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Chapter 8 Notes
(expanded by R. Ledesma from the publisher’s PPT slides)

An Economic Analysis of Financial Structure

Basic Facts about Financial Structure Throughout the World
• This chapter provides an economic analysis of how the U.S. financial structure is
designed to promote economic efficiency and how it may compare with that of the Philippines.

• The bar chart in Fig. 1 below shows how American businesses financed their activities using external funds
(those obtained from outside the business itself) in the period 1970–2000 and compares U.S. data to those of
Germany, Japan, and Canada. The Bank Loans category are made up mostly of loans from depository
institutions. Stocks consist of new issues of new equity.

Fig. 1

Eight Basic Facts

Fact (i) Stocks are not the most important source of external financing for U.S. businesses; the stock mkt.
accounts for only a small fraction of external financing. This also true for Philippine businesses where only a
few companies are able to issue stocks, much less bonds.
Fact (ii) Issuing marketable debt (bonds) and equity (stock) securities is not the primary way in which
businesses finance their operations (bonds are far more important as a source of financing than stocks⎯32 %
vs. 11 %). Stocks and bonds combined (43 %) supply less than half of the external funds of U.S. corporations.
(Corporate bonds in the Philippines are less than 10 % of GDP.)

Fact (iii) Indirect finance (involving financial intermediaries) is many times more important than direct
finance (involving the sale of marketable securities like stocks and bonds to households)

Fact (iv) Financial intermediaries, particularly banks, are the most important source of external funds used to
finance businesses (in industrialized countries, but even more so in developing countries).

Fact (v) The financial system is among the most heavily regulated sectors of the economy (governments
regulate financial markets to promote the provision of information and to ensure the soundness, i.e., stability, of
the financial system).

Fact (vi) Only large, well-established corporations have easy access to securities (stocks and bonds) markets to
finance their activities (individuals and smaller businesses that are not well-established don’t have it easy).
Why?

Fact (vii) Collateral (property that is pledged to a lender to guarantee payment in case the borrower is unable to
make debt payments) is a prevalent feature of debt contracts for both households and businesses. Secured debt
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or loans (i.e., collateralized debt) is the predominant form of household debt (or loan) in the U.S. Examples?
Car loans, home loans or mortgages. A credit card is an example of unsecured debt (i.e., debt that is not
collateralized).

Fact (viii) Debt contracts are extremely complicated legal documents that place substantial restrictive
covenants (or restrictions) on borrowers. E.g., when you take out an automobile loan, what could be one
restrictive covenant? You have to have car insurance. E.g., when you take out a home mortgage, what could be
a restrictive covenant? One is that maybe you cannot operate a business in your house or receive clients or build
a 5-story house.
Transaction Costs
Financial intermediaries have evolved to reduce transaction costs via economies of scale and the
development of expertise in financial transactions.
If you’re a small-time American investor, say, with $5,000 to invest in the stock market, you may not be able
to buy a lot of shares because commission costs from stock brokerage companies might eat up most of your
investments. With a limited number of shares, your portfolio is undiversified. On the other hand, if you decide
to buy a bond, your $5,000 might not be enough to buy some bonds whose smallest denomination is $10,000.
In both cases, transactions costs are too high for you. And so you are not able to participate in the stock and
bond markets. But you’re not alone.
How Financial Intermediaries Reduce Transaction Costs
(i) Economies of scale
By bundling investors’ funds together, financial intermediaries (like a mutual fund) can reduce transaction
costs for each individual investor through economies of scale (= the reduction in transaction costs per dollar of
investment as the size or scale of transactions increases).
A mutual fund pools together investors’ funds and then invests in stocks or bonds. Because mutual funds buy
big blocks of stocks or bonds, they are charged lower (discounted) commissions than small, individual investors
buying through a brokerage firm. These cost savings are then passed on to the individual investor. Another
benefit of a mutual fund is that, because of its size (or large pool of money), it is able to buy a diversified
portfolio of securities.
(ii) Expertise
Financial intermediaries have developed expertise in the use of computer technology that make it convenient
for customers to check how their investments are doing and write checks on their accounts. Also, because of the
financial intermediary’s low transaction costs, it is able to provide liquidity services that make it easy for its
customers to conduct transactions.

