverse Selection
Problems
-​ In the absence of asymmetric
information, purchasers of securities
can distinguish good firms from bad.
-​ they will pay the full value of
securities issued by good firms, and
good firms will sell their securities in
the market
●​ Private Production and Sale of
Information
-​
Data collection by private
companies allows
investors/lenders to know
more details on individuals or
firms that require funding
-​ Free Rider Problem occurs
when people who did not pay
benefit from what other
people have paid for
-​ Free riders to paid
information will prevent those
who paid for it to benefit
●​ Government Regulation to
Increase Information
-​ Production of information by
the government to help
distinguish firms free of
charge
-​ Mandating firms to reveal
honest information
●​ Financial Intermediation
-​ A financial intermediary, such
as a bank, becomes an
expert in producing and
information about firms
-​ avoids the free-rider problem
by primarily making private
loans, rather than by
purchasing securities that are
traded in the open market
●​ Collateral and Net Worth
-​ Collateral is the property
promised to the lender if the
borrower defaults
-​ Reduces the consequences
of adverse selection because
it reduces the lender’s losses
in the event of a default
-​ Net worth (equity capital)
performs similar role to
collateral
MORAL HAZARD IN EQUITY
CONTRACTS
The Principal–Agent Problem
-​ managers in control (the agents)
may act in their own interest rather
than in the interest of the
stockholder/owners (the principals)
because the managers have less
incentive to maximize profits than
the stockholder-owners do
-​ Managers have more information
about their activities and actual
profits than stockholders do
-​ Pursuing personal benefits or
corporate strategies that does not
enhance profitability
Tools to Help Solve the Principal–Agent
Problem
●​ Production of
Information:Monitoring
-​ Auditing the firm frequently
and checking on what the
management is doing
-​ Can be expensive (costly
state verification) and can
cause free rider problem
●​ Government Regulation to
Increase Information
-​ Laws that force firms to
adhere to standard
accounting principles and
impose penalties on fraud
●​ Financial intermediation
-​ Venture capital firms pool
resources from partners to
invest, often requiring own
members to participate in
management
-​ Allows for monitoring of firm
activities
●​ Debt Contracts
-​
-​
Alternative to equity
contracts
Lender receives the
contractual payments
regardless of firm activities or
profit
MORAL HAZARD IN DEBT
CONTRACTS
●​ A borrower has a higher incentive to
take on riskier investment projects
than what a lender would like
Tools to Help Solve Moral Hazard in Debt
Contracts
●​ Net Worth and Collateral
-​ When borrowers have more
at stake the risk of moral
hazard is greatly reduced
because the borrowers
themselves have a lot to lose
-​ They are likely to take less
risk at the lender’s expense
-​ Makes debts
incentive-compatible (aligns
incentives of borrowers and
lenders)
●​ Monitoring and Enforcement of
Restrictive Covenants
-​ Covenants restrict
undesirable behavior and
promotes desirable behavior
1.​ Covenants to discourage
undesirable behavior
-​ Prevents risky behavior by
borrower
2.​ Covenants to encourage desirable
behavior
-​ Encourages desirable
activities that makes
payment of loan more likely
3.​ Covenants to keep collateral
valuable
-​ Keep collateral in good
condition and in the
borrower’s possession
4.​ Covenants to provide information
-​ Periodic information on firm
activities
●​ Financial intermediation
-​ Financial intermediaries,
particularly banks, can make
private loans
-​ Allows for direct monitoring
and enforcement of
covenants