1. Financial System Design
Chapter 16
Financial System Design

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

3. 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

4. Common Elements Deposit Insurance Central Bank
Protecting individual depositor
Central Bank
Responsible for issuing currency and interest rates
Maintaining stability of the system
Implementing monetary policy
Macroeconomic objectives:
Inflation control
Unemployment reduction

5. Differences Financing
Primarily difference is related to how businesses obtain financing
Conflict Resolution
The private ownership of business leads to two fundamental conflicts:
Stockholder-lender conflict
Management-stockholder conflict
These problems are handled differently.

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
Arises primarily with large companies where 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
Principal-agent problems however produce this conflict

8. Principal-Agent Problem
Manager often have objectives different from the owners.
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 than strategies that may involve more risk, proportionately larger gains

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. Conflict Resolution in Different Financial Systems
Two Conflicts
Stockholder – Lender Conflict
Manager –stockholder Conflict
Two Systems
Banking oriented system
Market oriented system
These two conflicts are dealt with differently in a banking-oriented financial system as compared to a markets-oriented financial system

12. 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

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

14. Information and System Design
Small Firms:
Manager-Stockholder Conflict
Not a problem in either financial system
Manager is often the owner of the firm

15. 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

16. Information and System Design
Large firms: Stockholder-Lender Conflict
Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky

17. 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

18. 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

19. 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

20. 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

21. Large Firms: Manager-Stockholder Conflict
Markets-Oriented Systems
To minimize the conflict, management’s compensation packages are structured to link compensation to performance desired by stockholders

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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.

33. Financial System Design: Summary of Four Countries
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