Chapter 8 An Economic Analysis of Financial Structure

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Chapter 8 An Economic Analysis of Financial
Structure
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Chapter 8 An Economic Analysis of Financial
Structure

• Basic Facts About Financial Structure Throughout
  the World
• Transaction Costs
• Asymmetric Information Adverse Selection and
  Moral Hazard
• The Lemons Problem
• Moral Hazard Applications
• Conflicts of Interest

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Eight Basic Facts

• Stocks are not the most important sources of
  external financing for businesses
• Issuing marketable debt and equity securities is
  not the primary way in which businesses finance
  their operations
• Less than half (43) of total financing
• Indirect finance is many times more important
  than direct finance
• Direct financing is used in less than 10 of all
  external financing
• Financial intermediaries are the most important
  source of external funds
• Bank loans are responsible for 56 of U.S.
  financing

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Eight Basic Facts

• The financial system is among the most heavily
  regulated sectors of the economy
• Promotes efficiency and economic growth
• Only large, well-established corporations have
  easy access to securities markets to finance
  their activities
• Small firms are confined to banks
• Collateral is a prevalent feature of debt
  contracts
• Debt contracts are extremely complicated legal
  documents that place substantial restrictive
  covenants on borrowers

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Transaction Costs

• Financial intermediaries have evolved to reduce
  transaction costs
• Economies of scale
• Deceasing average total costs
• Able to bundle funds from many investors
• Mutual funds are the best example of a financial
  intermediary taking advantage of economies of
  scale
• Expertise

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Asymmetric Information

• Adverse selection occurs before the transaction
• Bad credit risks most actively seek out loans
• Moral hazard arises after the transaction
• Borrower engages in undesirable activities
• Agency theory analyzes how asymmetric information
  problems affect economic behavior

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Adverse Selection The Lemons Problem

• 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
• Good firms face higher interest rates

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The Lemons Problem

• The buyer will decide not to buy at all because
  all that is left in the market is poor quality
  items
• Only bad firms will sell in the market
• This problem applies to stocks and bonds
  explaining fact 2 and partially explains fact 1
• Fact 2 Why marketable securities are not the
  most common
• Fact 1 Why stocks are not the most important
  source of financing

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Adverse Selection Solutions

• Private production and sale of information (Bond
  Ratings)
• Free-rider problem
• Investors follow other investors which prevents
  anyone from buying information, once one person
  buys the information no one else will
• Government regulation to increase information
• Government agencies force firms to release
  information
• Fact 5 Financial Markets are the most heavily
  regulated

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Free-Rider Problem
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Free-Rider Problem

• In 1992 investors followed George Soros lead
• George Soros lead investors into the belief that
  the Bank of England was going to need to let
  their currency appreciate or raise their interest
  rate
• The Sterling appreciated
• At the peak Soros dumped the Sterling leading to
  a large devaluation

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Adverse Selection Solutions

• Financial intermediation
• Banks have better information make mostly private
  loans to avoid the free riding problem
• Fact 3 Indirect finance is more important than
  direct financing
• Fact 4 Banks are the most important source of
  external funding
• Fact 6 Large firms are more likely to obtain
  funds via the securities market (more info is
  available in the market)
• Collateral and net worth
• Fact 7 Collateral is an important feature

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Moral Hazard in Equity Contracts

• Called the Principal-Agent Problem
• Separation of ownership and control of the firm
• Managers pursue personal benefits and power
  rather than the profitability of the firm
• Managers are often short sided, they sacrifice
  good long term investments for short term risky
  adventures
• Managers receive a small fraction of profits

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Principal-Agent Problem Solutions

• Monitoring (Costly State Verification)
• Free-rider problem Other stockholders will do
  the monitoring
• Fact 1 It is costly for stockholders to monitor
  managers
• Government regulation to increase information
• Fact 5 Governments force firms to adhere to
  high accounting standards
• Financial Intermediation
• Fact 3 Venture capital firms provide funds in
  exchange for shares in the company and managerial
  positions
• Debt Contracts
• Fact 1 Require frequent payments, lenders only
  care about receiving their payment not if the
  firm is making high levels of profit

