Transcript An Economic Analysis of Financial Structure Chapter 8 Eight Basic Facts 1. 2. 3. 4. Stocks are not the most important source of external finance. Issuing marketable debt and.

An Economic Analysis of
Financial Structure
Chapter 8
1
Eight Basic Facts
1.
2.
3.
4.
Stocks are not the most important
source of external finance.
Issuing marketable debt and equity
securities is not the primary source
of financing.
Financial intermediaries are more
important than direct finance to
raise funds.
Banks are the most important
source of external funds.
2
Eight Basic Facts
5. Financial system is the most heavily
regulated sector of the economy.
6. Only large, well-established
corporations have access to direct
finance.
7. Both households and businesses are
usually required to put up a
collateral for a loan.
8. Debt contracts are typically
extremely complicated legal
documents.
3
External Finance
4
Funds Raised By Issuing Stock
A very small portion of the funds raised
by businesses come from issuing stock.
 In the U.S., only 2.1% of the external
funds came from issuing stock between
1970 and 1985.
 Between 1970-96, this ratio is 9.2%.
 Other industrialized countries show
similar behavior.

5
External Financing Through
Bonds and Stocks
Bonds and stocks combined still make up
a small portion of the external funds for
businesses.
 The relative importance of bonds is
overemphasized because every time a
firm issues a bond to keep the debt
constant (debt rollover), it shows as an
addition to financing.

6
Indirect Finance Is The Primary
Source of Funding
Even when the business issues stock or
bond, the primary purchasers are mutual
funds, insurance companies, or pension
funds.
 Households buy small portions of newly
issued bonds (5%) or stocks (50%).

7
Bank Loans Are the Major
Source
In the US more than half of external
funds raised by businesses come from
banks.
 Bank loans are 4 times higher than
funds raised through stocks.
 In other countries, like France or Japan,
banks are even more important.

8
Regulation of the Financial Markets
Throughout the world, financial markets
are heavily regulated by governments.
 The soundness of the financial system
partly relies on the government control.
 Government also provides information on
the system.

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10
http://www.economist.com/node/16485376?story_id=16485376
Small vs. Large Firms
Small firms almost never raise funds
through the issuing of stock or bonds.
 Small firms rely on banks.
 Only large, well-established firms have
traditionally raised funds through
securities.

11
Collateral
Collateral is the property pledged to the
lender in case the borrower defaults.
 Collateralized debt (secured debt) is the
primary form of lending to households.

Mortgage
 Car


Business borrowing is also widely
undertaken by pledging collateral.
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Debt Contracts
Debt contracts are long, legal
documents.
 Debt contracts have provisions that
restrict the activities of the borrower.
 Debt contracts specify the
responsibilities of the borrower.

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The Importance of Transaction Costs
A single mother who earns $1 a day can
improve her income by 15-25% if she could
only get a loan of $43. (John Hatch, FINCA,
Sep. 29, 2000).
 Banks find it very expensive to process and
operate such small loans.
 Income (production) remains lower than it
would be because the financial system is not
more efficient.

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Transaction Costs

Financial intermediaries have evolved to
reduce transaction costs
Economies of scale
 Expertise

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How FINCA Reduces
Transactions Costs
By establishing a “club” of women,
FINCA reduces the costs of information
collection and guarantees that loans will
be paid.
 By forming such clubs around the world,
it gains expertise in the problem areas.
 By specializing on a particular size and
type of loan and a particular clientele, it
enjoys economies of scale.

16
Asymmetric Information
Asymmetric information means one of the
parties in an exchange has much more
information about the good, service than the
other.
 Adverse selection is asymmetric information
before the transaction takes place.
 Moral hazard is asymmetric information
after the transaction takes place.

17
http://www.nobel.se/economics
/laureates/2001/public.html
George Akerlof, Michael Spence and Joseph Stiglitz
received the Bank of Sweden Prize in Economic
Sciences in Memory of Alfred Nobel, 2001, "for
their analyses of markets with asymmetric
information".
18
http://www.nobel.se/economic
s/laureates/2001/public.html
Agents on one side of the market have much better
information than those on the other side.
•Why are interest rates often excessively high on
local lending markets in Third World countries?
•Borrowers know more than the lender about their
repayment prospects
•Why do people who want to buy a good used car
turn to a dealer rather than a private seller?
• The seller knows more than buyers about the quality of
his car
19
http://www.nobel.se/economics/l
aureates/2001/public.html
Why does a firm pay dividends even if they are taxed
more heavily than capital gains?
The CEO and the board know more than the shareholders about
the profitability of the firm
Why is it advantageous for insurance companies to
offer clients a menu of contracts where higher
deductibles can be exchanged for lower premiums?
Policyholders know more than the insurance company about
their accident risk
Why do rich landowners not bear the entire harvest risk
in contracts with poor tenants?
Tenants know more than the landowner about their work effort
and harvesting conditions.
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Adverse Selection: The Lemons Problem

