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Chapter 8

An Economic Analysis of Financial Structure

One of the main requirements for a healthy economy is an efficient

financial system that channel funds from savers to investors. The chapter provides an economic analysis of how our financial structure is

designed promote economic efficiency. BASIC FACTS ABOUT FINANCIAL STRUCTURE:

1. Stocks are not the most important source of external financing for

businesses.

2. Issuing marketable debt and equity securities is not the primary way in

which businesses finance their operations.

3. 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.

4. Financial intermediaries, particularly banks, are the most important source

of external funds used to finance businesses.

5. The financial system is among the most heavily regulated sectors of the

economy.

6. Only large, well-established corporations have easy access to securities

market to finance their activities.

7. Collateral is a prevalent feature of debt contracts for both households and

businesses.

8. Debt contracts typically are extremely complicated legal documents that

place substantial restrictions on the behavior of the borrower.

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TRANSACTION COSTS

Transaction costs are a major problem in financial markets. Transaction

costs are too high for ordinary people.

Financial intermediaries help in reducing transaction costs and allow small

savers and borrowers to benefit from the existence of financial markets.

One solution to the problem of high transaction costs is to package the

funds of many investors together so that they can take advantage of

economies of scale.

Economies of scale refer to the reduction in transaction costs per unit of the

amount invested as the size (scale) of transaction increases. It exist because

the total cost of carrying out a transaction in financial markets increases

only a little as the size of the transaction grows.

The presence of economies of scale in financial markets helps explain why

financial intermediaries developed and have become such an important part

of financial structure.

An additional benefit for individual investor is that the presence of

economies of scale in an investment means that the investment is large

enough to purchase a widely diversified portfolio of securities. The

increased diversification for individual investors reduces their risk, making

them better off.

Financial intermediaries are also better able to develop expertise to lower

transaction costs.

Another important outcome of a financial intermediary’s low transaction

costs is the ability to provide its customers with liquidity services that

make it easier to conduct transactions.

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ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL

HAZARD

Asymmetric information is a situation that arises when one party’s

insufficient knowledge about the other party involved in a transaction

makes it impossible to make accurate decision when conducting the

transaction.

Asymmetric information is an important aspect of financial markets.

The presence of asymmetric information leads to adverse selection and

moral hazard problems.

Adverse selection is an asymmetric information problem that occurs before

the transaction. Potential bad credit risks are the ones who most actively

seek out loans. Because adverse selection increases the chances that a loan

might be made to a bad credit risk, lenders might decide not to make any

loans, even though there are good credit risks in the marketplace.

Moral hazard arises after the transaction occurs. The lender runs the risk

that the borrower will engage in activities that are undesirable from the

lenders point of view because they make it less likely that the loan will be

paid back. Because moral hazard lowers the chance that the loan will be

paid back, lenders may decide that they would rather not make loans.

The analysis of how asymmetric information problems affect economic

behavior is called agency theory.

How Adverse Selection Influences Financial Structure

Because of asymmetric information problem of adverse selection the

potential buyer of stocks or bonds can’t distinguish between good firms

with high expected profits and low risk and bad firms with low expected

profits and high risk. In this situation,

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1. The potential buyer will be willing to pay only a price that reflects

the average quality of firms issuing securities– a price that lies

between the value of securities from bad firms and the value of those

from good firms.

2. If the owners or managers of a good firm have better information

that they are sure they have a good firm they will not accept the

undervalued price that is offered by the potential buyer.

3. The only firms willing to sell at the price offered will be bad firms

because the price offered is higher than the securities are worth.

4. But the potential buyer is not willing to hold securities of bad firms,

and hence he will decide not to purchase securities in the market.

5. Therefore, this securities market will not work very well because

few firms will sell securities in it to raise capital.

The analysis is similar if the potential buyer considers purchasing a corporate

debt instrument in the bond market.

1. The potential buyer will purchase a bond only if its interest rate is

high enough to compensate him for the average default risk of the

good and bad firms willing to sell the debt.

2. The owners of the good firm have more information than the

potential buyer that their firm is going to pay higher interest rate than

the buyer is expecting and hence they are unlikely willing to borrow

in this market.

3. Only the bad firms will be ready to borrow but the potential buyer is

not willing to buy bonds issued by them.

4. Again, few bonds are likely to sell in this market, so it will not be a

good source of financing.

The analysis discussed above explains why marketable securities are not

the primary source of financing (fact 2). It also partly explains why stocks

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are not the most important source of financing (fact 1). The presence of

adverse selection problem keeps securities markets from being effective in

challenging funds from savers to borrowers

Tools to help Reduce Adverse Selection Problems

In the absence of asymmetric information, the adverse selection problem

goes away. If the buyers know as much information as the sellers, so that

they can distinguish good firms from bad firms, buyers will be willing to

pay full value for securities issued by good firms, and good firms will sell

their securities in the market. The securities market will then be able to

move funds to the good firms that have the most productive opportunities.

