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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