Chapter 8 Mishkin Notes

An Economic Analysis of Financial Structure Why do Financial Institutions Exist? (Why is Indirect Finance so Important? ) Chapter 8 Chapter Preview W e take a closer look at why financial institutions exist and how they promote economic efficiency. Topics include: • A Few Basic Facts About Financial Structure • Transaction Costs • Asymmetric Information: Adverse Selection and Moral Hazard Chapter Preview (cont. ) • The Lemons Problem: How Adverse Selection Influences Financial Structure • How Moral Hazard Affects the Choice Between Debt and Equity Contracts • How Moral Hazard Influences Financial Structure in Debt Markets 1

Basic Facts About Financial Structure Throughout the World • The chart on the next slide shows how non-financial business get external funding in the U. S. , Germany, Japan, and Canada. • Notice that, although many aspects of these countries are quite different, the sources of financing are somewhat consistent, with the U. S. being different in its focus on debt. Sources of External Finance Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-5 Eight Basic Facts of Financial Structure 1. Stocks are not the most important source of external financing for businesses [Direct Finance] 2. Issuing marketable debt and equity ecurities is not the primary way in which businesses finance their operations [Direct Finance] 2 Eight Basic Facts of Financial Structure 3. Indirect finance, which involves the activities of financial intermediaries, is m any times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. Eight Basic Facts of Financial Structure 5. The financial system is among the most heavily regulated sectors of economy. 6. Only large, well -established corporations ave easy access to securities markets to finance their activities. Eight Basic Facts of Financial Structure 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. 3 W hy is Indirect Finance so Important? • Transactions Cost • Information Cost Transaction Costs • Financial intermediaries to reduce transaction costs (and make profits) through – • Economies of scale • Expertise • Read the municipal bond article. Transaction Costs • Transactions costs ? ? ? E. g. a $5,000 investment only allows you to purchase 100 shares @ $50 / share (equity) No diversification Bonds even worse—most have a $1,000 size 4 Transaction Costs • Financial intermediaries make profits by reducing transactions costs – Take advantage of economies of scale (example: mutual funds) – Develop expertise to lower transactions costs – provide investors with liquidity and diversification Information Costs – Asymmetric Information • symmetric information—the case where all parties to a transaction or contract have the same information. • In many situations, this is not the case. We refer to this as asymmetric information.

Asymmetric Information: Adverse Selection and Moral Hazard • We will focus on two specific forms of asymmetric information: ? Adverse selection ? Moral hazard 5 Asymmetric Information: Adverse Selection and Moral Hazard • Adverse Selection 1. Occurs when one party in a transaction has better information than the other party 2. Before transaction occurs 3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan The Lemons Problem: How Adverse Selection Influences Financial Structure • If quality cannot be assessed, the buyer is willing to pay at m ost 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 result, when bad quality pushes good quality from the m arket because of an information gap, is known as “adverse selection” • This problem explains fact 2 and partially explains fact 1 Asymmetric Information: Adverse Selection and Moral Hazard • Moral Hazard 1. Occurs when one party has an incentive to behave differently once an agreement is made between parties 2. After transaction occurs 3. Hazard that borrower has incentives to ngage in undesirable (immoral) activities making it more likely that won’t pay loan back 6 Health Insurance • Symmetric Information: Suppose, if you get sick, drugs cost $10,000/year • Everyone has a 1/10 chance of getting sick • Solution – Insurance will be offered at $1,000 per year Health Insurance – Symmetric Information continued • Suppose 10% of the population (2 out of 20) is sickly and has a 50%(1/2) chance of getting sick – independent. • Other 90% (18 people) only has 1/18 chance of getting sick. • This information in known to everyone. • How do you price the insurance? Health Insurance – Symmetric Information ontinued • Sickly types pay? • Healthy types pay? 7 Health Insurance – Asymmetric Information Adverse Selection • Same as previous example, but one’s type (sick or healthy) is private information. Suppose insurance company offers policy at $1,000 per year? Suppose insurance company offers policy at $1,000 per year? • Sickly type happy to save $4,000. • Healthy drop out and go without insurance. • Adverse selection: Bad quality pushes good quality from the market because of an information gap. 8 How about charging less say $555. 56 to everyone? How about charging less say $555. 56 to everyone? Break even on the healthy type, but lose on sickly type. • Only way for insurance company in this case to break even is to charge $5,000 ? Healthy will go without insurance. Adverse Selection and Financial Structure Lemons Problem in Securities Markets • Suppose investors cannot distinguish between good and bad securities, willing to pay only the average of the good and bad securities’ values. • Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued. 9 Lemons Problem in Securities Markets • Investors won’t want to buy bad securities, so m arket won’t function well. ?

Explains Facts 1 and 2 ? Also explains Fact 6: only large well established firms have access to securities m arkets • Bad quality pushes good quality from the m arket because of an information gap. Tools to Help Solve Adverse Selection Problems • Private Production and Sale of Information ? Free-rider problem interferes with this solution • Government Regulation to Increase Information (explains Fact # 5) Tools to Help Solve Adverse Selection Problems • Financial Intermediation ? Analogy to solution to lemons problem provided by used car dealers ? Avoid free-rider problem by making private loans (explains Fact # 3 and # 4) ?

Also explains fact #6—large firms are more likely to use direct instead of indirect financing 10 Tools to Help Solve Adverse Selection Problems • Collateral and Net Worth ? Explains Fact # 7 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 Tools to help solve the Principal-Agent Problem: • Monitoring ? Expensive • Government regulation to increase information Fact 5 • Financial Intermediation ? Venture capital firms provides the equity and place there own people in management • Debt Contracts ? Reduces the need to monitor as long as borrower is performing. Explains Fact 1, why debt is used more than equity 11 How Moral Hazard Influences Financial Structure in Debt Markets • Even with the advantages just described, debt is still subject to moral hazard. ? Debt may create an incentive to take on very risky projects. How Moral Hazard Influences Financial Structure in Debt Markets • Most debt contracts require the borrower to pay a fixed amount (interest) and keep any ash flow above this amount. • For example, suppose a firm owes $100 in interest, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash. Tools to Help Solve Moral Hazard in Debt Contracts Lenders need to find ways ensure that borrower’s do not take on too much risk. ? A good legal contract ? Bonds and loans often carry restrictive covenants • Restrict how funds are used Require minimum net worth, collateral, bank balance, credit rating. • Financial Intermediaries have special advantages in monitoring[Facts 3 and 4] ? 12 STOP HERE!! 13