chapter 16 financial system design. financial system two models of financial system can be found in...

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Chapter 16 Financial System Design

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Page 1: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Chapter 16

Financial System Design

Page 2: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Financial System

Two models of financial system can be found in industrialized nations. Those are: Markets-oriented

United States and United Kingdom Banking-oriented

Germany and Japan

Page 3: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Common Elements Payments system

Processing of checks Electronic transfers

Specialized Financial Intermediaries Organizations or activities designed to perform specific functions within the financial system

Page 4: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Common Elements Deposit Insurance

Protecting individual depositor Central Bank

Responsible for issuing currency and interest rates

Maintaining stability of the system Implementing monetary policy Macroeconomic objectives:

Inflation control Unemployment reduction

Page 5: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Differences Financing Primarily difference is related to how businesses obtain financing

Conflict Resolution The private ownership of business leads to two fundamental conflicts:

Stockholder-lender conflict Management-stockholder conflict

These problems are handled differently.

Page 6: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 7: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Manager-Stockholder Conflict

Arises primarily with large companies where 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 Principal-agent problems however produce this conflict

Page 8: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Principal-Agent Problem

Manager often have objectives different from the owners. 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 than strategies that may involve more risk, proportionately larger gains

Page 9: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 10: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 11: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Conflict Resolution in Different Financial

Systems

Two Conflicts Stockholder – Lender Conflict Manager –stockholder Conflict

Two Systems Banking oriented system Market oriented system

These two conflicts are dealt with differently in a banking-oriented financial system as compared to a markets-oriented financial system

Page 12: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 13: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 14: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Information and System Design

Small Firms: Manager-Stockholder Conflict

Not a problem in either financial system

Manager is often the owner of the firm

Page 15: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 16: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Information and System Design

Large firms: Stockholder-Lender Conflict Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky

Page 17: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 18: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 19: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 20: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 21: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

Large Firms: Manager-Stockholder Conflict

Markets-Oriented Systems To minimize the conflict, management’s compensation packages are structured to link compensation to performance desired by stockholders

Page 22: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 23: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 24: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 25: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 26: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 27: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 28: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 29: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 30: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 31: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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

Page 32: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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.

Page 33: Chapter 16 Financial System Design. Financial System  Two models of financial system can be found in industrialized nations. Those are:  Markets-oriented

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