Lectures 3-4:

Chapter 8

An Economic
Analysis of
Financial
Structure
 1. Basic Puzzles About Financial Structure
1. Stocks: not the most important source of ext.
finance for firms
2. Debt & Share: not primary way of business finance
3. Indirect finance: more important than direct fin.
4. Bank: most important source of firms’ ext. finance
5. Financial system: most heavily regulated
6. Only large & established firms: easy access to
securities market
7. Collateral: prevalent feature of debt contracts
secured debt vs unsecured debt
8. Debt contracts: substantial restrictions on
borrowers <restrictive covenants>

11-2 © 2013 Pearson Education, Inc. All rights reserved.

 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 1970–2000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.

11-3 © 2013 Pearson Education, Inc. All rights reserved.

 2. Transaction Costs
Smaller savers ($1000), problem of I in fin. market
– high transaction cost (per $ of investment)
– cannot diversify
How financial intermediaries  transaction costs
1. economies of scale:
• bundle funds of many investors   tran. costs per $
of I (e.g., mutual funds)
• can also diversify (risk); can also invest overseas
• can use computer tech (better access to information,
better service: free checking on investment
performance)
2. expertise
<but principal-agent problem, high charge>
11-4 © 2013 Pearson Education, Inc. All rights reserved.
 3. Asymmetric Information:
Adverse Selection, Moral Hazard
Presence of transaction cost explains why financial
intermediaries (indirect fin.) play an important role in
the fin. system <puzzle 3>

Asymmetric information: one party’s insufficient

knowledge about the other party (e.g., shareholders
don’t know a manager is honest)
• adverse selection (before transaction): can’t tell
which one is a good borrower  don’t lend at all
• moral hazard (after transaction): borrower might
engage in undesirable (risky) behavior don’t lend
at all

11-5 © 2013 Pearson Education, Inc. All rights reserved.

 4. The Lemon Problem:
adverse selection affect fin. structure
A. used-car market
• potential buyer: can’t assess the quality of car
(good/bad), P reflect average quality of car:
lemon value & peach value
• owner: know whether his car is good bad
- if lemon: more than happy to sell at that range
- if peach: under-valued, may not want to sell
 very few good used cars will come to market
 average quality in the used car market is low
As few people want to buy a lemon  few sales
 used car market will function poorly
11-6 © 2013 Pearson Education, Inc. All rights reserved.
 4. The Lemon Problem:
adverse selection affect fin. structure
B. Lemons in stock and bond market
• Investors can’t distinguish good & bad firms, only
willing to pay a P that reflect average quality of firm
• Owner or manager of a good firm: undervalued, not
willing to sell (shares or bonds)
 those firms willing to sell are bad firms,
investors know this  won’t purchase the S or B
 securities market work poorly (few K raised)
explain puzzle 2: securities mkt not primary source of
firms’ fin.; partly puzzle 1: US stock mkt not most
important source of firm fin

11-7 © 2013 Pearson Education, Inc. All rights reserved.

 4. The Lemon Problem:
adverse selection affect fin. structure
C. Tools to help solve adverse selection problem
If no asymmetric information  no lemon problem
buyer & seller: same information about quality of
used car (shares)
buyer: willing to pay full value for good used car
(good shares)
owner: get fair value  willing to sell

 many transaction, mkt functions well (channel $ to

good firms)

11-8 © 2013 Pearson Education, Inc. All rights reserved.

 C. Tools to help solve the AS problem
• Private production and sale of information
eg Moody, S&P; can’t completely solve the problem
<free-rider problem, won’t purchase the inf.>
• Government regulation to increase information
pol. difficult for govt to release –ve inf. about firm
regulate securities mkt that encourage firms to
reveal honest inf.
SEC: standard accounting principle, disclosed
information about their sales, asset & earnings; but
- firms still more information
- disclosure requirement not always work, eg Enron
explain puzzle 5: why fin. mkt heavily regulated

11-9 © 2013 Pearson Education, Inc. All rights reserved.

 C. Tools to help solve the AS problem
• Financial Intermediation
clue from used-car market: car not sold from one
ind. to another; magazine: new car, not used car;
mechanics: high fee (lemon), don’t know reliable
mechanics
Thus, cars sold by intermediary (used-car dealers),
become expert in determining a car is lemon/peach
once know it is good, sell with (explicit/implicit)
guarantee (P)
 able to profit from the production of information
on the quality of car
(can avoid free-riding on the information)

11-10 © 2013 Pearson Education, Inc. All rights reserved.

 C. Tools to help solve the AS problem
• Financial Intermediation
Financial intermediaries can play similar role in the
financial mkt
Banks become experts in production of information
about firms, can sort out good and bad firms, acquire
funds from depositors & lend them to good firms
As bank is able to lend mostly to good firms
 able to earn a higher return on its loans,
profit allows it to engage in inf. production activity,
avoid free rider problem thro’ private loans (not traded)
explain puzzle 3: indirect fininance more important
than direct fin.; explain puzzle 4: banks are most
important source of firms’ fin.
11-11 © 2013 Pearson Education, Inc. All rights reserved.
 C. Tools to help solve the AS problem
• Financial Intermediation
Corollary: developing countries: more difficult to
collect firm information than developed economies
 greater role for banks (when the economy grows
towards US level, less role for banks)
explain puzzle 6: why large firms more likely to
obtain funds from securities markets (direct finance):
the better known the firm, the more information
about its activities is available, easier for investors to
evaluate the quality of firm
pecking order hypothesis: the larger and more
established a firm, the more likely it will raise funds
by issuing securities
11-12 © 2013 Pearson Education, Inc. All rights reserved.
 C. Tools to help solve the AS problem
• Collateral and Net Worth
Collateral: reduce the consequence of adverse
selection (if default, can sell the collaterals)
 i (risk premium) and more likely to get the loans
explain puzzle 7: collateral, an important feature of
debt contract

Net Worth: assets-liabilities, perform similar role as

collateral
If a firm has high net worth, even default, lender can
take title of firm’s net worth;
also less likely to default (can sell asset to pay back)

11-13 © 2013 Pearson Education, Inc. All rights reserved.

