An Economic Analysis of Financial Structure Chapter 8

Eight Basic Facts 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.

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.

External Finance

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.

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.

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%).

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.

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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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.

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.

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.

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.

Transaction Costs Financial intermediaries have evolved to reduce transaction costs Economies of scale Expertise 15

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.

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.

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".

http://www.nobel.se/economics/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

http://www.nobel.se/economics/laureates/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.

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 21

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.

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

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.

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.

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.

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, well-established corporations have access to direct finance.

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.

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 Avoid free-rider problem by making private loans 4. Collateral and Net Worth Explains Puzzle 7

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 30

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.

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.

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.

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.

Solving Moral Hazard in Contracts High net worth discourages the borrower from risky investments. Monitoring the borrower’s activities and restricting risky behavior. 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.

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

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

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

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

Conflicts of Interest: Remedies Global Legal Settlement of 2002 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

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.

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.

Problems in LDCs Governments usually direct credit toward themselves or toward favored sectors. 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.

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.

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.

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.

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.

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).

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.

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

U.S. Financial Crises

Third World Financial Crises