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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 16 Financial System Design.

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1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 16 Financial System Design

2 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

3 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

5 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

6 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

7 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

8 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

9 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

10 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

11 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

12 Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 16.1 Financial system design: the problems.

13 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

14 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

15 Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 16.2 Financial system design: conflict resolution.

16 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

17 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

18 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

19 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

20 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

21 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

22 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

23 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

24 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

25 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

26 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

27 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

28 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

29 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

30 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

31 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

32 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

33 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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.

34 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

35 Copyright © 2009 Pearson Addison-Wesley. All rights reserved Financial System Design: Summary of Four Countries (Cont.) United States –Financial system in the United States has been extensively examined in Chapters –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

36 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

37 Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 16.3 Size of banking and stock markets (percentage of GDP), 2007.

38 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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.

39 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

40 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

41 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

42 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

43 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

44 Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

45 Copyright © 2009 Pearson Addison-Wesley. All rights reserved TABLE 16.1 Estimated Ownership Patterns (percentage)

46 Copyright © 2009 Pearson Addison-Wesley. All rights reserved TABLE 16.2 Merger and Acquisition Activity: 2002


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