If quality cannot be assessed, the buyer is willing
to pay at most a price that reflects the average
quality

Sellers of good quality items will not want to sell
at the price for average quality

The buyer will decide not to buy at all because
all that is left in the market is poor quality items
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Adverse Selection



Adverse selection problem explains
Puzzle #1 and Puzzle #2.
Puzzle #1: Stocks are not the most
important source of external finance.
Puzzle #2: Issuing marketable debt
and equity securities is not the primary
source of financing.
22
Adverse Selection



You meet someone; you want to go on a date. You
don’t know if s/he will be a pain. The date becomes a
little dance to check each other out without
commitments.
Used car market has different quality cars. You are
willing to pay the average price for quality range.
Those who have better cars refrain from the market.
Those with lemons are happy to sell. Used car
market has more lemons than random sampling
would yield.
http://emlab.berkeley.edu/users/akerlof/index.html
23
Adverse Selection




If high and low quality stocks are difficult to
distinguish, potential buyers will be willing to pay
the average price.
Owners who know their profit potential is high
and their risk is low will not offer their stock.
Owners with low profit horizon and high risk will
be happy to sell.
Overabundance of lemons in the stock market
will discourage lenders to enter the market.
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Solving Adverse Selection


The party with the scant information needs to
be informed.
Private firms might collect and sell the needed
information.



Free-rider problem would cut into their earnings and
sub-optimal information would be generated.
Government would regulate the market and
require firms to supply information. This solves
the public good problem and the political
problem of having to reveal harmful data.
Explanation of Puzzle #5: Financial system is
the most heavily regulated sector of the
economy.
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Solving Adverse Selection



One way to solve the lemons problem in the used
car market has been to utilize an intermediary:
used car dealer.
Financial intermediaries collect information about
firms and loan them the funds provided by their
depositors. Because the loan process is private
and loans are not traded, there is no free-rider
problem.
This explains puzzles #4 and #5: Banks are the
most important source of external funds.
Financial system is the most heavily regulated
sector of the economy.
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Role of Banks

The less information available about firms,
the more prominent banks will be in the
financial system.



LDCs rely on banks much more.
Puzzle #4: Banks are the most important
source of external funds.
In the US banks have seen a decline in
their control of the financial flows.

This explains puzzle # 6: Only large, wellestablished corporations have access to
direct finance.
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Collateral and Net Worth to Solve
Adverse Selection

If a borrower defaults, the lender will get the
collateral.

It reduces the risk from lack of knowledge for
the lender.
A firm with high net worth (assets –
liabilities) will be able to pay the loan even if
the business goes sour.
 This explains puzzle # 7: Both households
and businesses are usually required to put
up a collateral for a loan.

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Tools to Help Solve Adverse Selection
1. Private Production and Sale of Information
Free-rider problem interferes with this solution
2. Government Regulation to Increase Information
Explains Puzzle 5
3. Financial Intermediation: Explains Puzzles 3, 4 and 6
A. Analogy to solution to lemons problem provided by
used-car dealers
B. Avoid free-rider problem by making private loans
4. Collateral and Net Worth
Explains Puzzle 7
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Moral Hazard in Equity Contracts

Called the Principal-Agent Problem
Principal: less information (stockholder)
 Agent: more information (manager)


Separation of ownership and control
of the firm

Managers pursue personal benefits and
power rather than the profitability of the firm
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Moral Hazard of Equity

Principal-Agent Problem.
The owner hires an agent.
 Agent isn't too keen on profits.
 The owner loses.

The question of trust would make
savers rely more on debt instruments
than stocks.
 Board of Trustees, Board of Governors,
Board of Directors are supposed to
monitor the activities of the managers.

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Solving Moral Hazard
The activities of agents need to be
monitored.
 Monitoring might be costly.
 Monitoring may lead to free-rider
problem and collapse.



Some owners do the monitoring and others
enjoy the outcome.
Less demand for stocks compared to
bonds.
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Solving Moral Hazard
Imposing regulation to have standard
accounting principles, the government tries
to make monitoring easier.
 Venture capital firms are financial
intermediaries that monitor the activities of
the firms by being on the Board of Directors.
 Owning a stock requires monitoring; owning
a bond doesn’t. Debt is more prevalent as
external finance.

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Moral Hazard for Lenders
The borrower has to pay fixed amounts
and keeps the extra.
 Incentives for the borrower are to
undertake risky endeavors.
 If the risky investment works, the
borrower will gain a lot.
 If the risky investment doesn’t work, the
borrower will be unable to pay the
lender.

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Solving Moral Hazard in Contracts


High net worth discourages the borrower from risky
investments.
Monitoring the borrower’s activities and restricting
risky behavior.




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Loan can only be used in specific activities.
Life insurance may be required.
Collateral’s value is protected by insurance.
Periodic auditing of the borrower.
Financial intermediaries


extend non-tradable loans and reduce the problem of
free-rider under marketable debt.
Reduce the costs of monitoring.
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Why Do Conflicts of Interest Arise?