Asymmetric Information: Adverse Selection and Moral Hazard

Asymmetric Information = when one party in a transaction has more information than another so that this
other party makes an inaccurate decision in conducting the transaction. The presence of asymmetric information
leads to adverse selection (before the transaction) and moral hazard (after the transaction) problems in financial
markets.
E.g., adverse selection creates a situation wherein potential bad credit risks (who are most likely to default,
an undesirable/adverse outcome) are the ones who would most actively seek out loans from a bank. Because
this increases the likelihood that a loan might be made to a bad credit risk, lenders or banks might decide not to
make any loans (withdraw from the market) even though there are also good credit risks in the marketplace.
E.g., in moral hazard, once borrowers have obtained the loan, they may take on big risks (which could lead
to default and the loan goes unpaid) because maybe they think they’re playing with someone else’s money. This
increases the likelihood of the loan not being repaid and so lenders may decide not to make the loan at all.
Agency theory = the analysis of how asymmetric information problems affect economic behavior.
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The Lemons Problem:

In a used car market, a potential car buyer knows less about the value of a car than does the car owner trying
to sell it. Thus, the potential car buyer is likely to pay at most a price that reflects the average quality of the cars
in the market, somewhere between the low value of a lemon (a bad car that will cause a lot of repair problems)
and the high value of a good car.
On the other hand, the car owner knows whether the car is a peach (a good car) or a lemon (a bad car). If the
car is a lemon, the car owner would be happy to receive a price the buyer is willing to pay (which would be
greater than the lemon’s value). But if the car is a peach, the owner knows that the price the buyer is willing to
pay undervalues the car, and so he/she may not want to sell the car.
As a result of this adverse selection, few good used cars will come to the market (the owner of the good car
will withdraw from the market). And because the average quality of a used car available in the mkt. will be low,
and because few people want to buy a lemon, they’ll stay away from the market and so there will be few sales.
Hence, the used-car market will poorly function.
When you apply the above situation to the stock and bond markets, then it explains Fact (ii)⎯why
marketable securities (like bonds and stocks) is not the primary source of financing for businesses in any
country in the world⎯and partially explains Fact (i)⎯why stocks are not the most important source of
financing for American businesses (or Philippine businesses for that matter).
The (Used Car) Lemons Market: An Illustration
(Created from scratch by Rudy Ledesma using Word and a mouse)

Scene I: The Offer

Hey, Buddy. Looking for a
Used car buyer Used car seller used car? Step right up.
You won’t find a better one
than my used car here.

1. Who do you think knows more about the used car he owns that he’s now selling, the used car seller or the potential used car buyer?
______________ (the repair history of the car, whether it’s been flooded or not, whether it’s been in an accident or not, etc.)

2. What would you call this case where both parties possess unequal amounts of information (i.e., one knows more than the other)?
___________________________ (2 words; Hint: if both possess the same or equal amounts of information, it’s a case of symmetric information)

Scene II: Huh? I’d like to buy your My car is a good used car,
car for 300K*. Used car seller a peach, not a lemon. It’s
Used car buyer worth 400K. This bum is
lowballing me with only
300K. No way, José.

*The used car buyer cannot tell a good car (a peach) from a bad car (a lemon). So he offers to buy at a price (300K pesos) that reflects
the average quality of used cars⎯between 200K pesos for a lemon and 400K pesos for a peach.

3. What do you think will the used car seller do now⎯stay in the market and try to find another used car buyer or get out knowing
he’ll meet the same type of used car buyer everywhere he turns? ____________________________________________________
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Adios, Amigo. See

you next year.
Scene III: The Unoffer Hey, where are
Used car buyer
you going?
315K, last offer. Used car seller

4. Conclusion: Will there now be many or fewer good used cars in the market as a result? ____________
5. Will the used car market function properly as a result (i.e., channel good used cars to those wanting to buy them) or not? _______
6. Application: Apply the principle of the lemons market above to the stock and bond markets in any country in the world. Why are
the stock and bond markets not effective in channeling funds from savers to borrowers (direct finance)? Why is indirect finance
(through a financial intermediary) more important? __________________________________________________________________

