1. Chapter 8 An Economic Analysis of Financial Structure Dr. Mohammed Alwosabi

2.  One of the main requirements for a healthy economy is an efficient financial system that channel funds from savers to investors.  This chapter provides an economic analysis of how financial structure is designed to promote economic efficiency.

3. BASIC FACTS ABOUT FINANCIAL STRUCTURE: 1. Stocks are not the most important source 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, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

4. 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 market to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.

5. TRANSACTION COSTS  Transaction costs are a major problem in financial markets.  Transaction costs are too high for ordinary people.  Financial intermediaries help in reducing transaction costs and allow small savers and borrowers to benefit from the existence of financial markets.  One solution to the problem of high transaction costs is to package the funds of many investors together so that they can take advantage of economies of scale.

6.  Economies of scale refer to the reduction in transaction costs per unit of the amount invested as the size (scale) of transaction increases.  The presence of economies of scale in financial markets helps explain why financial intermediaries developed and have become such an important part of financial structure.

7.  An additional benefit of the presence of economies of scale in an investment means that the investment is large enough to purchase a widely diversified portfolio of securities.  The increased diversification for individual investors reduces their risk, making them better off.  Financial intermediaries are also better able to develop expertise to lower transaction costs.  Another important outcome of a financial intermediary’s low transaction costs is the ability to provide its customers with liquidity services that make it easier to conduct transactions.

8. ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL HAZARD  Asymmetric information is a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decision when conducting the transaction.  The analysis of how asymmetric information problems affect economic behavior is called agency theory.  The presence of asymmetric information leads to adverse selection and moral hazard problems.

9. How Adverse Selection Influences Financial Structure  Because of asymmetric information problem of adverse selection the potential buyer of stocks or bonds can’t distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk.  In this situation, in equity market,  The potential buyer will be willing to pay only a price that reflects the average quality of firms issuing securities– a price that lies between the value of securities from bad firms and the value of those from good firms.

10.  If the owners or managers of a good firm have better information that they are sure they have a good firm they will not accept the undervalued price that is offered by the potential buyer.  The only firms willing to sell at the price offered will be bad firms because the price offered is higher than the securities are worth.  But the potential buyer is not sure of the securities and, hence, he will decide not to spend that much money on securities.  Therefore, this securities market will not work very well because few firms will sell securities in it to raise capital.

11.  The analysis is similar if the potential buyer considers purchasing a corporate debt instrument in the bond market.  The potential buyer will purchase a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms willing to sell the debt.  The owners of the good firm have more information than the potential buyer that their firm is going to pay higher interest rate than the buyer is expecting and hence they are unlikely willing to borrow in this market.

12. 3. Only the bad firms will be ready to borrow but the potential buyer is not willing to buy bonds issued by them. 4. Again, few bonds are likely to be sold in this market, so it will not be a good source of financing.

13.  The analysis discussed above explains why marketable securities are not the primary source of financing (fact 2). It also partly explains why stocks are not the most important source of financing (fact 1).  The presence of adverse selection problem keeps securities markets from being effective in challenging funds from savers to borrowers

14. Tools to help Reduce Adverse Selection Problems  In the absence of asymmetric information, the adverse selection problem goes away. If the buyers know as much information as the sellers, so that they can distinguish good firms from bad firms, buyers will be willing to pay full value for securities issued by good firms, and good firms will sell their securities in the market. The securities market will then be able to move funds to the good firms that have the most productive opportunities.

15. ( 1) Production and Sale of Information  The solution to adverse selection problem in financial markets is to eliminate asymmetric information by furnishing the people supplying funds with full details about the individuals or firms seeking to finance their investment activities.

16.  One way to provide information to savers- lenders is through establishing private companies specialized in collecting and producing information that distinguishes good from bad firms and then sell this information to those who are interested in acquiring them. These firms such as Standard and Poor’s gather information of firms’ balance sheet positions and investment activities and then sell them to subscribers.

17.  However, the system of private production and sale of information does not completely solve the adverse selection problem in securities market because of the free-rider problem.  The free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for.  Free-riders watch the investors who have bought the information to make better decision in purchasing the securities of good firms that are undervalued, and then he buys the same securities that investors who paid for information bought.

