1. Financial System Design
Chapter 16
Financial System Design

2. Key Topics
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. Financial System
Two models of financial system in industrialized nations are:
Markets-oriented
United States and United Kingdom
Banking-oriented
Germany and Japan

4. Common Elements Payments system Specialized Financial Intermediaries
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

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

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

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

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

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

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

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

12. 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

13. FIGURE 16.2 Financial system design: conflict resolution.

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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.

32. 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

33. Financial System Design: Summary of Four Countries (Cont.)
United States
Financial system in the United States has been extensively examined in Chapters 11-15
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

34. 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

35. FIGURE 16.3 Size of banking and stock markets (percentage of GDP), 2007.

36. 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.

37. 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

38. 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

39. Financial System Design and Conflict Resolution (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

40. 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

41. Financial System Design for Eastern Europe and other Emerging Economics
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

42. Eastern Europe and other Emerging Economics
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