1. Production and Sale of Information

The solution to adverse selection problem in financial markets is to

eliminate asymmetric information by furnishing the people supplying funds

with full details about the individuals or firms seeking to finance their

investment activities.

One way to provide information to savers-lenders is through establishing

private companies specialized in collecting and producing information that

distinguishes good from bad firms and then sell this information to those

who are interested in acquiring them. These firms such as Standard and

Poor’s gather information of firms’ balance sheet positions and investment

activities and then sell them to subscribers.

However, the system of private production and sale of information does not

completely solve the adverse selection problem in securities market because

of the free-rider problem.

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The free-rider problem occurs when people who do not pay for

information take advantage of the information that other people have paid

for.

Free-riders watch the investors who have bought the information to make

better decision in purchasing the securities of good firms that are

undervalued, and then he buys the same securities that investors who paid

for information bought.

If many free-riders act in the same way, the increased demand for the

undervalued good securities will lead to an increase in the prices of these

good firms’ securities.

Because of free-riders, investors who paid for information will not have any

advantage from purchasing the information and they wish they should

never paid for this information in the first place.

If many investors face the same problem and react in the same way, firms

selling information will realize that this information producing business is

not that profitable. This means less information will be produced and

adverse selection problem will prevail resulting in inefficient functioning of

securities market.

Thus, the free-rider problem prevents the private market from producing

enough information to eliminate all the asymmetric information that leads

to the adverse selection problem.

2. Government Regulation to Increase Information

To compensate the shortage of information production in the private market

government intervention is necessary.

Government regulates securities markets in a way that forces firm to reveal

honest information about themselves so that investors can determine how

good or bad the firms are.

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Special government agencies require firms selling their securities to have

independent audits to certify that the firm is adhering to standard

accounting principles and disclosing accurate information about sales,

assets, and earnings.

However, disclosure requirements do not always work well. For example,

the collapse of Enron, WorldCom and other firms illustrates that

government regulation can lessen asymmetric information problems of

adverse selection and moral hazard, but cannot eliminate them.

Even when firms provide information to the public about their sales, assets,

or earnings, they still have more information than investors: There is

information related to quality that cannot be provided merely by statistics.

Furthermore, bad firms have an incentive to make themselves look like

good firms making it hard for investors to sort out good firms from the bad

one.

The adverse selection in financial markets helps explain why financial

markets are among the most heavily regulated sectors in the economy (fact

5).

3. Financial Intermediation

As discussed above, private production of information and government

regulation to encourage provision of information lessen but don not

eliminate the adverse selection problem in financial markets.

Financial intermediaries help solve adverse selection problems in financial

markets. Financial intermediary, such as a bank, becomes an expert in

producing information about firms, so that it can sort out good credit risks

from bad ones. Then it can acquire funds from depositors and lend them to

the good firms, which results in high profit for the bank.

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An important element in the bank’s ability to profit from the information it

produces is that it avoids the free-rider problem by mainly making private

loans rather than purchasing securities that are traded in the open market.

The bank’s role as an intermediary that hold mostly non-traded loans is the

key to its success in reducing asymmetric information in financial markets.

Since financial intermediaries play a greater role in moving funds to firms

than securities markets do, indirect finance is so much more important than

direct finance and banks are the most important source of external funds for

financing businesses (facts, 3 and 4).

Since information about private firms is harder to collect in developing

countries than in industrialized countries, there is a greater role for banks

and smaller role for securities markets.

The larger and more established a firm is, the more likely it will be to issue

securities to raise funds, because investors have fewer worries about

adverse selection with well-known corporations.

4. Collateral and Net Worth

Collateral reduces the consequences of adverse selection because it reduces

the lenders losses in the event of a default. Lenders are more willing to

make loans secured by collateral, and borrowers are willing to supply

collateral in order to get the loan and at better rate (fact 7).

If a firm has a high net worth (equity capital) it is less likely to default and

if it defaults the lender can sell its net worth to recover its loan. When firm

seeking credit has high net worth, adverse selection problem will not be

severe and lenders are more willing to make loans.

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HOW MORAL HAZARD AFFECTS THE CHOICE BETWEEN DEBT

AND EQUITY CONTRACTS

Moral hazard is the asymmetric information problem that occurs after

financial transaction takes place, when the seller of a security may have

incentives to hide information and engage in activities that are undesirable

for the purchaser of the security.

Moral hazard has important consequences for whether a firm finds it easier

to raise funds with debt than with equity contracts.

Moral Hazard in Equity Contracts: The Principal-Agent Problem

Equity contracts, such as common stock, are claims to a share in the profits

and assets of a business.

Equity contracts are subject to a particular type of moral hazard called the

principal-agent problem.

The stockholders who own most of the firm's equity (the principals) are not

the same people as the managers of the firm who may own only a small

fraction of the firm they work for (the agents of the owners).

This separation of ownership and management involves moral hazard.

The managers in control (the agents) may act in their own interest rather

than in the interest of the owners (principals) because the managers have

less incentive to maximize profits than stockholders-owners do.