 5. Moral Hazard Affects Choice ٪
Debt & Equity Contracts
Moral Hazard (after transaction): incentives to hide
information & engage in undesirable activities from
point of view of investor
Equity contracts (shares): claims to a share in profits
and assets
Principal-agent problem (a moral hazard problem):
when manager (agent) owns a small fraction of firm
they work for, act on their interest rather than that of
shareholders or owners (principals)
 shirking, cheating (Enron: divert funds for their own use)
No such moral hazard problem if
(a) no asymmetric information; or
(b) no separation of ownership and control
11-14 © 2013 Pearson Education, Inc. All rights reserved.
 5. Moral Hazard Affects Choice ٪
Debt & Equity Contracts
Tools to help solve the principal-agent problem
• Production of information: monitoring
auditing the firm frequently & checking on what
management doing  the monitoring process is
costly (costly state verification)
also free-rider problem ( information & monitoring)

make equity contract less desirable,

explain partly why stock is not more important

feature of our F.S.
explain puzzle 1: stock not most common source of
firm fin.
11-15 © 2013 Pearson Education, Inc. All rights reserved.
 Tools to help solve the P.A. problem

• Government regulation to  information

- Laws force firms to adhere to standard accounting
principles that make profit verification easier
- Stiff criminal penalties on fraud of hiding and
stealing profit
But can only be partly effective, catching this kind of
fraud is not easy, managers can also make it hard

11-16 © 2013 Pearson Education, Inc. All rights reserved.

 Tools to help solve the P.A. problem

• Financial Intermediation
can avoid free-rider problem  explains puzzle 3: F.I.
important
e.g. venture capital firm, pool funds to bud new firms
receives equity share in return, staffs in firm (BoD)
equity of firm is not marketable to anyone but the
V.K. firm
Others unable to free-ride the VK firm’s verification
activities  full benefit from its v.a. ( moral hazard
problem)
Help develop US high-tech sector (e.g. Microsoft),
also mistakes

11-17 © 2013 Pearson Education, Inc. All rights reserved.

 Tools to help solve the P.A. problem

• Debt Contracts
equity contract: moral hazard problem in all situation
debt contract: moral hazard only in certain situation
  need to monitor moral hazard
 the contract can be more attractive
no need to know profit, OK as long as firm meets
debt payment
only in situation of default, need to check
 lower cost of state verification

help explain puzzle 1: stock not most common source

of firm fin.

11-18 © 2013 Pearson Education, Inc. All rights reserved.

 6. How Moral Hazard Influence
Financial Structure in Debt Markets
debt contracts: still moral hazard problem, borrower
has incentives to take on investment that are riskier
than lenders would like
e.g., ice-cream store versus inventing diet ice-cream,
bank lends too much to property mkt/high risk loans

Tools to help solve MH in Debt Contracts

• Net Worth
If borrower has more at stake, risk of riskier I ,
greater borrowers’ net worth, greater borrowers’
incentive to behave towards the lenders’ desires
  moral hazard problem
 easier for the firm to borrow
11-19 © 2013 Pearson Education, Inc. All rights reserved.
 Tools to help solve MH in Debt Contracts
• Monitoring & Enforcement of Restrictive
Covenants
Provisions (restrictive covenants) in debt contract
to restrict firms’ activities, ruling out undesirable
behaviors, 4 types:
– contracts to discourage undesirable behavior
e.g., purchase of particular equipment

– contracts to encourage desirable behavior

e.g., life insurance for mortgagee,
min holdings of certain assets to firm size

11-20 © 2013 Pearson Education, Inc. All rights reserved.

 Tools to help solve MH in Debt Contracts
– contracts to keep collateral value
e.g., fire and home insurance for mortgaged flat,
collision and theft insurance for mortgaged car

– contracts to provide information

e.g., quarterly accounting and income report,
lenders has the right to audit and inspect the
firm’s book at any time

explain puzzle 8: Debt contracts have restrictions

and complicated covenant (to  moral hazard)

11-21 © 2013 Pearson Education, Inc. All rights reserved.

 Tools to help solve MH in Debt Contracts
• Financial Intermediation
restrictive covenant helps, but impossible to write
covenants to rule out every risky activity, borrower
can also find loopholes,
cost of monitoring and enforcement (free-rider
problem)
F.I.: private loans (not traded), no one can free-
ride the FI’s monitoring and enforcement cost
 full benefit from these activities
  moral hazard problem
additional reasons for puzzle 3: indirect finance
more important; puzzle 4: bank more important
11-22 © 2013 Pearson Education, Inc. All rights reserved.