1. An Economic Analysis of Financial Structure
Chapter 8
An Economic Analysis of Financial Structure

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3. Eight Basic Facts
Stocks are not the most important sources of external financing for businesses
Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
Indirect finance is many times more important than direct finance
Financial intermediaries are the most important source of external funds
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4. Eight Basic Facts (cont’d)
The financial system is among the most heavily regulated sectors of the economy
Only large, well-established corporations have easy access to securities markets to finance their activities
Collateral is a prevalent feature of debt contracts
Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
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5. Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
Economies of scale – combining the funds of many investors together. For example, the cost of purchasing 10,000 shares of stock is not much greater than purchasing 50 shares of stock.
Expertise – for example, computer technology, toll-free numbers, easy access.
Liquidity services – easier for customers to do transactions.
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6. Asymmetric Information
Adverse selection occurs before the transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric information problems affect economic behavior
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7. 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
This problem explains fact 2 and partially explains fact 1
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8. Adverse Selection: Solutions
Private production and sale of information
Free-rider problem – when people who do not pay for information take advantage of the information other people have paid for.
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7
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9. Moral Hazard in Equity Contracts
Called the Principal-Agent Problem
Example of Steve, his venture capital partner and the moral hazard. Page
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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10. Principal-Agent Problem: Solutions
Monitoring (Costly State Verification)
Free-rider problem
Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation – venture capital firm. Combine resources of many partners.
Fact 3
Debt Contracts
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11. Moral Hazard in Debt Markets
Borrowers have incentives to take on projects that are riskier than the lenders would like
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12. Moral Hazard: Solutions
Net worth and collateral
Incentive compatible – good for both borrower and lender. Security for lender, keeps credit strong.
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior – loan can only be used for certain activities.
Encourage desirable behavior – example of life insurance or mortgage insurance for house loan
Keep collateral valuable – also life insurance or theft insurance for car.
Provide information – requiring an audit of company or individual activity.
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13. Moral Hazard: Solutions
The problem with restrictive covenants is that you cannot completely eliminate the moral hazard problem. Covenants cannot rule out every risky activity. They must be monitored to be effective.
Restrictive Covenants are written provisions that are in every debt contract. A lot of legal information protecting borrower.
Financial Intermediation
Facts 3 & 4
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14. Summary
The presence of asymmetric information in financial markets leads to adverse selection and moral hazard problems.
Tools to help solve these problems involve sale of information, government regulation, collateral and net worth to debt contracts and the use of monitoring and restrictive covenants.
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15. Summary
Note that the existence of the free-rider problem for traded securities indicates that financial intermediaries, banks, should play a greater role in financing businesses.
Economic analysis of adverse selection and moral hazard has helped explain the basic features of our financial system outlined at the beginning of the chapter.
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17. Conflicts of Interest
Type of moral hazard problem caused by economies of scope – so much information that sometime it can be misleading
Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
A reduction in the quality of information in financial markets increases asymmetric information problems
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be
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18. 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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19. Why Do Conflicts of Interest Arise? (cont’d)
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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20. China and Financial Development
What China needs to do to become a legitimate world economic powerhouse:
More legal enforcement of financial contracts and new bankruptcy law
Better accounting standards and more high-quality information
More and better regulation in the banking system
Allocate capital more efficiently by improving its financial system
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21. China and Financial Development
How has China been able to grow so rapidly for 20 years?
Extremely high savings rate of 40%
Rural to Urban shift of massive pool of underutilized labor from subsistence-agriculture sector to higher-productivity activities that use capital
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22. Financial Crises & Aggregate Economic Activity
Crises can be caused by (p )
Increases in interest rates – invites more risk
Increases in uncertainty – economy downturns
Asset market effects on balance sheets – failures of major corporations
Problems in the banking sector – bank failures
Government fiscal imbalances – too much deficit spending
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23. SUMMARY CHAPTER 8
There are 8 basic facts about US Financial structure. First four are the importance of financial intermediaries and the unimportance of securities for financing corporations. 5th is bank regulation, 6th only large banks have access to the securities markets, 7th importance of collateral, 8th debt contracts.
Financial intermediaries have economies of scale reducing transaction costs.
Asymmetric information results in 2 problems: adverse selection & moral hazard
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24. SUMMARY CHAPTER 8
4. Adverse selection hurts efficient functioning financial markets. Tools to help reduce adverse selection include sale of information, government regulation, financial intermediation, and collateral and net worth.
5. Tools to reduce moral hazard problem in debt contracts include net worth, monitoring & enforcement of restrictive covenants, and financial intermediaries.
6. Conflicts of interest are when financial service providers misuse or hide important information.
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25. SUMMARY CHAPTER 8
Conflicts of interest reduce the amount of reliable information in financial markets which makes it difficult to channel or move funds to people who have productive investment opportunities.
Financial crises are major disruptions or problems in financial markets. Some of these problems are caused by increase in interest rates, uncertainty, problems in the banking sector and government deficits.
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26. Study/discussion questions
How can economies of scale help explain the existence of financial intermediaries?
How do standard accounting procedures help financial markets work more efficiently?
Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? Why?
Rich people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection.
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27. Study/discussion questions
5. The more collateral there is backing a loan, the less the lender has to worry about adverse selection. Is this statement true, false, or uncertain? Explain your answer.
6. How can a stock market crash provoke a financial crisis?
7. How can a sharp rise in interest rates provoke a financial crisis?
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