Chapter 16

Financial System Design

Learning Objectives

• Analyze the stockholder-lender and manager-stockholder conflicts• Understand the different financial structures that limit these conflicts• Compare and contrast the financial system design of Germany,

Japan, the United Kingdom, and the United States

16-2

Introduction

•As Eastern European countries adopt capitalism, they are faced with task of designing a financial system•Two models in industrialized nations are:•Markets-oriented—United States and United Kingdom• Banking-oriented—Germany and Japan

•Chapter examines/contrasts the two models•Ends with observations/recommendations for

emerging capitalistic countries

16-3

Information and System Design

• All financial systems have things in common• Payments system—processing of checks and 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

16-4

Information and System Design (Cont.)• However, there are significant differences

• Primarily related to how businesses obtain financing• The private ownership of business leads to two fundamental problems that

are handled differently by the financial sectors in the various systems• Both are based on the issue of asymmetric information• Stockholder-lender conflict• Management-stockholder conflict

16-5

Information and System Design (Cont.)• 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 these two problems is much less for large companies because

of large amounts of publicly available information

16-6

Information and System Design (Cont.)• Manager-Stockholder Conflict

• This conflict presents a much greater problem with large companies• Stockholders (owners) delegate the management to professional managers• Owners would like the manager to operate the firm in their best interest—

maximize value of the stock

16-7

Information and System Design (Cont.)• Manager-Stockholder Conflict (Cont.)

• Unfortunately, the manager may have other objectives• Minimize their own effort and maximize their salaries and perks• May want to maximize the firm’s size to increase their importance• Want to preserve their jobs which suggests choosing excessively safe strategies rather

than value-maximizing strategies that may involve more risk

16-8

Information and System Design (Cont.)• Manager-Stockholder Conflict (Cont.)

• Firing the manager is one way to resolve the differences between stockholders and managers• This requires close monitoring of their performances• Difficult to judge whether an activity is in the best interest of the stockholders• Might prove difficult and costly• Since there are often a large number of stockholders, they may be no incentive for any

individual to monitor the performance

16-9

Information and System Design (Cont.)•Manager-Stockholder Conflict (Cont.)• Small, closely held firms this conflict is less• A significant amount of stock is held by one investor• Major stockholder has a great incentive to monitor the manager’s

performance• Potential gains of monitoring the performance is much greater

than the costs• The owner in a closely held firm often has the power to control

the firm’s board of directors and fire managers• In privately held firms, the owner is often the manager--

eliminates the stockholder-manager conflict

16-10

Information and System Design (Cont.)• Conflict Resolution and Financial System Design

• Figure 16.1 summarizes the relationship between firm size and the two problems just discussed• Stockholder-lender conflict (risk-shifting problem) is significant for small

firms, but not large ones• Manager-stockholder conflict (corporation governance)—does not arise for

small firms, but exists for large firms with professional managers

16-11

FIGURE 16.1 Financial system design: the problems.

16-12

Information and System Design (Cont.)• Conflict Resolution and Financial System Design (Cont.)

• These 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

16-13

Information and System Design (Cont.)• Conflict Resolution and Financial System Design (Cont.)

• 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

• Figure 16.2 summarizes how banking-oriented systems (a) and markets-oriented systems (b) solve the stockholder-lender and manager-stockholder conflicts

16-14

FIGURE 16.2 Financial system design: conflict resolution.

16-15

Information and System Design (Cont.)•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

16-16

Information and System Design (Cont.)• 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

16-17

Information and System Design (Cont.)• Large firms: Stockholder-Lender Conflict (Cont.)• 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

16-18

Information and System Design (Cont.)• 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

16-19

Information and System Design (Cont.)• Large Firms: Manager-Stockholder Conflict (Cont.)•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

16-20

Information and System Design (Cont.)• Large Firms: Manager-Stockholder Conflict (Cont.)•Markets-Oriented Systems (Cont.)• 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

16-21

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

16-22

Financial System Design: Summary of Four Countries (Cont.)• Germany (Cont.)

• Hausbank (Cont.)• 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

16-23

Financial System Design: Summary of Four Countries (Cont.)• Germany (Cont.)

• 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

16-24

Financial System Design: Summary of Four Countries (Cont.)• Germany (Cont.)

• Organization of the banking system (Cont.)• 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

16-25

Financial System Design: Summary of Four Countries (Cont.)• Germany (Cont.)

• 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

16-26

Financial System Design: Summary of Four Countries (Cont.)• Germany (Cont.)

