Chapter 8 An Economic Analysis of Financial Structure

Learning Objectives Mishkin identifies eight basic facts about the 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.

----Indirect Finance ---- ---- Direct Finance ---- Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany, Japan, and Canada: 1970 - 2000 ----Indirect Finance ---- ---- Direct Finance ----

Basic Facts about Financial Structure Throughout the World Stocks are not the most important sources of external financing for businesses. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. (direct finance) Indirect finance is many times more important than direct finance Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. (indirect)

Basic Facts about Financial Structure Throughout the World The financial system is among the most heavily regulated sectors of the economy. Only large, well-established corporations have easy access to securities markets to finance their activities. Collateral is a prevalent feature of debt contracts for both households and businesses. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers.

Why is Indirect Finance so Important? Transactions Costs Direct finance is expensive Financial Intermediaries take advantage of economies of scale. Spread fixed legal cost over many loan contracts Expertise Information Costs

Information Costs - Asymmetric Information symmetric information—the case where all parties to a transaction or contract have the same information. However, in many situations, this is not the case. Information is not the same. We refer to this imbalance in information as asymmetric information.

Asymmetric Information: Adverse Selection and Moral Hazard Occurs when one party in a transaction has better information than the other party Occurs before transaction occurs In financial markets, potential borrowers most likely to produce adverse outcome are the ones most likely to seek loan

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 Bad quality pushes good quality from the market because of an information gap. This is known as "adverse selection”

The Classic Example - The Lemons Problem Suppose that used cars come in two types: those that are in good repair (peaches) and bad shape (lemons). The sellers know the quality of the cars. Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. If buyers had the information to tell good from bad, they could strike fair trades with the sellers, $20,000 for good car and $10,000 for the lemon.

Asymmetric Information - The Lemons Problem If buyers do not have good information and cannot tell the quality difference, there will be only one market for all used cars. buyers will pay only the average price of a good car and a lemon, or $15,000 This is below the $20,000 that good-car owners require; so they will exit the market, leaving only bad cars. Bad quality pushes good quality from the market because of an information gap, is known as "adverse selection". How does CarMax address the “adverse selection” problem?

Adverse Selection and Financial Structure Lemons Problem in Securities Markets Suppose investors cannot distinguish between good and bad securities, willing to pay only the average of the good and bad securities’ values. Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued. High expected profit and low risk Low expected profit and high risk

Tools to Help Solve Adverse Selection Problems Private production and sale of information Free-rider problem Government regulation to increase information explains Fact 5 Financial intermediation Explains facts 3, 4, & 6 Collateral and net worth Explains fact 7

Moral Hazard Occurs after transaction occurs. Occurs when one party has an incentive to behave differently once an agreement is made between parties. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that borrower will not repay the loan.

How Moral Hazard Influences Financial Structure in Debt Markets Borrowers have incentives to take on projects that are riskier than the lenders would like. Borrowers take on too much risk and may default – unable to pay back the loan.

Tools to Help Solve Moral Hazard in Debt Contracts Net worth and collateral 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