18.  If many free-riders act in the same way, the increased demand for the undervalued good securities will lead to an increase in the prices of these good firms’ securities.  Because of free-riders, investors who paid for information will not have any advantage from purchasing the information and they wish they should never paid for this information in the first place.

19.  If many investors face the same problem and react in the same way, firms selling information will realize that this information producing business is not that profitable. This means less information will be produced and adverse selection problem will prevail resulting in inefficient functioning of securities market.  Thus, the free-rider problem prevents the private market from producing enough information to eliminate all the asymmetric information that leads to the adverse selection problem.

20. (2) Government Regulation to Increase Information  To compensate the shortage of information production in the private market government intervention is necessary.  Government regulates securities markets in a way that forces firm to reveal honest information about themselves so that investors can determine how good or bad the firms are.

21.  Special government agencies require firms selling their securities to have independent audits to certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings.  However, disclosure requirements do not always work well. For example, the collapse of Enron, WorldCom and other firms illustrates that government regulation can lessen asymmetric information problems of adverse selection and moral hazard, but cannot eliminate them.

22.  Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors: 1. There is information related to quality that cannot be provided merely by statistics. 2. Furthermore, bad firms have an incentive to make themselves look like good firms making it hard for investors to sort out good firms from the bad one.  The adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy (fact 5).

23. (3) Financial Intermediation  As discussed above, private production of information and government regulation to encourage provision of information lessen but don not eliminate the adverse selection problem in financial markets.  Financial intermediaries help solve adverse selection problems in financial markets by producing information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms, which results in high profit for the bank.

24.  An important element in the bank’s ability to profit from the information it produces is that it avoids the free-rider problem by mainly making private loans rather than purchasing securities that are traded in the open market.  The bank’s role as an intermediary that hold mostly non-traded loans is the key to its success in reducing asymmetric information in financial markets.  Since financial intermediaries play a greater role in moving funds to firms than securities markets do, indirect finance is so much more important than direct finance and banks are the most important source of external funds for financing businesses (facts, 3 and 4).

25.  Since information about private firms is harder to collect in developing countries than in industrialized countries, there is a greater role for banks and smaller role for securities markets.  The larger and more established a firm is, the more likely it will be to issue securities to raise funds, because investors have fewer worries about adverse selection with well-known corporations.

26. (4) Collateral and Net Worth  Collateral reduces the consequences of adverse selection because it reduces the lenders losses in the event of a default. Lenders are more willing to make loans secured by collateral, and borrowers are willing to supply collateral in order to get the loan and at better rate (fact 7).  If a firm has a high net worth (equity capital) it is less likely to default and if it defaults the lender can sell its net worth to recover its loan. When firm seeking credit has high net worth, adverse selection problem will not be severe and lenders are more willing to make loans.

27. HOW MORAL HAZARD AFFECTS THE CHOICE BETWEEN DEBT AND EQUITY CONTRACTS  Moral hazard is the asymmetric information problem that occurs after financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security.  Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts.

28. Moral Hazard in Equity Contracts: The Principal- Agent Problem  Equity contracts, such as common stock, are claims to a share in the profits and assets of a business.  Equity contracts are subject to a particular type of moral hazard called the principal-agent problem.  The stockholders who own most of the firm's equity (the principals) are not the same people as the managers of the firm who may own only a small fraction of the firm they work for (the agents of the owners).

29.  This separation of ownership and management involves moral hazard.  The managers in control (the agents) may act in their own interest rather than in the interest of the owners (principals) because the managers have less incentive to maximize profits than stockholders-owners do.

30.  Agents (managers in control) may 1. have different goals than the owners 2. have less incentives to maximize firm’s profit 3. not provide a quick and friendly service to the firm’s customers 4. spend money unnecessarily on decoration and artificial issues 5. waste time in their own personal leisure 6. not be honest with the firm’s owner 7. diverting funds for their own personal use, 8. pursue corporate strategies that enhance their own personal power but do not increase the firm’s profitability.

