Chapter 8

An Economic
Analysis of
Financial
Structure

Basic Facts about Financial Structure

Throughout the World
This chapter provides an economic analysis of how
our financial structure is designed to promote
economic efficiency
The bar chart in Figure 1 shows how American
businesses financed their activities using external
funds (those obtained from outside the business
itself) in the period 19702000 and compares U.S.
data to those of Germany, Japan, and Canada

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Figure 1 Sources of External Funds for

Nonfinancial Businesses: A Comparison of the
United States with Germany, Japan, and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, Financing Patterns: Measurement Concepts and Empirical Results, Johann
Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 19702000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.
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Eight Basic Facts

1. Stocks are not the most important sources of
external financing for businesses
2. Issuing marketable debt and equity securities is
not the primary way in which businesses finance
their operations
3. Indirect finance (involves intermediaries) is many
times more important than direct finance
4. Financial intermediaries, particularly banks, are
the most important source of external funds used
to finance businesses.

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Eight Basic Facts (contd)

5.
6.
7.

The financial system is among the most heavily

regulated sectors of the economy
Only large, well-established corporations have
easy access to securities markets to finance their
activities
Collateral is a prevalent feature of debt contracts
for both households and businesses.
-Debt is backed by some physical good (ie house).

8.

Debt contracts are extremely complicated legal

documents that place substantial restrictive
covenants on borrowers
-Ever read the fine print on student loans? More complex
than an IOU

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Transaction Costs
Financial intermediaries have evolved to
reduce transaction costs
Economies of scale
Total cost of carrying out many transactions decreases
for a larger entity

Expertise
Match those wanting $, with those who have
excess $

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Asymmetric Information: Adverse

Selection and Moral Hazard
Adverse selection occurs before the
transaction
EX: Health insurance

Moral hazard arises after the transaction

EX: Bailouts of 2008-2009

Agency theory analyses how asymmetric

information problems affect economic
behavior

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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
The buyer will decide not to buy at all because all
that is left in the market is poor quality items
How do we tell which stocks/bonds are lemons
and which are good investments?
This problem explains fact 2 and partially explains
fact 1
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EX: Lemons Problem in Used Car

Market
Say there are two types of used cars
Good type (Peaches)
Bad type (Lemons), need repairs

Also assume that buyers have full information. In

other words they can perfectly tell the true type
of a used car.

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EX: Lemons Problem in Used Car

Market
Sellers are willing to accept
Lemons sell for: $1,000
Peaches sell for: $2,000

Buyers are willing to pay

$1,200 for a lemon
$2,400 for a peach
With full information, there is no problem.

Lemons sell for an equilibrium price between $1,000 and

$1,200
Peaches sell for an equilibrium price between $2,000 and
$2,400
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EX: Lemons Problem in Used Car

Market
Now assume, only the sellers know the cars
true type, buyers cant tell. But buyers know
the probability that they are buying a peach
or a lemon.
Let there be 50 lemons and 50 peaches
So the probability of buying a lemon is 50% (PL)
The probability of buying a peach is 50% (PP)

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EX: Lemons Problem in Used Car

Market
Thus on average, what are buyers willing to
pay:
PL * WTPL + PP * WTPP =
50%*$1,200 + 50% * $2,400 = $1,800

So buyers are only willing to pay $1,800

because they arent sure if theyre buying a
lemon or a peach.
Whats the equilibrium look like?
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EX: Lemons Problem in Used Car

Market
Sellers of peaches will only accept a price of $2,000
or more
This is greater than the buyers willingness to pay
($1,800)
No peaches are sold, sellers of peaches exit the
market.
Only lemons remain (buyers become aware of
this) and only lemons are sold for a price between
$1,000 and $1,200
Thus since sellers of high quality cars (peaches) have
been driven out of the market in favor of low quality
cars, the market has become adversely selected

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Lemons in the Stock/Bond Mkt.

If we cant distinguish between high-qualitylow-risk (peaches) stocks and low-qualityhigh-risk stocks (lemons) the same problem
arises.
When forming out expectations of what to
pay, we may offer a price to low to good
companies driving them from the market,
leaving only high risk companies.

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Lemons in the Stock/Bond Mkt.