Answers:
1. The used car seller. He owns the used car so he knows more about it (repair history, etc.) than the potential
used car buyer.
2. Asymmetric information.
3. The used car seller will withdraw from the market because he believes he has a good used car that’s worth
more than the lowball offer of the potential used car buyer.
4. As a result, there will be fewer good used cars in the market. Other used car sellers selling peaches will also
withdraw.
5. As a result, the used car market will not function properly in terms of channeling good used cars to those
wanting to buy them.
6. In the presence of the lemons problem, a potential buyer of stocks or bonds will not likely be able to
distinguish good firms (those with high expected profits and low risk) from bad firms (those with low expected
profits and high risk) so they will offer to pay for these securities a price that reflects the average quality of
good and bad firms (essentially undervaluing the securities of good firms and overvaluing those of the bad
firms). Hence, the good firms will not want to participate in this market.

The Lemons Problem in the Stock and Bond Markets

The presence of the lemons problem keeps securities markets such as stocks and bonds from being effective
in channeling funds from savers to borrowers (hence, economic efficiency suffers).
A potential buyer of stocks would not be able to tell good firms from bad ones. And so he/she will likely pay
at most a price that reflects the average quality of firms issuing stocks⎯a price between the value of securities
from bad firms and the value of those from good firms.
If the owners or managers of good firms have better information and know they have a good firm, they would
also know that the price a potential investor will pay would undervalue the firm’s stock. So they would not want
to sell to the investor. Only the managers or owners of bad firms would want to sell (issue their stocks) because
the price the investor is willing to pay is higher than the securities are worth (their valuation of their stock is
lower than the offer price so they’ll take the offer price of the investor).
The potential investor is not stupid and would know this so he/she will not likely participate in the
marketplace (i.e., not buy securities/withdraw). Also, few firms will sell securities in the marketplace to raise
capital or obtain external financing.
The same principle applies in the bond market. The potential investor will likely buy a bond if its interest rate
compensates him/her for the average default risk of the good and bad firms selling the bonds.
The better-informed owners of the good firm realize that they will be paying a higher interest rate than they
should (the cost of borrowing is higher with undervalued securities/bonds---remember the inverse relationship
between the price of the bond and its yield or interest rate?).
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So they won’t be borrowing (issuing bonds) in this market. Because they’ll stay away from the market, only
the bonds from bad firms will likely be selling in this market. Knowing this, potential bond buyers will also stay
away from this market, resulting in few bond sales and this market not becoming a good source of financing for
firms.
Tools to Help Solve Adverse Selection Problems
In the absence of asymmetric information, the lemons problem goes away. If car buyers know as much as
sellers (have the same or as much information) about the quality of used cars (enabling them to tell a good car
from a bad one), then they’d be willing to pay full value for a good used car. And if sellers (or car owners) can
get a fair price for their good used cars, then they’d be willing to sell them in the market. Then the market will
have many transactions/sales and will do a good job of channeling good cars to people who want them
(economic efficiency is achieved).
In the same manner in the securities market, if securities buyers can tell between a good firm from a bad one,
they’d be willing to pay full value for the securities that good firms are issuing. And because good firms will
now want to sell their securities in the marketplace as a result, the securities market will be able to do its
intended function of moving funds to the good firms that have the most productive investment opportunities.
Private Production and Sale of Information
Asymmetric information is reduced when people wanting to buy securities (savers) are provided detailed
information about the firms selling those securities (borrowers) so these potential buyers can tell the good firms
from the bad ones. In the U.S., there are private firms that supply this kind of information⎯Standard & Poor’s,
Moody’s, and Value Line⎯for a fee. Subscribers to this kind of service (the private sale of information) include
not only individuals but also libraries and other financial intermediaries involved in buying securities.
But there is a downside to all this⎯the free-rider problem. The free-rider problem happens when people
who do not pay for the information take advantage of the information that other people have paid for.
Say, for e.g., you are an individual investor wanting to buy securities so you subscribe to one of these private
information services (say, Moody’s) to acquire information about good (likely undervalued) and bad firms
issuing stocks or bonds. You believe that you can more than make up for the cost of the subscription services
from the profit you expect to get from buying an undervalued security.
But, after you start buying securities, another investor who does not subscribe to these information-providing
services somehow is able to “copy” or piggy back on your investments. If many other investors also “copy”
your investment strategy, they will bid up the price of the undervalued securities to the point that any profit you
expect to get from buying then selling them them will not amount to much. It might discourage you from
subscribing to such information services provider and other good-faith investors like you might also come to the
same conclusion. With few subscriptions, the outcome might be that these information-providing services might
altogether stop producing and selling such information because they won’t be profitable enough to do so. In
their absence (with less information available to investors), adverse selection will interfere in the financial
market once more.

