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Chapter 8: An Economic Analysis of Financial Structure

I. Basic Facts about the Financial Structure Throughout the World a. Sources of External Funds i. Bank loans made up primarily of loans from depository institutions. ii. Non-bank loans primarily loans by other financial intermediaries. iii. Bonds marketable debt securities, such as corporate bonds and commercial paper. iv. Stock new issues of new equity b. Stocks are not the most important source of external financing for businesses. i. Bonds are more important part of financing than stocks c. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. d. 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. e. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. f. The financial system is among the most heavily regulated sectors of the economy. g. Only large, well-established corporations have easy access to securities markets to finance their activities. h. Collateral is a prevalent feature of debt contracts for both households and businesses i. Collateral: property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. 1. Secured debt vs. Unsecured debt i. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. i. Restrictive covenants Transaction costs a. Economies of Scale i. The reduction in transaction costs per dollar of investment as the size of the transactions increases. ii. Mutual fund financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. 1. Diversified portfolios b. Expertise i. Financial intermediaries are also better able to develop expertise to lower transaction costs. ii. Ability to provide costumers with liquidity services easier for customers to conduct transactions.

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Asymmetric Information: Adverse Selection and Moral Hazard a. Adverse selection i. Before the transaction ii. Potential band credit risks are the ones who most actively seek out loans b. Moral hazard i. After the transaction occurs ii. The lender runs the risk that the borrower will engage in activities that are undesirable form the lenders point of view because they make it less likely that the loan will be paid back. c. Agency theory: the analysis of how asymmetric information problems affect economic behavior. The Lemons Problem: How Adverse Selection Influence Financial Structure a. George Akerlof lemons in used car market i. Price must reflect the average quality of the cars in the market ii. Adverse Selection b. Lemons problem arises in the securities market c. Explains why marketable securities are not the primary source of financing for businesses in any country in the world. Also why stocks are not the most important source of financing for American businesses. d. Tools to help solve adverse selection problems i. Private Production and Sale of Information 1. Private companies collect and produce information that distinguishes good from bad firms and then sell it. a. Standard and Poors, Moodys, and Value Line 2. Free-rider problem: when people who do not pay for information take advantage of the information that other people have paid for. a. Prevents the market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. ii. Government Regulation to Increase Information 1. Government could produce information for the public and make it free. 2. Also could regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are a. SEC iii. Financial Intermediation 1. Financial intermediaries become experts in producing information about firms so that it can sort out good credit risk from bad ones 2. Avoids free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. 3. The larger and more established a corporation is, the more likely it will be to issue securities to raise funds. iv. Collateral and Net Worth

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1. Reduces the consequences of adverse selection because it reduces the lenders losses in the event of a default 2. Net worth (equity capital): the difference between a firms assets (what it owns or is owed) and its liabilities (what it owes). How Moral Hazard Affects the Choice Between Debt and Equity Contracts a. Equity contracts (common stock) claims to a share in the profits and assets of a business. i. Principal-agent problem: the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do. b. Preventing the Principal-agent Problem i. Production of Information Monitoring 1. Auditing the firm frequently and checking on what the management is doing. a. Costly state verification makes the equity contract less desirable, and explains why equity is not a more important element in our financial structure. ii. Government Regulation to Increase Information iii. Financial Intermediation 1. Venture capital firm: firms that pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses. a. Firm receives an equity share in the new business. b. Equity in the firm is not marketable to anyone except the venture capital firm. iv. Debt contracts 1. It is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. How Moral Hazard Influences Financial Structure in Debt Markets a. Solving Moral Hazard in Debt Contracts i. Net Worth and Collateral 1. If borrowers have more skin in the game because they have higher net worth or pledge collateral, they are likely to take less risk at the lenders expense. 2. Incentive-compatible: it aligns the incentives of the borrower with those of the lender. 3. The greater the borrowers net worth and collateral pledged, the greater the borrowers incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract. ii. Monitoring and Enforcement of Restrictive Covenants 1. Four types of restrictive covenants: a. Covenants to discourage undesirable behavior b. Covenants to encourage desirable behavior

c. Covenants to keep collateral valuable d. Covenants to provide information iii. Financial Intermediation 1. Make private loans not traded so that no one else can free-ride on the intermediarys monitoring and enforcement of the restrictive covenants.