• 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

16-27

Financial System Design: Summary of Four Countries (Cont.)•Germany (Cont.)• 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

16-28

Financial System Design: Summary of Four Countries (Cont.)• 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

16-29

Financial System Design: Summary of Four Countries (Cont.)• Japan (Cont.)• 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

16-30

Financial System Design: Summary of Four Countries (Cont.)• Japan (Cont.)• Historically corporate debt markets have been

suppressed, further enhancing power of banks • The result is a vast majority of debt financing that comes

from the banking system• Unlike Germany, stock market is quite large, however

extensive cross ownership masks high degree of concentration of ownership• Adopted laws that separate commercial banking from

investment banking, however, this separation has been eroded

16-31

Financial System Design: Summary of Four Countries (Cont.)• 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

16-32

Financial System Design: Summary of Four Countries (Cont.)•United Kingdom (Cont.)• 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.

16-33

Financial System Design: Summary of Four Countries (Cont.)•United Kingdom (Cont.)• Banks in the United Kingdom generally do not own

nonfinancial corporations• While not explicitly prohibited, this practice is discourage by The

Bank of England to promote a safer banking system• The Bank of England supervises banks on an informal

basis, relying on the English tradition—“Old boy network” and applying moral suasion to influence the banking system

16-34

Financial System Design: Summary of Four Countries (Cont.)•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

16-35

Financial System Design and Conflict Resolution•Measure differences between banking-oriented and

markets-oriented systems• Figure 16.3 shows the size of the banking market and

stock market in each of the four countries• Banking dominates in Germany and Japan, while financial

markets dominate in the U.K. and U.S.• Large degree of ownership by banks in banking-oriented

system, much less in markets-oriented• Quantitative evidence strongly supports labeling

Germany and Japan as banking-oriented and the U.S. and U.K. as markets-oriented

16-36

FIGURE 16.3 Size of banking and stock markets (percentage of GDP), 2007.

16-37

Financial System Design and Conflict Resolution (Cont.)•Conflict Resolution in the Big Four• How is financial distress managed within the two major

orientations of the financial system•When a company is in financial distress it cannot meet its

financial obligations• For markets-oriented system, during these periods, stockholder-

bondholder (lender) conflict is extreme since owners have very little stake left in their firm and cannot agree on a strategy short of bankruptcy• In banking-oriented systems it is easier for company to deal with

conflict under protective wing of its main bank.

16-38

Financial System Design and Conflict Resolution (Cont.)•Conflict Resolution in the Big Four (Cont.)• Dealing with manager-stockholder conflict varies

between the two systems• Concentration of ownership in the banking-oriented system gives

banks a major incentive to monitor corporate management• Due to diffusion of concentration in the markets-oriented system,

little incentive for the individual stockholder to monitor performance• Predictably, there is a much larger volume of mergers and

acquisitions under the markets-oriented system

16-39

Financial System Design and Conflict Resolution (Cont.)•And the Winner is. . .• Each system has advantages and disadvantages• A few conclusions:• Banks with substantial ownership are better at solving the

stockholder-lender or management-stockholder conflict than rating agencies or individual stockholders• This requires intensive monitoring which is expensive• Stocks and bonds issued by firms in banking-oriented systems are

much less liquid because of poorly developed markets

16-40

Financial System Design and Conflict Resolution (Cont.)• And the Winner is. . . (Cont.)

• A few conclusions:• This raises the cost of raising capital in Germany and Japan• Therefore, there is a trade-off between the two systems

• Financial innovations and developments in all four countries suggest that there might be a good compromise between extremes of the two systems

16-41

Financial System Design for Eastern Europe and other Emerging Economics•An initial development in these countries was to

develop privatization programs which transforms government-owned companies into privately owned firms•Typically involve distribution of shares to major

stockholders (employees, managers, and creditors)•Privatization initially focused on small and midsize

companies

16-42

Financial System Design for Eastern Europe and other Emerging Economics (Cont.)• Privatization must occur with developments of new securities

markets—primarily equity markets• However, it is likely a banking-oriented system may make more

sense for these formerly planned economies that are accustomed to strict governmental control

16-43

Financial System Design for Eastern Europe and other Emerging Economics (Cont.)

• At present, Eastern Europe can be regarded as an information-poor environment, with little public information about large firms• Rating agencies do not exist• Reputation building is extremely difficult• Lack of managerial talent and experience suggests that monitoring will be

especially critical

• All these factors indicate that a banking-oriented system may be more suitable

16-44

TABLE 16.1 Estimated Ownership Patterns (percentage)

16-45

TABLE 16.2 Merger and Acquisition Activity: 2002

16-46