Chapter 8: An Economic Analysis of Financial Structure

Question 1

8 Facts about Financial Structure Throughout the World

Answer 1

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.
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.

Question 2

Economies of scale:

Answer 2

bundle the funds of many investors together so they can take advantage of a
reduction in transaction costs per dollar of investment as the size of
transactions increases.

Question 3

Asymmetric information:

Answer 3

a situation when one party’s insufficient knowledge about the other party involved in the transaction makes it impossible for the first party to make accurate decisions when conducting the transaction – Managers and shareholders

(e.g., adverse selection & Moral hazard)

Question 4

Adverse selection:

Answer 4

asymmetric information problem that occurs before a transaction occurs.

E.g.: Potential bad credit risks are the ones that most actively seek for a loan

(you as a lender have not enough information )

Question 5

Moral hazard:

Answer 5

asymmetric information problem that arises after the transaction.

E.g.: Big risks (that possibly generate high returns, but run greater risk to default)
taken by borrowers after having obtained the loan.

(you only get information after the transaction and the money could be used for other purposes )

Question 6

Agency theory

Answer 6

analyses how asymmetric information problems affect economic behavior.

(is an economic theory that views the firm as a set of contracts among self-interested individuals.)

Question 7

The Lemons Problem:

- by George Akerlof

Answer 7

(-> lemon= a second hand car that is very bad, peach= a very good second hand car. )

= One aspect of the way adverse selection interferes with the efficient functioning of a market. (quality?, price of average car)

Question 8

(The Lemons Problem disappears in the absence of asymmetric information)
- how to solve the lemon problem?

Answer 8

1 ) Private production and sale of information
2 ) Government regulation to increase information
3 ) Financial intermediation
4 ) Collateral and net worth

Question 9

• Private production and sale of information: (+/-?)

Answer 9

(+) Private companies that collect and produce information that distinguishes good
firms from bad firms (e.g. Standard and Poor’s, Moody’s)

(-) Free-rider problem, (copycats will benefit with this information)

Question 10

Free-rider problem

Answer 10

people that do not pay for the information take

advantage of the information other people paid for

Question 11

Government regulation to increase information

Answer 11

Instead the government encourages firms to reveal honest information (and
to undergo external audits) so investors can determine how good/bad firms
are (to solve free- rider problem)

Question 12

financial intermediation

Answer 12

• Bank becomes experts in producing information about firms to distinguish
between good and bad credit risks, even more so for small firms than for large,
better-known firms.

Question 13

Collateral: (

meaning?, +/-?)

Answer 13

property promised to the lender if the borrower defaults.

• Reduces adverse selection because it reduces the lender’s loss in the event of a default
• Lenders are more willing to make loans secured by collateral
• Borrowers are willing to supply collateral to get a better loan rate
• The presence of adverse selection in the credit market explains why collateral is an important feature of debt contracts (fact 7)

Question 14

Net worth

Answer 14

(equity capital) : the difference between a firm’s assets and liabilities

• The more equity a firm has, the bigger the cushion for the debt holders (they have money left to pay back the debt )

Question 15

How Moral Hazard Affects the Choice Between Debt and Equity Contracts:

Answer 15

asymmetric information problem that occurs after a financial transaction, when
the seller of a security may have the incentive to hide information and step into
activities that are undesirable for the buyer of the security.

Question 16

Moral Hazard in Equity contracts:

Answer 16

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

Question 17

P-A problem:

Answer 17

Principal-Agent Problem, is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal.

Question 18

Why Borrowers have incentives to take on projects that are riskier than the lenders would like.

Answer 18

• This prevents the borrower from paying back the loan.

• Because of the potential moral hazard that the borrower might use your
money to finance very risky projects, lenders may not want to hand out loans.

Question 19

Tools to Help Solve Moral Hazard in Debt Contracts:

Answer 19

• Net worth and collateral (-> to reduce moral hasart, + get insuranse)
• Monitoring and enforcement of restrictive covenants (-> what happens with your money =helps to reduce your rate )
• Financial intermediation

Question 20

“Incentive Compatible”:

Answer 20

it aligns the incentives of

the borrowers with those of the lender. (in Net worth and collateral)

Question 21

Monitoring and enforcement of restrictive covenants (what it does?)

Answer 21

• Discourage undesirable behavior: loan for specific activities only, restricting
risky business activities

• Encourage desirable behavior: encourage firms to keep net worth (equity)
high

• Keep collateral valuable: keep collateral in good condition (eg home insurance when you apply for a mortgage)
• Provide information: e.g. inspect the books of the firm

Question 22

Financial intermediation (what it does?)

Answer 22

– particularly banks can avoid by making private loans.

• Since the private loans are not traded, there is no free-rider problem.
• Facts 3 (Indirect finance is many times more important than direct finance) and 4 (Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses)

Question 23

loopwholes

Answer 23

Covenants cannot eliminate moral hazard completely.

Question 24

Financial repression created by an institutional environment is characterized by:

Answer 24

• 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)

Question 25

Debt contracts

Answer 25

are extremely complicated legal documents that place
substantial restrictive covenants on borrowers.

a. Legal documents with provisions (or restrictive covenants) that restrict and specify
certain activities that the borrower can engage in.