chapter 16 financial system design. 16-2 key topics stockholder-lender and manager- stockholder...
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Chapter 16
Financial System Design
16-2
Key Topics
Stockholder-lender and Manager-stockholder conflicts
Different financial structures that limit these conflicts
Compare and contrast the financial system design of Germany, Japan, the UK, and the US
16-3
Financial System
Two models of financial system in industrialized nations are: Markets-oriented
United States and United Kingdom Banking-oriented
Germany and Japan
16-4
Common Elements Payments system
Processing of checks Electronic transfers
Specialized Financial Intermediaries Organizations or activities designed to perform
Specific functions within the financial system Deposit Insurance
Protecting individual depositor Central Bank
Responsible for issuing currency and implementing monetary policy
16-5
Differences
Primarily related to how businesses obtain financing
The private ownership of business leads to two fundamental problems:
Stockholder-lender conflict Management-stockholder conflict
These problems are handled differently by the financial sectors in the various systems
16-6
Stockholder-Lender Conflict
Adverse selection Firm owners (stockholders) have an
incentive to understate their true riskiness to obtain borrowing on a more favorable basis
Moral hazard Firms have an incentive to become riskier
after their loans are funded Magnitude of asymmetric information
Less for large companies Large amounts of publicly available
information
16-7
Manager-Stockholder Conflict Greater with large companies Owners (stockholders) delegate the
management to professional managers (CEO)
Owners want manager to operate the firm in their best interest maximize value of the stock
16-8
Manager-Stockholder Conflict Unfortunately, the manager may have
other objectives Minimize their own effort Maximize their salaries and perks Maximize the firm’s size to increase their
importance May give up value-maximizing projects
Want to preserve their jobs Choose excessively safe strategies rather than strategies that may involve more risk
16-9
Manager-Stockholder Conflict
Problems Difficult and costly to monitor performances Difficult to know if poor outcome is due to
poor performance or bad luck Difficult to judge and prove whether an
activity is in the best interest of the stockholders
Since there are often a large number of stockholders, there is no incentive for any owner to monitor the performance
16-10
Manager-Stockholder Conflict Less problem with Small, closely held
firms Owner is often the manager, which eliminates the
stockholder-manager conflict A significant amount of stock is held by one
investor Potential gains of monitoring the performance is much
greater than the costs Major stockholder has a great incentive to monitor the
manager’s performance The owner in a closely held firm often has the
power to control the firm’s board of directors and fire managers
16-11
Two conflicts are associated with external financing
almost all firms raise funds from outsiders in the form of debt or equity
These two conflicts are dealt with differently in a banking-oriented financial system as compared to a markets-oriented financial system
16-12
Information and System Design
Conflict Resolution and Financial System Design
Banking-oriented—banks actually own companies they monitor, and the stock and bond markets are relatively underdeveloped
Markets-oriented—banks do not own companies and public bond and stock markets are prominent institutions
16-13
Information and System Design
Small Firms: Stockholder-Lender Conflict Both systems treat small firms similarly Small firms borrow from banks and other
monitoring-intensive financial intermediaries Banks are specialists in information--ideally suited
to assess borrower risk before making the loan Design loan contracts to minimize the incentive to
become riskier after the loan is made Small firms: Manager-Stockholder Conflict
Not a problem in either financial system
16-14
Information and System Design
Large firms: Stockholder-Lender Conflict The two financial systems treat large firms
significantly differently Markets-Oriented System
Large firms tend to borrow short term in commercial paper market and borrow long term in the bond market
Production of information about business risk is delegated to bond rating agencies
Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky
16-15
Information and System Design
Large firms: Stockholder-Lender Conflict Banking-Oriented Systems
When lender and stockholders are the same (the bank), as is often the situation, this problem does not exists
No incentive for stockholder to exploit themselves However, it is generally not the case that banks own all
of the firm’s equity Nevertheless, consolidation of ownership is often large
enough that the bank owns a controlling interest
16-16
Information and System Design
Large Firms: Manager-Stockholder Conflict Banking-Oriented Systems
Solution is driven principally by the bank’s ownership of the business
Bank has the incentive to monitor the behavior of the firm’s management
Bank also has control over management so it can fire an incompetent manager
16-17
Information and System Design
Large Firms: Manager-Stockholder Conflict Markets-Oriented Systems
Because of diffuse ownership, little incentive for individual stockholders to monitor performance of managers
Often the CEO will influence who is selected to serve on the board of directors, which results in ignoring the CEO’s poor performance
