An Economic Analysis of

Financial Structure

Financial Markets
Week 7

Copyright © 2019 Pearson Education, Ltd.

Preview

• A healthy and vibrant economy requires a financial

system that moves funds from people who save to
people who have productive investment
opportunities.
Learning Objectives

• Identify eight basic facts about the global financial system.

• Summarize how transaction costs affect financial
intermediaries.
• Describe why asymmetric information leads to adverse
selection and moral hazard.
• Recognize adverse selection and summarize the ways in
which they can be reduced.
• Recognize the principal-agent problem arising from moral
hazard in equity contracts and summarize the methods for
reducing it.
• Summarize the methods used to reduce moral hazard in
debt contracts.
Basic Facts About Financial Structure
Throughout the World (1 of 3)

• This 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 1970–2000 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 Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Re
sults,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 a
nd are gross flows as percentage of the total, not including trade and other credit data, which are not available.
Basic Facts About Financial Structure
Throughout the World (2 of 3)

1. Stocks are not the most important sources 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 is many times more important than

direct finance

4. Financial intermediaries, particularly banks, are the most

important source of external funds used to finance
businesses.
Basic Facts About Financial Structure
Throughout the World (3 of 3)

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 markets to finance their activities.

7. Collateral is a prevalent feature of debt contracts for both

households and businesses.

8. Debt contracts are extremely complicated legal

documents that place substantial restrictive covenants on
borrowers.
Transaction Costs

• Financial intermediaries have evolved to reduce

transaction costs.
– Economies of scale
– Expertise
Asymmetric Information: Adverse Selection
and Moral Hazard

• Adverse selection occurs before a transaction occurs.

• Moral hazard arises after the transaction has developed.

• Agency theory analyses how asymmetric information

problems affect economic behavior.
The Lemons Problem: How Adverse
Selection Influences Financial Structure

• If quality cannot be assessed, the buyer is willing to pay

at most a price that reflects the average quality.

• Sellers of good quality items will not want to sell at the

price for average quality.

• The buyer will decide not to buy at all because all that is
left in the market is poor quality items.

• This problem explains fact 2 and partially explains fact 1.

Tools to Help Solve Adverse Selection
Problems

• Private production and sale of information

– Free-rider problem

• Government regulation to increase information

– Not always works to solve the adverse selection
problem, explains Fact 5

• Financial intermediation
– Explains facts 3, 4, & 6

• Collateral and net worth

– Explains fact 7
The Enron Implosion

• Enron Corporation declared bankruptcy in December

2001, up to that point the largest bankruptcy declaration
in U.S. history

• The Enron collapse illustrates that government regulation

can lessen asymmetric information problems but cannot
eliminate them. The Enron bankruptcy not only increased
concerns in financial markets about the quality of
accounting information supplied by corporations but also
led to hardship for many of the firm’s former employees,
who found that their pensions had become worthless
How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

• Called the Principal-Agent Problem:

– Principal: less information (stockholder)
– Agent: more information (manager)

• Separation of ownership and control of the firm

– Managers pursue personal benefits and power rather
than the profitability of the firm.
Tools to Help Solve the Principal-Agent
Problem

• Monitoring (Costly State Verification)

– Free-rider problem
– Fact 1

• Government regulation to increase information

– Fact 5

• Financial Intermediation
– Fact 3

• Debt Contracts
– Fact 1
How Moral Hazard Influences Financial
Structure in Debt Markets

• Borrowers have incentives to take on projects that are

riskier than the lenders would like.
– This prevents the borrower from paying back the loan.
Tools to Help Solve Moral Hazard in
Debt Contracts

• Net worth and collateral

– Incentive compatible

• Monitoring and enforcement of restrictive covenants

– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information

• Financial intermediation
– Facts 3 & 4
Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them (1 of 2)

Asymmetric Information Tools to Solve It Explains Fact

Problem Number
Adverse selection Private production and sale of 1, 2
information
Blank Government regulation to increase 5
information
Blank Financial intermediation 3, 4, 6
Blank Collateral and net worth 7
Moral hazard in equity Production of information: monitoring 1
contracts (principal–agent
problem)
Blank Government regulation to increase 5
information
Blank Financial intermediation 3
Blank Debt contracts 1
Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them (2 of 2)

Asymmetric Information Tools to Solve It Explains Fact

Problem Number
Moral hazard in debt Collateral and net worth 6, 7
contracts
Blank Monitoring and enforcement of 8
restrictive covenants
Blank Financial intermediation 3, 4

Note: List of facts:

1. Stocks are not the most important source of external financing.
2. Marketable securities are not the primary source of financing.
3. Indirect finance is more important than direct finance.
4. Banks are the most important source of external funds.
5. The financial system is heavily regulated.
6. Only large, well-established firms have access to securities markets.
7. Collateral is prevalent in debt contracts.
8. Debt contracts have numerous restrictive covenants.
Application: Financial Development and
Economic Growth (1 of 2)

• Financial repression created by an institutional

environment is 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 Development and
Economic Growth (2 of 2)

• The 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.
The Tyranny of Collateral

• To use property, such as land or capital, as collateral, a

person must legally own it. Unfortunately, it is extremely
expensive and time-consuming for the poor in
developing countries to make their ownership of
property legal.

• When the financial system is unable to use collateral

effectively, the adverse selection problem worsens
because the lender needs even more information about
the quality of the borrower in order to distinguish a
good loan from a bad one. Little lending will take place,
especially in transactions that involve collateral, such as
mortgages.
Application: Is China a Counterexample to
the Importance of Financial Development?

• As China gets richer, the strategy of maintaining a high

savings rate to support economic growth is unlikely to
continue to work. China will need to allocate its capital
more efficiently, which requires that it improve its
financial system. The Chinese leadership is well aware of
this challenge; the government has announced that
state-owned banks are being put on the path to
privatization.
Thank You