5 Mishkin Presents Eight Basic Facts of Financial Structure Stocks (direct finance) are not the most important source of external financing for businessesIssuing 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 CostsInformation CostsShades 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 partyOccurs before transaction occursIn 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 qualitySellers of good quality items will not want to sell at the price for average qualityBad 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 $15,000This 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 MarketsSuppose 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 riskLow 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 IntermediationFIs fill the information gapAnalogy to solution to lemons problem provided by used car dealersFIs 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 WorthExplains Fact # 7Private Production and Sale of InformationFree-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 partiesOccurs after transaction occursFor 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 ProblemSeparation of ownership and control of the firmPrincipal (stockholder) has less informationAgent (manager) has more informationManagers pursue personal benefits and power rather than the profitability of the firm
21 Actions to help solve the Principal-Agent Problem: Monitoring of managersExpensiveUse debt rather than equityReduces the need to monitor as long as borrower is performing. Explains Fact 1, why debt is used more than equityGovernment regulation to increase informationFact 5Financial IntermediationVenture capital firms provide the equity and place there own people in managementExplains 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 contractBonds and loans often carry restrictive covenantsRestrict how funds are usedRequire minimum net worth, collateral, bank balance, credit rating.Financial Intermediaries have special advantages in monitoring[Facts 3 and 4]