Govt. Regulation to Increase Information

The free-rider problem prevents private information services firms from producing enough information to
eliminate all of the asymmetric information that leads to adverse selection that leads to economic inefficiency.
One solution to the problem is for the government (and this is being done in the U.S. and other countries
including the Philippines) to regulate the securities market in such a way that encourages firms to reveal honest
information about themselves so that potential investors can make a decision on how good or bad they are. For
example, the SEC (Securities and Exchange Commission) is the govt. agency in the U.S. (and the Philippines)
that requires firms selling securities to have independent audits (in which accounting firms certify that a firm is
adhering to standard accounting principles and disclosing accurate information about sales, assets and
earnings)⎯a disclosure requirement.
Disclosure requirements help to reduce the adverse selection problem, which interferes with the efficient
functioning of securities (stock and bond) markets, but does not eliminate it. Even when firms are required to
disclose information on sales, assets and earnings, their owners or managers still have more information than
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investors. Also, bad firms have an incentive to make themselves look like good firms so they can fetch a higher
price for their security.

Financial Intermediation
In the used-car market, car buyers usually actually buy from car dealers (an intermediary to whom car owners
sell their cars) rather than directly from individual car sellers or owners. Car dealers produce information in the
market by becoming experts (they have experienced mechanics and modern diagnostic tools) in determining
whether a car is a peach or lemon and they share this information only with potential car buyers (hence, it is
private information not available to just about everyone).
Knowing that a car is good, a car dealer can give an implicit guarantee of the car he’s selling (say, a
warranty, in which he stands by his reputation for honesty). And people are more likely to buy a car from a
dealer because of his guarantee. If car dealers are able to resell cars by producing private information about
their quality, then they avoid the free-rider problem. Financial intermediaries in the financial marketplace play
the same role as used car dealers⎯they solve the adverse selection problem.

A financial intermediary like a bank becomes an expert in producing private information (it has an army of
analysts) about companies or individual borrowers to be able to sort out good credit risks from bad ones. It
acquires funds from depositors and then turns around to lend the money to mostly good borrowers at a higher
rate than what it pays depositors. The resulting profit gives the bank an incentive to engage in this information
production activity.
Note that these loans are private loans (which are not traded in the open market) so there is no free-rider
problem and the bank helps reduce the asymmetric information problem.
Thus financial intermediaries (particularly banks) could be expected to play a greater role in moving funds to
business firms than securities issuers do (Fact (iii) and Fact (iv))⎯why indirect finance is so much more
important than direct finance and why banks are the most important source of external financing for businesses.
In developing countries banks take on greater importance because information about private firms there are
harder to collect (than in industrialized countries), leading to a smaller role for securities markets. As
information about firms becomes easier to acquire, the role of banks should decline.
Why large firms are more likely to obtain funds from securities markets (a direct route) rather than from
banks and financial intermediaries (an indirect route) is because more information is available about them in the
marketplace (primarily because they’re a big company, and because they’re big they’re also better known,
analyzed/written about more). This explains Fact (vi). Investors worry less about adverse selection when it
comes to well-known corporations so they would be willing to directly buy their securities (invest in them).
Thus, the larger and more established a corporation is, the more likely it is to issue securities to raise funds.