Agents (managers in control) may

1. have different goals than the owners

2. have less incentives to maximize firm’s profit

3. not provide a quick and friendly service to the firm’s customers

4. spend money unnecessarily on decoration and artificial issues

5. waste time in their own personal leisure

6. not be honest with the firm’s owner

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7. diverting funds for their own personal use,

8. pursue corporate strategies that enhance their own personal power

but do not increase the firm’s profitability.

The principal-agent problem, which is an example of moral hazard, would

not arise if the owners of the firm had complete information about what the

managers were up to and could prevent wasteful expenditures and fraud.

The principal-agent problem arises only because a manager has more

information about his activities than the stockholder does-that is, there is

asymmetric information.

The principal-agent problem would not arise if there were no separation of

ownership and control- that is the owner is the manager.

Tools to Help Solve the Principal-Agent Problem

1. Production of Information: Monitoring

One way for stockholder to reduce this moral hazard problem is to monitor

the firm’s activities through different monitoring process such as auditing

and checking what the management is doing.

The problem is that monitoring process can be costly in terms of time and

money. This is called costly state verification, which makes equity

contract less desirable. It explains, in part, why equity is not the most

important element in our financial structure.

Because it is expensive to monitor, the free rider problem occurs which

decreases the possibility to monitor the firm properly. If you know that

other stockholders are paying to monitor the activities of the firm you hold

shares in, you can take a free ride on their activities and save yourself some

expenses. The problem occurs when every stockholder think the same. The

result is no one will spend any resources to monitor the firm.

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2. Government Regulation to increase information

Governments have laws to force firms to adhere to standard accounting

principles that make profit verification easier. They also impose stiff

criminal penalties on people who commit the fraud of hiding and stealing

profits. However, these laws and regulations are not fully effective. It is not

easy to catch the fraudulent managers because they have incentives to make

very hard for government agencies to find or prove fraud.

3. Financial Intermediation

Financial intermediation has the ability to avoid the free-rider problem in

the face of moral hazard, and this is another reason why indirect finance is

so important.

One financial intermediary that helps reduce the moral hazard arising from

the principal-agent problem is the venture capital firm.

Venture capital firm pools the resources of their partners and uses the

funds to help new entrepreneurs to establish a new business firm with the

condition that the venture capital firm receives an equity share in the new

business and puts some of its own people in the management team of the

new firm so that they can keep close watch on the firm’s activities.

The equity of the new business firm splits only between the entrepreneurs

and the venture capital firm and no other investors are allowed. Thus, the

free-rider problem in monitoring the firm does not exist.

4. Debt Contracts

Debt contract is an agreement whereby the borrower pays the lender a fixed

amount at periodic intervals. As long as the lender receives the agreed

amount, he does not care whether the firm is making profit or suffering a

loss.

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The less frequent need to monitor the firm, and thus the lower cost of state

verification, helps explain why debt contracts are used more frequently than

equity contracts to raise capital.

HOW MORAL HAZARD INFLUENCES FINANCIAL STRUCTURE IN

DEBT MARKETS

Even with the advantages over equity contact, debt contracts are still

subject to moral hazard.

Because a debt contract requires the borrower to pay out a fixed amount

and lets him keep any profits above this amount, the borrower has an

incentive to take on investment projects that are riskier than the lenders

would like. Because of the potential moral hazard, lenders my not make the

loan to the borrower.

Tools to Help Solve Moral Hazard in Debt Contract

1. Net Worth and Collateral

When the net worth is high or the collateral is valuable, the risk of moral

hazard will be highly reduces because the borrower himself have a lot to

lose.

Net wroth and collateral make the debt contract incentive-compatible. It

makes the incentives of both borrowers and lenders are the alike. The

greater the borrower’s net worth and collateral, the greater the borrower’s

incentive to behave in the way that the lender expects and desires, the

smaller the moral hazard problem in the debt contract, and easier for the

borrower to get the loan.

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2. Monitoring and Enforcement of Restrictive Covenants

Lenders can ensure that the borrower uses the fund for the purpose it has

been agreed upon by writing provisions (restrictive covenants) into the

debt contract that restrict the borrower’s activities in order to reduce moral

hazard. Then the lenders can monitor the borrower’s activities to see

whether he is complying with the restrictive covenants or not.

There are four types of restrictive covenants

1. Covenants to discourage undesirable behavior,

2. covenants to encourage desirable behavior,

3. covenants to keep collateral valuable,

4. covenants to provide information

3. Finance intermediation

Although restrictive covenants help reduce the moral hazard problem, they

do not eliminate it completely. It is almost impossible to write covenants

that rule out every risky activity.

Furthermore, borrower may be clever enough to find loopholes in

restrictive covenants that make them ineffective.

Restrictive covenants must be monitored and enforced. Monitoring and

enforcement is costly. Thus, the free-rider problem arises in debt market,

and moral hazard continues to be high.

Financial intermediaries-particularly banks- have the ability to avoid the

free-rider problem as the make primarily private loans.

Private loans are not traded, so no free-rider problem exists.

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