31.  The principal-agent problem, which is an example of moral hazard, would not arise if the owners of the firm had complete information about what the managers were up to and could prevent wasteful expenditures and fraud.  The principal-agent problem arises only because a manager has more information about his activities than the stockholder does-that is, there is asymmetric information.  The principal-agent problem would not arise if there were no separation of ownership and control- that is the owner is the manager.

32. Tools to Help Solve the Principal-Agent Problem 1. Production of Information: Monitoring  One way for stockholder to reduce this moral hazard problem is to monitor the firm’s activities through different monitoring process such as auditing and checking what the management is doing.  The problem is that monitoring process can be costly in terms of time and money. This is called costly state verification, which makes equity contract less desirable. It explains, in part, why equity is not the most important element in our financial structure.

33.  Because it is expensive to monitor, the free rider problem occurs which decreases the possibility to monitor the firm properly. If you know that other stockholders are paying to monitor the activities of the firm you hold shares in, you can take a free ride on their activities and save yourself some expenses. The problem occurs when every stockholder think the same. The result is no one will spend any resources to monitor the firm.

34. 2. Government Regulation to increase information  Governments have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits. However, these laws and regulations are not fully effective. It is not easy to catch the fraudulent managers because they have incentives to make very hard for government agencies to find or prove fraud.

35. 3. Financial Intermediation  Financial intermediation has the ability to avoid the free-rider problem in the face of moral hazard, and this is another reason why indirect finance is so important.  One financial intermediary that helps reduce the moral hazard arising from the principal-agent problem is the venture capital firm.

36.  Venture capital firm pools the resources of their partners and uses the funds to help new entrepreneurs to establish a new business firm with the condition that the venture capital firm receives an equity share in the new business and puts some of its own people in the management team of the new firm so that they can keep close watch on the firm’s activities.  The equity of the new business firm splits only between the entrepreneurs and the venture capital firm and no other investors are allowed. Thus, the free-rider problem in monitoring the firm does not exist.

37. 4. Debt Contracts  Debt contract is an agreement whereby the borrower pays the lender a fixed amount at periodic intervals. As long as the lender receives the agreed amount, he does not care whether the firm is making profit or suffering a loss.  The less frequent need to monitor the firm, and thus the lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital.

38. HOW MORAL HAZARD INFLUENCES FINANCIAL STRUCTURE IN DEBT MARKETS  Even with the advantages over equity contact, debt contracts are still subject to moral hazard.  Because a debt contract requires the borrower to pay out a fixed amount and lets him keep any profits above this amount, the borrower has an incentive to take on investment projects that are riskier than the lenders would like. Because of the potential moral hazard, lenders my not make the loan to the borrower.

39. Tools to Help Solve Moral Hazard in Debt Contract 1. Net Worth and Collateral  When the net worth is high or the collateral is valuable, the risk of moral hazard will be highly reduces because the borrower himself have a lot to lose.  Net wroth and collateral make the debt contract incentive-compatible. It makes the incentives of both borrowers and lenders are the alike. The greater the borrower’s net worth and collateral, the greater the borrower’s incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and easier for the borrower to get the loan.

40. 2. Monitoring and Enforcement of Restrictive Covenants  Lenders can ensure that the borrower uses the fund for the purpose it has been agreed upon by writing provisions (restrictive covenants) into the debt contract that restrict the borrower’s activities in order to reduce moral hazard. Then the lenders can monitor the borrower’s activities to see whether he is complying with the restrictive covenants or not.  There are four types of restrictive covenants 1. Covenants to discourage undesirable behavior, 2. covenants to encourage desirable behavior, 3. covenants to keep collateral valuable, 4. covenants to provide information

41. 3. Finance intermediation  Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it completely. It is almost impossible to write covenants that rule out every risky activity.  Furthermore, borrower may be clever enough to find loopholes in restrictive covenants that make them ineffective.  Restrictive covenants must be monitored and enforced. Monitoring and enforcement is costly. Thus, the free-rider problem arises in debt market, and moral hazard continues to be high.

42.  Financial intermediaries-particularly banks- have the ability to avoid the free-rider problem as the make primarily private loans.  Private loans are not traded, so no free-rider problem exists.