CH8.ppt

Chapter 8An Economic Analysis of Financial Structure

2013 Pearson Education, Inc. All rights reserved. 8-*

Basic Facts about Financial Structure Throughout the WorldThis chapter provides an economic analysis of how our financial structure is designed to promote economic efficiency The bar chart in Figure 1 shows how American businesses financed their activities using external funds (those obtained from outside the business itself) in the period 19702000 and compares U.S. data to those of Germany, Japan, and Canada


Figure 1 Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany, Japan, and CanadaSource: Andreas Hackethal and Reinhard H. Schmidt, Financing Patterns: Measurement Concepts and Empirical Results, Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 19702000 and are gross flows as percentage of the total, not including trade and other credit data, which are not available.


Eight Basic FactsStocks are not the most important sources of external financing for businessesIssuing marketable debt and equity securities is not the primary way in which businesses finance their operationsIndirect finance (involves intermediaries) is many times more important than direct financeFinancial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.


Eight Basic Facts (contd)The financial system is among the most heavily regulated sectors of the economyOnly large, well-established corporations have easy access to securities markets to finance their activitiesCollateral is a prevalent feature of debt contracts for both households and businesses. -Debt is backed by some physical good (ie house). Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers-Ever read the fine print on student loans? More complex than an IOU


Transaction CostsFinancial intermediaries have evolved to reduce transaction costsEconomies of scaleTotal cost of carrying out many transactions decreases for a larger entityExpertiseMatch those wanting $, with those who have excess $


Asymmetric Information: Adverse Selection and Moral HazardAdverse selection occurs before the transaction EX: Health insuranceMoral hazard arises after the transactionEX: Bailouts of 2008-2009Agency theory analyses how asymmetric information problems affect economic behavior


The Lemons Problem: How Adverse Selection Influences Financial StructureIf quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average qualitySellers of good quality items will not want to sell at the price for average qualityThe buyer will decide not to buy at all because all that is left in the market is poor quality itemsHow do we tell which stocks/bonds are lemons and which are good investments?This problem explains fact 2 and partially explains fact 1


EX: Lemons Problem in Used Car MarketSay there are two types of used carsGood type (Peaches)Bad type (Lemons), need repairs

Also assume that buyers have full information. In other words they can perfectly tell the true type of a used car.


EX: Lemons Problem in Used Car MarketSellers are willing to acceptLemons sell for: $1,000Peaches sell for: $2,000Buyers are willing to pay$1,200 for a lemon$2,400 for a peachWith full information, there is no problem. Lemons sell for an equilibrium price between $1,000 and $1,200Peaches sell for an equilibrium price between $2,000 and $2,400


EX: Lemons Problem in Used Car MarketNow assume, only the sellers know the cars true type, buyers cant tell. But buyers know the probability that they are buying a peach or a lemon.Let there be 50 lemons and 50 peachesSo the probability of buying a lemon is 50% (PL)The probability of buying a peach is 50% (PP)


EX: Lemons Problem in Used Car MarketThus on average, what are buyers willing to pay:PL * WTPL + PP * WTPP =50%*$1,200 + 50% * $2,400 = $1,800

So buyers are only willing to pay $1,800 because they arent sure if theyre buying a lemon or a peach.

Whats the equilibrium look like?


EX: Lemons Problem in Used Car MarketSellers of peaches will only accept a price of $2,000 or moreThis is greater than the buyers willingness to pay ($1,800)No peaches are sold, sellers of peaches exit the market.Only lemons remain (buyers become aware of this) and only lemons are sold for a price between $1,000 and $1,200Thus since sellers of high quality cars (peaches) have been driven out of the market in favor of low quality cars, the market has become adversely selected


Lemons in the Stock/Bond Mkt.If we cant distinguish between high-quality- low-risk (peaches) stocks and low-quality-high-risk stocks (lemons) the same problem arises.When forming out expectations of what to pay, we may offer a price to low to good companies driving them from the market, leaving only high risk companies.


