Chapter 16 Financial System Design

16-2 Key Topics  Stockholder-lender and Manager- stockholder conflicts  Different financial structures that limit these conflicts  Compare and contrast the financial system design of Germany, Japan, the UK, and the US

16-3 Financial System  Two models of financial system in industrialized nations are:  Markets-oriented  United States and United Kingdom  Banking-oriented  Germany and Japan

16-4 Common Elements  Payments system  Processing of checks  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

16-5 Differences  Primarily related to how businesses obtain financing  The private ownership of business leads to two fundamental problems:  Stockholder-lender conflict  Management-stockholder conflict  These problems are handled differently by the financial sectors in the various systems

16-6 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 asymmetric information  Less for large companies  Large amounts of publicly available information

16-7 Manager-Stockholder Conflict  Greater with large companies  Owners (stockholders) delegate the management to professional managers (CEO)  Owners want manager to operate the firm in their best interest  maximize value of the stock

16-8 Manager-Stockholder Conflict  Unfortunately, the manager may have other objectives  Minimize their own effort  Maximize their salaries and perks  Maximize the firm’s size to increase their importance  May give up value-maximizing projects  Want to preserve their jobs  Choose excessively safe strategies  rather than strategies that may involve more risk

16-9 Manager-Stockholder Conflict  Problems  Difficult and costly to monitor performances  Difficult to know if poor outcome is due to poor performance or bad luck  Difficult to judge and prove whether an activity is in the best interest of the stockholders  Since there are often a large number of stockholders, there is no incentive for any owner to monitor the performance

16-10 Manager-Stockholder Conflict  Less problem with Small, closely held firms  Owner is often the manager, which eliminates the stockholder-manager conflict  A significant amount of stock is held by one investor  Potential gains of monitoring the performance is much greater than the costs  Major stockholder has a great incentive to monitor the manager’s performance  The owner in a closely held firm often has the power to control the firm’s board of directors and fire managers

16-11 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

16-12 Information and System Design  Conflict Resolution and Financial System Design  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

16-13 Information and System Design  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

16-14 Information and System Design  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

16-15 Information and System Design  Large firms: Stockholder-Lender Conflict  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

16-16 Information and System Design  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

16-17 Information and System Design  Large Firms: Manager-Stockholder Conflict  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

16-18 Information and System Design  Large Firms: Manager-Stockholder Conflict  Markets-Oriented Systems  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

16-19 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

16-20 Financial System Design: Summary of Four Countries  Hausbank  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

16-21 Financial System Design: Summary of Four Countries  Germany  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

16-22 Financial System Design: Summary of Four Countries  Germany  Organization of the banking system  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

16-23 Financial System Design: Summary of Four Countries  Germany  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

16-24 Financial System Design: Summary of Four Countries  Germany  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

16-25 Financial System Design: Summary of Four Countries  Germany  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

16-26 Financial System Design: Summary of Four Countries  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

16-27 Financial System Design: Summary of Four Countries  Japan  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

16-28 Financial System Design: Summary of Four Countries  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

16-29 Financial System Design: Summary of Four Countries  United Kingdom  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.

16-30 Financial System Design: Summary of Four Countries  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