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Chapter 16 Financial System Design
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16-2 Key Topics Stockholder-lender and Manager- stockholder conflicts Different financial structures that limit these conflicts Compare and contrast the financial system design of Germany, Japan, the UK, and the US
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16-3 Financial System Two models of financial system in industrialized nations are: Markets-oriented United States and United Kingdom Banking-oriented Germany and Japan
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16-4 Common Elements Payments system 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
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16-5 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
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16-6 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
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16-7 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
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16-8 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
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16-9 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
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16-10 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
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16-11 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
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16-12 Information and System Design 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
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16-13 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 Small firms: Manager-Stockholder Conflict Not a problem in either financial system
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16-14 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 Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky
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16-15 Information and System Design 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
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16-16 Information and System Design 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
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16-17 Information and System Design 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
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16-18 Information and System Design 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 To minimize the conflict, management’s compensation packages are structured to link compensation to performance desired by stockholders
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16-19 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
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16-20 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
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16-21 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
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16-22 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
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16-23 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
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16-24 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
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16-25 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
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16-26 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
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16-27 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
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16-28 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
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16-29 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.
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16-30 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
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