Collateral and Net Worth

Collateral reduces the consequences of adverse selection because it reduces the lender’s losses in case of
default by the borrower. The lender can seize the collateral after the borrower defaults and sell it to use the
proceeds to make up for the losses on the loan. In the case of a mortgage, what’s the collateral? The house. In
the case of a car loan? The car. In the case of a boat loan? You get the drift.
Thus, lenders are more willing to make a loan if the loan is secured by a collateral. Borrowers may also be
more willing to borrow if they think the lender can give them a lower/better interest rate on the loan secured by
a collateral. Thus, the presence of adverse selection in credit markets explains why collateral is an important
feature of debt contracts (Fact (vii)).
Net worth (also called equity capital, the difference between a firm’s assets (what it owns) and its liabilities
(what it owes)) can play a role similar to that of a collateral. A high net worth for the firm means it is less likely
to default on its debt payment because it has a cushion of assets that it can sell to pay off debt.
Even if a high-net worth firm defaults, the lender can take title to (ownership of) the firm’s net worth, sell it
off, and use the proceeds from the sale to recoup some its losses from the loan.
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Moral Hazard in Equity Contracts: The Principal-Agent Problem

Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt (bonds)
rather than equity (stock) contracts. The principal-agent problem is a type of moral hazard that arises because
of the separation of ownership from the control of the firm.
Stockholders, who own most of the firm’s equity, are called the principals while the (professional) managers,
who own only a small fraction of the firm but who run or control the firm, are the agents of the owners
(stockholders).
The problem comes up because the agents (after they’ve been hired by the owners) might act in their own
interest and not in the best interest of the principals (owners or stockholders) maybe because the managers have
less incentives to maximize the profits (or value) of the firm than do the owners. E.g., managers might simply
be motivated in enhancing their personal power within the company or in benefitting themselves personally (by,
say, hiring their relatives) even though these do not increase the profitability of the firm. The principal-agent
problem happens because the owners have less information about what managers do (and about actual profits)
and could not prevent fraud or wasteful expenditures. The principal-agent problem would also not arise if the
managers were also the owners of the firm in which case ownership and control are not separate.

Tools to Help Solve the Principal-Agent Problem

Production of Information: Monitoring
To help reduce the moral hazard problem, managers can engage in a type of information production like
monitoring the firm’s activities---auditing the firm frequently and checking on what management is doing
(which can be expensive as known by its name costly state verification). (“state” means status) Costly state
verification makes equity contracts less desirable, and explains in part why equity (stock) is not a more
important source of external financing.
The free-rider problem, in decreasing monitoring, decreases the amount of private information production
that could help reduce the moral hazard (principal-agent) problem. Other investors can free ride (and save
money) on the monitoring activities of others and could discourage their monitoring activities.
Govt. Regulation to Increase Information
As with adverse selection, the govt. tries to reduce the moral hazard problem created by asymmetric
information by regulating the financial system⎯passing laws to make firms adhere to standard accounting
principles (and make profit verification easier) and with stiff penalties for fraudulent activities.
Financial Intermediation
A venture capital firm is one type of financial intermediary that helps reduce the moral hazard arising from
the principal-agent problem. Venture capital firms pool the resources (funds) of their partners/clients and use
(invest) these funds to help budding entrepreneurs start new businesses, and in exchange it receives an equity
share in the new business.
Because verification of earnings and profits is so important in eliminating moral hazard, venture capital firms
usually insist on having several of their own people participate as members of the managing body of the
firm⎯the board of directors⎯so that they can keep a close watch on the firm’s activities.
When a venture capital firm supplies start-up funds, the equity in the firm is not marketable to anyone except
the venture capital firm. This way, other investors cannot free ride on the venture capital firm’s verification
activities and so it is able to reduce the moral hazard problem.
Debt Contracts
If a debt contract can be structured so that moral hazard would exist only under certain situations, the need to
monitor managers would be reduced, and the debt contract would be more attractive than an equity contract.
The debt contract (say, for a bond) has exactly these attributes because it is a contractual agreement by the
borrower to pay the lender fixed dollar amounts at periodic intervals (the coupon payments).
As long as the lender receives the regular contractual payments, the borrower does not need to know if the
firm is profitable. Or, even if its managers are hiding profits, as long as the managers’ activities are not
interfering with the ability of the firm to meet its debt payments on time, there is no need for monitoring.
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But once the firm is not able to meet its debt payments (the firm is in a state of default), then the monitoring
kicks in. That’s when the lender needs to verify the state of the firm’s profits (i.e., acting more like an equity
holder). Thus, this is why debt contracts are used more frequently than equity contracts to raise capital (external
financing).

