1. An Economic Analysis of Financial Structure
Why do Financial Institutions Exist?
(Why is Indirect Finance so Important?)
Chapter 8

2. Chapter Preview
Look at why financial institutions exist and how they promote economic efficiency.
Topics include:
Some Basic Facts About Financial Structure
Transaction Costs
Asymmetric Information: Adverse Selection and
Moral Hazard

3. Basic Facts About Financial Structure Throughout the World
The chart on the next slide shows how non-financial business get external funding in the U.S., Germany, Japan, and Canada.

4. Sources of External Finance for Nonfinancial Businesses
Bank loans are from depository institutions
Nonbank loans are from non-depository institutions.
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5. Mishkin Presents Eight Basic Facts of Financial Structure
Stocks (direct finance) are not the most important source of external financing for businesses
Issuing marketable debt and equity securities (direct finance) is not the primary way in which businesses finance their operations

6. Mishkin’s Eight Basic Facts of Financial Structure
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.
Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.

7. Eight Basic Facts of Financial Structure
The financial system is among the most heavily regulated sectors of economy.
Only large, well-established corporations have easy access to securities markets (direct finance) to finance their activities.

8. Eight Basic Facts of Financial Structure
Collateral is a prevalent feature of debt contracts for both households and businesses.
Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers.

9. Why is Indirect Finance so Important?
Transactions Costs
Information Costs
Shades of Chapter 2

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

11. 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

12. 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
Bad quality pushes good quality from the market because of an information gap is known as "adverse selection”

13. 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.

14. 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.
This result, when bad quality pushes good quality from the market because of an information gap, is known as "adverse selection".

15. 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

16. Actions to Help Solve Adverse Selection Problems
Government Regulation to Increase Information (explains Fact # 5)

17. Actions to Help Solve Adverse Selection Problems
Financial Intermediation
FIs fill the information gap
Analogy to solution to lemons problem provided by used car dealers
FIs avoid free-rider problem. Make private loans and keep information private (explains Fact # 3 and # 4)
Also explains fact #6 - large firms are more likely to use direct instead of indirect financing

18. Actions to Help Solve Adverse Selection Problems
Collateral and Net Worth
Explains Fact # 7
Private Production and Sale of Information
Free-rider problem interferes with this solution

19. Asymmetric Information: Adverse Selection and Moral Hazard
Occurs when one party has an incentive to behave differently once an agreement is made between parties
Occurs after transaction occurs
For example, Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

20. How Moral Hazard Affects the Choice Between Debt and Equity Contracts
With equity, have Principal-Agent Problem
Separation of ownership and control of the firm
Principal (stockholder) has less information
Agent (manager) has more information
Managers pursue personal benefits and power rather than the profitability of the firm

21. Actions to help solve the Principal-Agent Problem:
Monitoring of managers
Expensive
Use debt rather than equity
Reduces the need to monitor as long as borrower is performing. Explains Fact 1, why debt is used more than equity
Government regulation to increase information
Fact 5
Financial Intermediation
Venture capital firms provide the equity and place there own people in management
Explains Fact 1

22. Moral Hazard Influence in Debt Markets
Even with the advantages just described, debt is still subject to moral hazard.
Debt may create an incentive to take on very risky projects.
Example:
suppose a firm owes $100, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash. Know as “Gambling for Resurrection”.

23. Lenders need to find ways ensure that borrower’s do not take on too much risk.
A good legal contract
Bonds and loans often carry restrictive covenants
Restrict how funds are used
Require minimum net worth, collateral, bank balance, credit rating.
Financial Intermediaries have special advantages in monitoring[Facts 3 and 4]

24. STOP HERE!!