Lemons in the Stock/Bond Mkt.Likewise for bonds, due to buyers inability to detect good bonds from poor ones, they will require a high interest rate as compensationOnly those willing to pay a high interest (risky loans) will remain


Tools to Help Solve Adverse Selection ProblemsPrivate production and sale of information

Why not just hire people/firms to find out what investments are lemons and which are peaches?ex: Bond rating agencies

Free-rider problem (comes from public economics)People who dont pay for info can take advantage of info that others pay for.You buy info and purchase stock others see you buy stock, dont buy info, and also buy stock stock price rises to true value you make no profit, regret buying info agency loses money, exits market


Tools to Help Solve Adverse Selection Problems2) Government regulation to increase informationCompel firms to reveal their true qualitySEC requires firms to conduct independent audits, but these are not always done correctly (Enron scandal)Not always works to solve the adverse selection problem, The info provided isnt always enough to distinguish a firms true quality Bad firms make themselves look good, can skew their information making them seem better than they are.explains Fact 5.


Tools to Help Solve Adverse Selection Problems3) Financial intermediation Costly for individuals to acquire reliable financial information on their own, intermediaries can do a better job.Banks avoid free-rider problem my making private loans (no other agent can bid up the price of the loan)Ex: Banks can better distinguish good credit risks from bad credit risks (and earn profit by doing so). Explains facts 3, 4, & 6. (banks can better determine credit worthiness compared to individuals).


Tools to Help Solve Adverse Selection Problems4) Collateral and net worth Can back the loan with these to cushion investors if a loss occursCollateral: back the loan with a physical goodNet worth: difference between assets and liabilitiesExplains fact 7.


How Moral Hazard Affects the Choice Between Debt and Equity ContractsMoral Hazard is prevalent in equity contracts (i.e. common stock)Called the Principal-Agent ProblemPrincipal: stockholdersAgent: managerThe manger may only own a small fraction of the stock. This may give agent incentives different from those of the principals (stockholders) EX: take lavish vacations paid for by company, run up expense accounts, etc.


How Moral Hazard Affects the Choice Between Debt and Equity ContractsSeparation of ownership and control of the firmManagers pursue personal benefits and power rather than the profitability of the firmHard and costly to monitor agentsCollective action problem : There are many stockholders (principals), individually they may feel its not worth there time to monitor the agent because someone else will do it.


Tools to Help Solve the Principal-Agent ProblemMonitoring (Costly State Verification)Free-rider problem, monitoring agents is expensive (audits)Fact 1Government regulation to increase informationFact 5Financial IntermediationVenture capital firm investors usually sit on board of companyFact 3


How Moral Hazard Influences Financial Structure in Debt MarketsDebt Contracts (as opposed to stock/equity)Contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals.If the firm is profitable, the principals (lenders) get their fixed payment and dont really care if the agent is taking extra vacations etc. When a firm cannot make its debt payments, only then do lenders get involved to verify the state of the firms profits.Put agents incentives inline with principals so need to monitor is reducedFact 1


Tools to Help Solve Moral Hazard in Debt ContractsBorrowers have incentives to take on projects that are riskier than the lenders would like.This prevents the borrower from paying back the loan. Net worth and collateralIncentive compatibleMonitoring and Enforcement of Restrictive CovenantsDiscourage undesirable behaviorEncourage desirable behaviorKeep collateral valuableProvide informationFinancial IntermediationFacts 3 & 4


Summary Table 1 Asymmetric Information Problems and Tools to Solve Them


Asymmetric Information in Transition and Developing CountriesFinancial repression created by an institutional environment characterized by:Poor system of property rights (unable to use collateral efficiently)Poor legal system (difficult for lenders to enforce restrictive covenants)Weak accounting standards (less access to good information)Government intervention through directed credit programs and state owned banks (less incentive to proper channel funds to its most productive use).


Application: Financial Developmentand Economic GrowthThe financial systems in developing and transition countries face several difficulties that keep them from operating efficiently

In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, absence of corruption) functions poorly, making it hard to use these two tools effectively

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