An Economic Analysis of Financial Structure Why do Financial Institutions Exist? (Why is Indirect Finance so Important?) Chapter 8

Chapter Preview Look at why financial institutions exist and how they promote economic efficiency. Topics include: Some Basic Facts About Financial Structure Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard

Basic Facts About Financial Structure Throughout the World The chart on the next slide shows how non-financial business get external funding in the U.S., Germany, Japan, and Canada.

Sources of External Finance for Nonfinancial Businesses Bank loans are from depository institutions Nonbank loans are from non-depository institutions. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Mishkin Presents Eight Basic Facts of Financial Structure Stocks (direct finance) are not the most important source of external financing for businesses Issuing marketable debt and equity securities (direct finance) is not the primary way in which businesses finance their operations

Mishkin’s Eight Basic Facts of Financial Structure 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. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

Eight Basic Facts of Financial Structure The financial system is among the most heavily regulated sectors of economy. Only large, well-established corporations have easy access to securities markets (direct finance) to finance their activities.

Eight Basic Facts of Financial Structure Collateral is a prevalent feature of debt contracts for both households and businesses. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

Why is Indirect Finance so Important? Transactions Costs Information Costs Shades of Chapter 2

Information Costs - Asymmetric Information symmetric information—the case where all parties to a transaction or contract have the same information. In many situations, this is not the case. Information is not the same. We refer to this imbalance in information as asymmetric information.

Asymmetric Information: Adverse Selection and Moral Hazard Occurs when one party in a transaction has better information than the other party Occurs before transaction occurs In financial markets, potential borrowers most likely to produce adverse outcome are the ones most likely to seek loan

The Lemons Problem: How Adverse Selection Influences Financial Structure 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 Bad quality pushes good quality from the market because of an information gap is known as "adverse selection”

The Classic Example - The Lemons Problem Suppose that used cars come in two types: those that are in good repair (peaches) and bad shape (lemons). The sellers know the quality of the cars. Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. If buyers had the information to tell good from bad, they could strike fair trades with the sellers, $20,000 for good car and $10,000 for the lemon.

Asymmetric Information - The Lemons Problem If buyers do not have good information and cannot tell the quality difference, there will be only one market for all used cars. buyers will pay only the average price of a good car and a lemon, or $15,000 This is below the $20,000 that good-car owners require; so they will exit the market, leaving only bad cars. This result, when bad quality pushes good quality from the market because of an information gap, is known as "adverse selection".

Adverse Selection and Financial Structure Lemons Problem in Securities Markets Suppose investors cannot distinguish between good and bad securities, willing to pay only the average of the good and bad securities’ values. Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued. High expected profit and low risk Low expected profit and high risk

Actions to Help Solve Adverse Selection Problems Government Regulation to Increase Information (explains Fact # 5)

Actions to Help Solve Adverse Selection Problems Financial Intermediation FIs fill the information gap Analogy to solution to lemons problem provided by used car dealers FIs avoid free-rider problem. Make private loans and keep information private (explains Fact # 3 and # 4) Also explains fact #6 - large firms are more likely to use direct instead of indirect financing

Actions to Help Solve Adverse Selection Problems Collateral and Net Worth Explains Fact # 7 Private Production and Sale of Information Free-rider problem interferes with this solution

Asymmetric Information: Adverse Selection and Moral Hazard Occurs when one party has an incentive to behave differently once an agreement is made between parties Occurs after transaction occurs For example, Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

How Moral Hazard Affects the Choice Between Debt and Equity Contracts With equity, have Principal-Agent Problem Separation of ownership and control of the firm Principal (stockholder) has less information Agent (manager) has more information Managers pursue personal benefits and power rather than the profitability of the firm

Actions to help solve the Principal-Agent Problem: Monitoring of managers Expensive Use debt rather than equity Reduces the need to monitor as long as borrower is performing. Explains Fact 1, why debt is used more than equity Government regulation to increase information Fact 5 Financial Intermediation Venture capital firms provide the equity and place there own people in management Explains Fact 1

Moral Hazard Influence in Debt Markets Even with the advantages just described, debt is still subject to moral hazard. Debt may create an incentive to take on very risky projects. Example: suppose a firm owes $100, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash. Know as “Gambling for Resurrection”.

Lenders need to find ways ensure that borrower’s do not take on too much risk. A good legal contract Bonds and loans often carry restrictive covenants Restrict how funds are used Require minimum net worth, collateral, bank balance, credit rating. Financial Intermediaries have special advantages in monitoring[Facts 3 and 4]

STOP HERE!!