Net Worth and Collateral

When borrowers have more at stake because their net worth is high or the collateral they have pledged is
valuable, the risk of moral hazard is greatly reduced because the borrowers themselves have a lot to lose. Put
differently, they are likely to take less risk at the lender’s expense. The debt contract is said to be incentive
compatible when it aligns the incentives of the borrower with those of the lender.
Thus, the greater the borrower’s net worth and collateral pledged, then 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 the easier it is for the firm or household to borrow, increasing the efficiency of moving funds from savers to
borrowers.

Tools to Help Solve Moral Hazard in Debt Contracts

Monitoring and Enforcement of Restrictive Covenants
Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable (risky) behavior
or by encouraging desirable behavior. Four types of restrictive covenants:
1. Covenants to discourage undesirable behavior
Some covenants require that a loan be used only to finance specific activities such as buying a particular
equipment or inventories. Others restrict the borrowing firm from engaging in certain risky businesses such as
buying other businesses out of line with the firm’s core underlying business. For example, the firm might be
restricted to merging only with another business that is synergistic with it (one that creates value).
2. Covenants to encourage desirable behavior
One restrictive covenant of this type (say, in the case of a home loan) may require the breadwinner of the
household to carry life insurance that pays off the mortgage upon the borrower’s death. For businesses, a
covenant might encourage the borrowing firm to keep its net worth high because higher borrower net worth
reduces moral hazard and makes it less likely that the lender will suffer losses.
3. Covenants to keep collateral valuable
Collateral serves as a protector for the lender so a covenant of this type might encourage the borrower to keep
the collateral in good condition and make sure it stays in the possession of the borrower (not stolen).
Automobile loan contracts can require the car owner to have theft and collision insurance and prevent the sale
of the car unless the loan is paid off. Home mortgage holders must have adequate insurance on the home.
4. Covenants to provide information
Restrictive covenants also require a borrowing firm to periodically provide information about its activities in the
form of quarterly accounting and income reports, making it easier for the lender to monitor the firm and reduce
moral hazard. This type of covenant might also stipulate that the lender has the right to audit and inspect the
firm’s books any time.

Financial Intermediation
Restrictive covenants help reduce the moral hazard problem but they do not eliminate it completely. It is (i)
almost impossible to write covenants that rule out every risky activity. Also, (ii) borrowers may be clever
enough to find loopholes in restrictive covenants that make them ineffective. Another problem with restrictive
covenants is that (iii) they must be monitored and enforced (which can be costly), and the free-rider problem
arises in the debt securities market as it does in the stock market.
Financial intermediaries⎯particularly banks⎯have the ability to avoid the free-rider problem as long as they
make primarily private loans. Private loans are not traded so no one else can free ride on their monitoring and
enforcement of restrictive covenants. The intermediary making the private loan receives the benefits of
monitoring and enforcement and will do its best to reduce the moral hazard problem inherent in debt contracts.
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Financial Development and Economic Growth

Developing and transition countries (ex-communist countries like Russia) face suffer from financial
repression (in that their financial system are underdeveloped) and so do not operate efficiently, leading to low
economic growth and slow development.
The earlier discussions have shown that the two important tools used to help solve adverse selection and
moral hazard problems in credit markets are (i) collateral and (ii) restrictive covenants. In many developing
countries, these two tools are difficult to use effectively because the system of property rights (the rule of law,
constraints on govt. expropriation or spending, absence of corruption) function poorly.
In many developing countries, creditors (lenders) must first (i) sue the defaulting debtor for payment (which
can take years to get a judgment), then (ii) sue again to obtain title to a collateral. By the time the collateral is
acquired, it might well have been neglected and, thus, have little value.
In some cases, (iii) govt. block lenders from foreclosing on borrowers in politically powerful sectors like
agriculture. Where the market is unable to use collateral effectively, the adverse selection problem worsens and
it becomes harder for lenders to channel funds to borrowers with the most productive investment opportunities,
hence, a slow-growing economy.
A poorly developed or corrupt legal system may make it difficult for lenders to enforce restrictive covenants.
With limited ability to reduce moral hazard on the part of borrowers, lenders would be less willing to lend,
slowing growth in the economy.