chapter 9: An Economic Analysis of Financial Structure Flashcards
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
- 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
- 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
- A prevalent feature of debt contracts for both households and businesses is collateral
- Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
collateral
Property pledged to a lender to guarantee payment
Collateralized debt
secured debt
Transaction costs
a major problem in financial markets
Brokerage fees, for example
Inability to diversify will subject you to risk
how have financial intermediaries evolved to reduce transaction costs?
Economies of scale
Expertise
how have financial intermediaries taken advantage of economies of scale to reduce transaction costs?
cost of transaction increases only slightly for the increased size of transaction
many of the large costs of resources in finance are fixed
the more people making transactions, the lower they will be
how have financial intermediaries taken advantage of expertise to reduce transaction costs?
better service and information about investments
liquidity services (cheque-writing, etc.)
Asymmetric Information
one party has insufficient knowledge about the other party involved in a transaction
problems of asymmetric information
Adverse selection
Moral hazard
Adverse selection
occurs before the transaction
refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality
Moral hazard
arises after the transaction
the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity
Agency theory
analyses how asymmetric information problems affect economic behaviour
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
The buyer will decide not to buy at all because all that is left in the market is poor quality items
consequences of the lemon problem
keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers
how can asymmetric information lead to the lemon problem in stock and bonds market?
lack of information will make investors struggle in
distinguishing high-profit/low-risk firms from low-profit/high-risk firms
Owners and managers of good firms have better information than the investors, so they would know that their securities are undervalued in the market and won’t bother issuing securities in the first place
the principal agent problem basically
Tools to Help Solve Adverse Selection Problems
Private production and sale of information
Government regulation to increase information
Financial intermediation
Collateral and net worth (or equity capital)
negative effect of private production and sale of information
free rider problem
which fact does “Government regulation to increase information” explain?
- The financial system is among the most heavily regulated sectors of the economy
which facts does “Financial intermediation” explain?
- 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
- Only large, well-established corporations have easy access to securities markets to finance their activities
which facts does “Collateral and net worth” explain?
- A prevalent feature of debt contracts for both households and businesses is collateral
The Principal-Agent Problem
Principal: less information (stockholder)
Agent: more information (manager
negative effect of separation of ownership and control of the firm
Managers pursue personal benefits and power rather than the profitability of the firm
Tools to Help Solve the Principal-Agent Problem
Monitoring (Costly State Verification)
Government regulation to increase information
Financial Intermediation
Debt Contracts
what is a downside of monitoring and which fact does monitoring confirm?
Free-rider problem
Fact 1 (stocks aren’t most common source of financing)
how does financial intermediation help reduce the principal agent problem
Economies of scale
Venture capital firms
which fact does the use pf debt contracts to reduce principal agent problems confirm?
Fact 1 (stocks aren’t most common source of financing)
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
Tools to Help Solve Moral Hazard in Debt Contracts
Net worth and collateral
Monitoring and Enforcement of Restrictive Covenants
Financial Intermediation
Net worth and collateral
Makes debt incentive comparable
Restrictive Covenants
Discourage undesirable behavior
encourage desirable behavior
keep collateral valuable
provide information
financial repression
Many developing countries experience low rates of economic growth
perhaps due to their underdeveloped financial system
Several difficulties keeping developing countries’ financial systems from operating efficiently
Poorly functioning system of property rights (collateral)
Poorly developed legal systems (restrictive covenants)
Government allocation of credit (lower incentive to solve the moral hazard and adverse selection problems)
State-owned banks
