An Economic Analysis of Financial Structure

Chapter 8 An Economic Analysis of Financial Structure Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Eight Basic Facts Stocks are not the most important sources of external financing for businesses (figure 1) ==> Why? Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations (figure 1) ==> Why? Indirect finance is many times more important than direct finance ((figure 1) ==> Why? Financial intermediaries are the most important source of external funds (figure 1) ==> Why? Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Eight Basic Facts (cont’d) The financial system is among the most heavily regulated sectors of the economy Only large, well-established corporations have easy to issue securities to markets to finance their activities Collateral is a prevalent feature of debt contracts Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Transaction Costs Financial intermediaries have evolved to reduce transaction costs [ex: mutual funds] Economies of scale Expertise Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Asymmetric Information Adverse selection occurs before the transaction Moral hazard arises after the transaction Agency theory analyses how asymmetric information problems affect economic behavior Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Adverse Selection: 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 This problem explains fact 2 and partially explains fact 1 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Adverse Selection: Solutions Private production and sale of information Free-rider problem Government regulation to increase information Fact 5 Financial intermediation Facts 3, 4, & 6 Collateral and net worth (Equity) Equity = Asset – Liability Fact 7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Moral Hazard in Equity Contracts Called the Principal-Agent Problem Agent: the managers of the firm (own only small fraction of equity of the firm) Principal: owner of the firm (own large fraction of equity of the firm) Separation of ownership and control of the firm Managers pursue personal benefits and power rather than the profitability of the firm Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Principal-Agent Problem: Solutions Monitoring (Costly State Verification) => auditor => costy Free-rider problem (not buy information any more) Government regulation to increase information Fact 5 Financial Intermediation (venture capital firm) Fact 3 Debt contract (instead of buy stock, take a debt contract) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Moral Hazard in Debt Markets Borrowers have incentives to take on projects that are riskier than the lenders would like Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Moral Hazard: Solutions Net worth and collateral “Incentive compatible”: The greater the borrower equity, the greater the borrower’s incentive to behave in the way that the lender expects & desires ( and vice versa) Monitoring and Enforcement of Restrictive Covenants Discourage undesirable behavior => sử dụng vốn vay đúng Encourage desirable behavior => mục đích đi vay Keep collateral valuable Provide information (provide financial statement periodically) => However, these solution just reduce moral hazard problem, not eliminate it (p.197) => Solution: Financial Intermediation (no free-rider) Facts 3 & 4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Problem in developing contries 1/ Disclosure of information: poor => law 2/ Gov. use financial systems to direct credit to themselves or to favored sectors of the economic 3/ Auditing and Consulting in Accounting Firms Auditors may be willing to skew their judgments and opinions to win consulting business Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit counterparts Auditors may provide an overly favorable audit to solicit or retain audit business Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Financial Crises and Aggregate Economic Activity Crises can be caused by: Increases in interest rates Increases in uncertainty Asset market effects on balance sheets Problems in the banking sector Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Increases in Interest Rates Only riskiest investors willing to pay high interest rate, good credit investor less likely to borrow => Lender will not longer to make loan => "Adverse Selection => Decline in investment => Influence heavily on the economic activities… Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Increases in Uncertainty Stock market crash => Make it harder for lender to screen good from bad credit risks => "Adverse Selection" => Lenders less willing to lend => Decline in investment => Influence heavily on the economic activities… Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Asset Market Effects on Balance Sheets 1/ Stock market decline => Share price of corporations fall => Equity (net worth) decrease & the value of collateral decrease => Willing to borrow to make risky investment => Banks will not lend these corporations => "Adverse Selection" => Decline in investment => Influence heavily on the economic activities… Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Asset Market Effects on Balance Sheets (cont'…) 2/ The economic in inflation: Firms' Asset decrease meanwhile firms' Liability increase. Equity = Asset - Liability => Equity decrease => Willing to borrow to make risky investment => Banks will not lend these corporations => "Adverse Selection" => Decline in investment => Influence heavily on the economic activities… Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Problems in Banking Sector Interest Rate high: Banks' Asset decrease meanwhile banks' Liability increase. Equity = Asset - Liability => Equity & Assets decrease => Banks not willing to lend investors => "Adverse Selection" => Decline in investment => Influence heavily on the economic activities… In worse situation: banks start to fail & fear spread from one bank to other => "Bank panic" => people withdraw deposit => no source of capital => no lending => Decline in investment => Influence heavily on the economic activities… Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-* END OF CHAPTER