Underwriting and Research in Investment
Banking

Information produced by researching companies is
used to underwrite the securities. The bank is
attempting to simultaneously serve two client
groups whose information needs differ.

Spinning occurs when an investment bank
allocates hot, but underpriced, IPOs to executives
of other companies in return for their companies’
future business
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Why Do Conflicts of Interest Arise?

Auditing and Consulting in Accounting Firms

Auditors may be willing to skew their judgments and
opinions to win consulting business

Auditors may be auditing information systems or tax
and financial plans put in place by their nonaudit
counterparts

Auditors may provide an overly favorable audit to
solicit or retain audit business
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Conflicts of Interest: Remedies

Sarbanes-Oxley Act of 2002 (Public Accounting
Return and Investor
Protection Act)

Increased supervisory oversight to monitor and
prevent conflicts of interest

Established a Public Company Accounting Oversight
Board

Increased the SEC’s budget

Made it illegal for a registered public accounting firm
to provide any nonaudit service along with an audit
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Sarbanes-Oxley Act of 2002

Beefed up criminal charges for white-collar
crime and obstruction of official investigations

Required the CEO and CFO to certify
that financial statements and disclosures are
accurate

Required members of the audit committee to
be independent
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Conflicts of Interest: Remedies

Global Legal Settlement of 2002




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Required investment banks to sever the link
between research and securities underwriting
Banned spinning
Imposed $1.4 billion in fines on accused
investment banks
Required investment banks to make their analysts’
recommendations public
Over a 5-year period, investment banks were
required to contract with at least 3 independent
research firms that would provide research to their
brokerage customers
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Problems in LDCs

Property rights are poorly defined and/or poorly
enforced.




Debtors may have more rights than creditors.
Courts may take too long to give ownership to
creditors.
Governments might protect politically powerful
borrowers.
Adverse selection problems become magnified
because under these conditions lenders need
much more reliable information about borrowers.
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Problems in LDCs
Moral hazard problems become magnified
because lenders cannot enforce restrictive
covenants.
 As a result, flow of funds from savers to
borrowers is minimal.

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Problems in LDCs

Governments usually direct credit toward
themselves or toward favored sectors.



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Allocation is determined on political grounds rather
than economic efficiency grounds.
Funds are wasted.
Government subsidize interest rates for
favored sectors.
Nationalized banks channel funds toward
political endeavors.
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Financial Crisis
A financial crisis happens when there is
sharp declines in asset prices and
widespread bankruptcies.
 Financial crises occur when there is a
sharp increase in adverse selection and
moral hazard.

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Causes of Financial Crisis

Increases in interest rates: Riskier investors
remain in the market while safer ones exit.

Increases in uncertainty: A major failure increases
the uncertainty and inability of the lenders to
gauge the creditworthiness of borrowers.

Balance sheet deterioration: Decline in asset
values, rise in liabilities, decline in net worth.

Banking sector problems: Deterioration of bank
balance sheets.

Government deficits: Possibility of default.
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Balance Sheet Deterioration

Stock market crash lowers the net worth of
corporations.



Adverse selection increases because the potential
losses to lenders are higher.
Moral hazard increases because borrowers have more
incentives to engage in risky behavior.
Unanticipated deflation raises liabilities.




Debt is usually long-term, fixed interest rate.
Falling prices raise the real value of nominal debt.
Assets are usually real, so they do not gain value.
Net worth declines.
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Balance Sheet Deterioration

Exchange rate risk may deteriorate balance
sheets.
If contracts are denominated in foreign
currency, any unanticipated devaluation or
depreciation of domestic currency increases
real value of debt.
 Assets are usually denominated in domestic
currency.


Rise in interest rates may increase interest
payments by debtors.

Cash flow will fall lowering the liquidity of the
firm.
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Mexican Financial Crisis of ‘94-95
Deregulation of financial markets led to a
lending boom.
 Unperforming loans increased causing a
decline in net worth of banks.

Weak supervision of regulators
 Inability to monitor borrowers


Lending slowed (tight credit market).
49
Tequila Crisis of ‘94-95

Interest rate hikes in the US forced Mexico to raise
its interest rates to keep the value of peso.


Higher interest rates increased adverse selection and
moral hazard.
Assassinations and uprisings increased
uncertainty.



Stock market crashed reducing net worth.
Firms had incentives to undertake risky investments
because the value of their collateral fell.
Adverse selection and moral hazard problems rose.
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Tequila Crisis of ‘94-95

Expected value of Mexican peso dropped
forcing the spot value downward as well.
Due to NAFTA, tariffs and quotas were to be
removed.
 Inflation in 1990-95 period had fallen to 15.5%
from 70.4% during 1980-90 period but it still was
significantly higher than the US to which the
peso was pegged.
 From 1980 to 1995 trade as a percentage of
GDP doubled from 24% to 48%.

Source: The World Bank, World Development Report 1997, pp. 219, 235, 245
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U.S. Financial Crises
52
Third World Financial Crises
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