Likewise for bonds, due to buyers inability to
detect good bonds from poor ones, they will
require a high interest rate as compensation
Only those willing to pay a high interest (risky
loans) will remain

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Tools to Help Solve Adverse Selection

Problems
1) Private production and sale of information
Why not just hire people/firms to find out what
investments are lemons and which are peaches?
ex: Bond rating agencies

Free-rider problem (comes from public economics)

People who dont pay for info can take advantage of info that
others pay for.

You buy info and purchase stock others see you buy stock, dont
buy info, and also buy stock stock price rises to true value you
make no profit, regret buying info agency loses money, exits market

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Tools to Help Solve Adverse

Selection Problems
2) Government regulation to increase information
Compel firms to reveal their true quality
SEC requires firms to conduct independent audits, but
these are not always done correctly (Enron scandal)
Not always works to solve the adverse selection problem,
The info provided isnt always enough to distinguish a
firms true quality
Bad firms make themselves look good, can skew their
information making them seem better than they are.
explains Fact 5.

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Tools to Help Solve Adverse

Selection Problems
3) Financial intermediation
Costly for individuals to acquire reliable financial
information on their own, intermediaries can do a better
job.
Banks avoid free-rider problem my making private loans
(no other agent can bid up the price of the loan)
Ex: Banks can better distinguish good credit risks from bad
credit risks (and earn profit by doing so).
Explains facts 3, 4, & 6. (banks can better determine
credit worthiness compared to individuals).

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Tools to Help Solve Adverse

Selection Problems
4) Collateral and net worth
Can back the loan with these to cushion investors if a loss
occurs
Collateral: back the loan with a physical good
Net worth: difference between assets and liabilities
Explains fact 7.

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How Moral Hazard Affects the Choice

Between Debt and Equity Contracts
Moral Hazard is prevalent in equity contracts
(i.e. common stock)
Called the Principal-Agent Problem
Principal: stockholders
Agent: manager

The manger may only own a small fraction of

the stock. This may give agent incentives
different from those of the principals
(stockholders)
EX: take lavish vacations paid for by company, run up
expense accounts, etc.
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How Moral Hazard Affects the

Choice Between Debt and Equity
Contracts
Separation of ownership and control
of the firm
Managers pursue personal benefits and power
rather than the profitability of the firm

Hard and costly to monitor agents

Collective action problem : There are many
stockholders (principals), individually they may
feel its not worth there time to monitor the
agent because someone else will do it.

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Tools to Help Solve the PrincipalAgent Problem

Monitoring (Costly State Verification)
Free-rider problem, monitoring agents is expensive (audits)
Fact 1

Government regulation to increase information

Fact 5

Financial Intermediation
Venture capital firm investors usually sit on board of
company
Fact 3

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How Moral Hazard Influences

Financial Structure in Debt Markets
Debt Contracts (as opposed to stock/equity)
Contractual agreement by the borrower to pay the lender
fixed dollar amounts at periodic intervals.
If the firm is profitable, the principals (lenders) get their
fixed payment and dont really care if the agent is taking
extra vacations etc.
When a firm cannot make its debt payments, only then do
lenders get involved to verify the state of the firms profits.
Put agents incentives inline with principals so need to
monitor is reduced
Fact 1

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Tools to Help Solve Moral Hazard in

Debt Contracts
Borrowers have incentives to take on projects that are riskier
than the lenders would like.
This prevents the borrower from paying back the loan.
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4

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Summary Table 1 Asymmetric

Information Problems and Tools to Solve
Them

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Asymmetric Information in Transition

and Developing Countries
Financial repression created by an
institutional environment characterized by:
Poor system of property rights (unable to use
collateral efficiently)
Poor legal system (difficult for lenders to enforce
restrictive covenants)
Weak accounting standards (less access to good
information)
Government intervention through directed credit
programs and state owned banks (less incentive
to proper channel funds to its most productive
use).
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Application: Financial Development

and Economic Growth
The financial systems in developing and transition
countries face several difficulties that keep them
from operating efficiently
In many developing countries, the system of
property rights (the rule of law, constraints on
government expropriation, absence of corruption)
functions poorly, making it hard to use these two
tools effectively

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