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Moral Hazard in Debt Markets

• Borrowers have incentives to take on projects
  that are riskier than the lenders would like
• Once a borrower receives the funds she/he could
  use them elsewhere, the track

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Moral Hazard Solutions

• Net worth and collateral
• Incentive compatible incentives are aligned
  between the agent and the principal
• The manager does not have an incentive to shirk
• Monitoring and Enforcement of Restrictive
  Covenants
• Discourage undesirable behavior
• Encourage desirable behavior
• Keep collateral valuable
• Provide information
• Fact 8
• Financial Intermediation
• Facts 3 4

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Conflicts of Interest

• Type of moral hazard problem caused by economies
  of scope
• Arise when an institution has multiple objectives
  and, as a result, has conflicts between those
  objectives
• A reduction in the quality of information in
  financial markets increases asymmetric
  information problems
• Financial markets do not channel funds into
  productive investment opportunities
• The economy is not as efficient as it could be

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Why Do Conflicts of Interest Arise?

• Underwriting and Research in Investment Banking
• Information produced by researching companies is
  used to underwrite the securities. The bank is
  attempting to simultaneously serve two client
  groups whose information needs differ.
• Spinning occurs when an investment bank allocates
  hot, but underpriced, IPOs to executives of other
  companies in return for their companies future
  business

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Why Do Conflicts of Interest Arise? (contd)

• Auditing and Consulting in Accounting Firms
• Auditors may be willing to skew their judgments
  and opinions to win consulting business
• Auditors may be auditing information systems or
  tax and financial plans put in place by their
  nonaudit counterparts
• Auditors may provide an overly favorable audit to
  solicit or retain audit business

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Conflicts of Interest Remedies

• Sarbanes-Oxley Act of 2002 (Public Accounting
  Return and Investor Protection Act)
• Increases supervisory oversight to monitor and
  prevent conflicts of interest
• Establishes a Public Company Accounting Oversight
  Board
• Increases the SECs budget
• Makes it illegal for a registered public
  accounting firm to provide any nonaudit service
  to a client contemporaneously with an
  impermissible audit

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Conflicts of Interest Remedies (contd)

• Sarbanes-Oxley Act of 2002 (contd)
• Beefs up criminal charges for white-collar crime
  and obstruction of official investigations
• Requires the CEO and CFO to certify that
  financial statements and disclosures are accurate
• Requires members of the audit committee to be
  independent

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Conflicts of Interest Remedies (contd)

• Global Legal Settlement of 2002
• Requires investment banks to sever the link
  between research and securities underwriting
• Bans spinning
• Imposes 1.4 billion in fines on accused
  investment banks
• Requires investment banks to make their analysts
  recommendations public
• Over a 5-year period, investment banks are
  required to contract with at least 3 independent
  research firms that would provide research to
  their brokerage customers

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Financial Development and Growth

• Recent research has found that many developing
  countries experience very low growth rates due to
  an under developed financial system
• Legal system
• Many developing countries the system of property
  rights functions poorly. This makes it difficult
  to use collateral and covenants when making
  loans.
• It often takes years for a lender to actually
  receive the collateral payment, and by the time
  they receive collateral it is worthless

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Financial Development and Growth

• An increase in asymmetric information
• Makes it more costly to find good borrowers
• Harder for investors with productive investments
  to secure funds
• A poorly developed legal system also increases
  moral hazard

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Financial Development and Growth

• Corrupt Governments
• Use their financial system to direct funds to
  themselves or favored sectors of the economy
• Low interest rates are set loan for certain types
  of loans
• Governments generally dont care about profits
  and often channel funds to lower productive
  investments
• Banks are often state owned

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Financial Development and Growth - China

• China A counter example
• Very weak legal system
• Poor accounting standards
• Regulating of banking is in its early stages
• Large state owned banks
• Nevertheless China has experienced rapid growth

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Financial Development and Growth - China

• What explains Chinas rapid growth?
• High savings rates (40) have allowed the country
  to build up its capital stock
• Shifted a massive pool of underutilized labor
  from the agricultural sector into higher
  productive jobs using the new capital stock
• Rapid growth in the export sector
• Artificially maintain low exchange rate

