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 1970–2000 and compares U.S.
data to those of Germany, Japan, and Canada
8-2 © 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.
8-3 © 2013 Pearson Education, Inc. All rights reserved.
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 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.
8-4 © 2013 Pearson Education, Inc. All rights reserved.
Eight Basic Facts (cont’d)
5. The financial system is among the most heavily
regulated sectors of the economy
6. Only large, well-established corporations have
easy access to securities markets to finance their
activities
7. Collateral is a prevalent feature of debt contracts
for both households and businesses.
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers
8-5 © 2013 Pearson Education, Inc. All rights reserved.
8 Basic Facts Summarized
• Stocks – not most important source of external financing
• Marketable securities (debt + equities) not the primary
market of financing
• Indirect finance more important than direct finance
• FLS or banks are the most important source of external
financing
• Financial sector – most regulated sector
• Only large well established corporations with easy access to
securities markets
• Collateral – prevalent for households and businesses
• Debt contracts – complicated legal documents with restrictive
covenants
8-6 © 2013 Pearson Education, Inc. All rights reserved.
Transaction Costs
• Financial intermediaries have evolved to
reduce transaction costs
– Economies of scale (reduction in transactions cost
per dollar of investment as the size of
transactions increases)
– Expertise
8-7 © 2013 Pearson Education, Inc. All rights reserved.
Asymmetric Information: Adverse
Selection and Moral Hazard
• Adverse selection occurs before the
transaction
• Moral hazard arises after the transaction
• Agency theory analyses how asymmetric
information problems affect economic
behavior
8-8 © 2013 Pearson Education, Inc. All rights reserved.
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
• This problem explains fact 2 and partially explains
fact 1
8-9 © 2013 Pearson Education, Inc. All rights reserved.
Tools to Help Solve Adverse Selection
Problems
• Private production and sale of information
– Free-rider problem
• Government regulation to increase information
– Not always works to solve the adverse selection problem,
explains Fact 5.
• Financial intermediation
– Explains facts 3, 4, & 6.
• Collateral and net worth
– Explains fact 7.
8-10 © 2013 Pearson Education, Inc. All rights reserved.
How Moral Hazard Affects the Choice
Between Debt and Equity Contracts
• Called the Principal-Agent Problem
– Principal: less information (stockholder)
– Agent: more information (manager)
• Separation of ownership and control
of the firm
– Managers pursue personal benefits and power
rather than the profitability of the firm
8-11 © 2013 Pearson Education, Inc. All rights reserved.
Tools to Help Solve the Principal-
Agent Problem
• Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
• Government regulation to increase information
– Fact 5
• Financial Intermediation (Venture Capital Firms)
– Avoids the free-rider problem (equity not marketable to
anyone except the VC)
– Fact 3
• Debt Contracts (verify the state of a firm’s profits
only if it is unable to meet its debt payments)
– Fact 1
8-12 © 2013 Pearson Education, Inc. All rights reserved.
How Moral Hazard Influences
Financial Structure in Debt Markets
• Borrowers have incentives to take on
projects that are riskier than the lenders
would like.
– This prevents the borrower from paying back the
loan.
8-13 © 2013 Pearson Education, Inc. All rights reserved.
Tools to Help Solve Moral Hazard in
Debt Contracts
• Net worth and collateral
– Incentive compatible (more “skin in the game”, aligns
incentives of borrower with lender)
• Monitoring and Enforcement of Restrictive Covenants
– Discourage undesirable behavior
– Encourage desirable behavior (ultimately, to keep net worth
high e.g., by maintaining minimum holdings of certain assets
relative to firm size)
– Keep collateral valuable (e.g., insurance)
– Provide information (e.g., income and accounting reports, the
right to audit or inspect books at any time)
• Financial Intermediation
– Avoids the free-rider problem in monitoring and enforcement
of debt covenants likely to occur in bond markets
– Facts 3 & 4
8-14 © 2013 Pearson Education, Inc. All rights reserved.
Summary Table 1 Asymmetric
Information Problems and Tools to Solve
Them
8-15 © 2013 Pearson Education, Inc. All rights reserved.
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).
– Similarly, state-owned banks
8-16 © 2013 Pearson Education, Inc. All rights reserved.
Application: Financial Development
and Economic Growth
• 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.
8-17 © 2013 Pearson Education, Inc. All rights reserved.
Application: Financial Development
and Economic Growth
• The financial systems in developing and transition
countries face several difficulties that keep them
from operating efficiently
• To sum, the institutional environment of a poor
legal system, weak accounting standards,
inadequate government regulation, and
government intervention through directed credit
programs and state ownership of all banks all help
explain why many countries stay poor while others
grow richer
8-18 © 2013 Pearson Education, Inc. All rights reserved.