Creates a distinct possibility that inefficient managers become entrenched and the firm becomes manager-controlled
16-18
Information and System Design
Large Firms: Manager-Stockholder Conflict Markets-Oriented Systems
Often this situation is resolved through a corporate takeover and new owners replace previous managers
Managers will actively resist such a takeover effort Hostile takeover—attempts to takeover a company
against current management’s wishes To minimize the conflict, management’s compensation
packages are structured to link compensation to performance desired by stockholders
16-19
Financial System Design: Summary of Four Countries
Germany A strong banking-oriented financial system Hausbank
A single bank that is the primary source of external financing, both debt and equity
The relationship between a business firm and their Hausbank is a very powerful one
This relationship fosters bank participation in the strategic activities of the firm through stock ownership and control, and sitting on company supervisory boards
16-20
Financial System Design: Summary of Four Countries
Hausbank Bank ownership participation is both
direct and indirect Direct—bank owns a large share of the stock Indirect—individuals and institutions deposit
stock holdings in a trust account with a bank and voting rights are conveyed to the bank
16-21
Financial System Design: Summary of Four Countries
Germany Organization of the banking system
Commercial banks Comprised of three major banks and a number of
regional and private banks Active participants in the international markets
Savings banks Typically owned by regional or town government
which operate locally Initially organized as mortgage lenders but now
offer full commercial banking services
16-22
Financial System Design: Summary of Four Countries
Germany Organization of the banking system
Cooperative banks First established to collect savings and extend credit
to individuals
Specialized banks Mortgage, consumer lending, small business loan
guarantees, export financing, and industry-specific financing
16-23
Financial System Design: Summary of Four Countries
Germany Dominance of banks in Germany comes at
the expense of the securities markets Stock, bond, and commercial paper markets are
not very important Eight regional stock exchanges, dominated by
the Frankfurt exchange Less than a quarter of the largest German
companies are listed, and a large proportion are not actively traded
16-24
Financial System Design: Summary of Four Countries
Germany Corporate bond and commercial paper market
is very small Largely due to taxes and regulations prior to 1992
making it very expensive to issue these securities
Therefore, most German companies are highly dependent on their banks for credit
16-25
Financial System Design: Summary of Four Countries
Germany Dominance of banking system is aided by
regulations that permits universal banking Can engage in a variety of financial service activities Permitted to own nonfinancial companies and underwrite
corporate securities and insurance Those who advocate giving U.S. banks full underwriting
privileges cite German universal banking as model of success
However, this success might be a result of a poorly developed stock and bond market which is not the case in the United States
16-26
Financial System Design: Summary of Four Countries
Japan Keiretsu form of industrial organization
A group of companies that are controlled through interlocking ownership—companies own stock in each other
Encourages strong loyalty among the companies, including favoritism in customer-supplier relationships
Each keiretsu has a main bank that typically owns stock in other members of the keiretsu
16-27
Financial System Design: Summary of Four Countries
Japan Japanese banks may own equity in nonfinancial
companies, although this is now limited to 5 percent in any single firm
Organization of the banking system City banks—represent a disproportionately large
fraction of the world’s biggest banks Regional banks Special-purpose financial institutions—include long-
term credit banks, specialized small business and industrial institutions
16-28
Financial System Design: Summary of Four Countries
United Kingdom Financial system is very much markets-oriented,
although banks play a very important role London serves as both a domestic financial
center as well as the center of the Eurobond market
Regulatory environment encourages foreign participation and competition in financial markets
16-29
Financial System Design: Summary of Four Countries
United Kingdom Organization of the banking system
Clearing banks—universal banks, securities activities through subsidiaries, extensive branch networks
Merchant banks—provide wholesale banking services to large corporations
“other” British banks—consisting of institutions similar to merchant banks and specialized banks
“other” deposit-taking institutions—mostly building societies which are similar to savings and loan associations in U.S.
16-30
Financial System Design: Summary of Four Countries
United States Financial system in the United States has been
extensively examined in Chapters 11-15 Very large stock, bond, and commercial paper
markets--model of the markets-oriented system Securitization of residential mortgages and other
financial assets has further strengthened the traded securities markets
Banks play a key role in external financing for small and midsize companies, not for large firms
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