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Financial Development and Growth - China

• Can China continue?
• The U.S.S.R. experience a very similar pattern to
  growth in the 1950s and 1960s, but once the
  pool of unskilled labor dried up, their growth
  slowed below that of the western economies
• U.S.S.R. failed to develop the institutions
  needed to allocate capital efficiently
• China has a much larger population
• State owned banks are becoming privatized
• They are developing a more regulated financial
  system

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Financial Crises and Aggregate Economic Activity

• What causes financial crises?
• Major disruptions in the financial markets
  characterized by sharp declines in asset prices
  and the failures of many financial and
  non-financial firms
• What impact do financial crises have on economic
  activity?
• Studying past problems helps prevent future
  occurrences

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Factors Causing Financial Crises

• Increases in interest rates
• Only attracts firms with risky opportunities
• Reduces capital investment
• Asset market effects on balance sheets
• A decline in the stock market lowers a
  corporations net worth, lenders decreases loans
• Firms will make riskier investments
• Decreasing price level decreases net worth
  (interest rates are generally nominal), firms
  debt burdens increase

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Factors Causing Financial Crises

• Problems in the banking sector
• Bank panics start to occur
• Government fiscal imbalances
• Increases in uncertainty
• Harder to screen good credit risks from bad risks
• Concern over government/bank defaults

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Financial Crises in the U.S.

• Last major crises 1930-1933
• Start with a deterioration in banks balance
  sheet, a sharp increase in interest rates, steep
  stock market decline, and increases in
  uncertainty (price level)
• These increase the severity of adverse selection
  and moral hazard problems making it less
  attractive for lenders to lend
• A decrease in lending leads to a decline in
  economic activity and investment

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Financial Crises in the U.S.

• The decline in economic activity increases
  uncertainty in the banking sector and depositors
  begin to withdraw their funds
• The decline in the number of banks allow other
  banks to raise interest rates even further
• At this point firms and banks were sorted out by
  bankruptcy proceedings and asymmetric information
  decreased

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Financial Crises in the U.S.

• Sometimes the decline in economic activity causes
  a rapid fall in the price level
• Debt-Deflation
• This leads to a further deterioration in firms
  net worth and balance sheet.
• The Great Depression

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Financial Crises in Emerging Countries

• Seen in Mexico 1994-1995, East Asia 1997-1998,
  and Argentina 2001-2002
• How can these countries prevent financial crises
  after experiencing rapid growth?
• These crises differ from the U.S. due to
  different institutional features in debt markets

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Financial Crises in Emerging Countries

• Mexico and East Asia experience large losses on
  banks balance sheets due to loan defaults
• Deregulation in the 1990s lead to a financial
  boom
• Weak regulation allowed banks to make very risky
  loans
• Banks net worth fell dramatically
• Investors began to pull out funding

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Financial Crises in Emerging Countries

• Argentina also experienced a deterioration in
  bank balance sheets
• Argentina has a well supervised and regulated
  banking system
• Fiscal problem lead to the deterioration in bank
  balance sheets
• Argentina was running large fiscal deficits
  financed by foreign investment

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Financial Crises in Emerging Countries

• Argentinas government forced banks to pick up
  this debt
• Foreign investors lost confidence in the
  government to pay back the debt
• Investors pulled funds out of the banking sector
• Government eventually defaulted

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Financial Crises

• The effect of interest rates abroad
• When the U.S. (large economy) increases interest
  rates developing countries are forced to follow
  or else lose funds
• U.S. in the 19th century, Mexico and Argentina
  were forced to raise interest rates
• This increases adverse selection

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Financial Crises

• The interest rate effect
• Central banks are reluctant to raise rates
• Leads to a speculative attack on the countrys
  currency
• Investors dump the currency
• Large current account deficits
• Large trade deficits
• Large government deficits
• Weak financial systems

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Financial Crises

• Forces countries to devalue their currency
• The devaluation increases the countries
  indebtedness
• Most debt is financed in foreign currency
• Also causes high levels of inflation
• Due to risk most developing countries only issue
  short term debt
• Short term changes have large balance sheet
  effects

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