Lecture 7 - An economic analysis of the financial structure

Question 1

How do businesses finance their activities?

Answer 1

Through a combination of internal and external funds.

Question 2

What is the bank credit category?

Answer 2

Made up of primarily loans from depository institutions but also includes loans from development banks.

Question 3

What is the trade credit category?

Answer 3

Composed of credit extended by one company to another in the process of transactions between each other.

Question 4

What is equity and what does the other category include?

Answer 4

Equity is stock market shares and the other category includes informal sources such as venture capital.

Question 5

Eight facts about financing.

Answer 5

• Stocks are not the most important source of external financing for businesses.
• Issuing equities is not the only type of marketable security by which businesses finance their operations.
• Indirect finance, which involves the activities of financial intermediaries, is more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
• Financial intermediaries, particularly banks, are the most important source of external funds used to finance business.
• 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.
• Collateral is a prevalent feature of debt contrats for both households and businesses.
• Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower.

Question 6

What is collateral?

Answer 6

Property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments.

Question 7

Collateralised debt is…

Answer 7

Secured debt.

Question 8

Unsecured debt, such as credit card debt is not…

Answer 8

Collateralised. Majority of household debt in the UK consists of collateralised loans.

Question 9

What are restrictive covenants?

Answer 9

Bond or loan contracts are typically long legal documents with provisions that restrict and specify certain activities that the borrower can engage in.

Question 10

Restrictive covenants are just a feature of…

Answer 10

Debt contracts for businesses.

Question 11

What do transaction costs do?

Answer 11

Limit the flow of funds to agents with productive investment opportunities.

Question 12

What sometimes happens if households try to invest in stocks?

Answer 12

Brokerage commissions for buying a stock households pick will be a large percentage of the purchase price of the shares. Additionally, the smallest denominations for some bonds are 1,000 or 10,000 and you may not have that much money to invest.

Question 13

What is one solution to the problem of high transaction costs?

Answer 13

Bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction is transaction costs per unit of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for each individual investor.

Question 14

Why do economies of scale exist?

Answer 14

The total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows.

Question 15

What is a mutual fund and how is this an example of a financial intermediary that arose because of economics of scale?

Answer 15

A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. It can take advantage of lower transaction costs as it buys large blocks of stocks and bonds. These cost savings are then passed on to individual investors after the mutual fund has taken its cut in the form of management fees for administering their accounts.

Question 16

What is an additional benefit for investors of a mutual fund?

Answer 16

A mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification for individual investors reduces their risk, making them better off.

Question 17

Financial intermediaries are also better at developing…

Answer 17

Expertise to lower transaction costs. Expertise in computer technology enables them to offer customers convenient services.

Question 18

An important outcome of a financial intermediary’s low transaction costs is the ability to…

Answer 18

Provide its customers with liquidity services, services that make it easier for customers to conduct transactions.

Question 19

What is asymmetric information?

Answer 19

A situation that arises when one’s party insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transactions.

Question 20

What is adverse selection?

Answer 20

It is an information problem that occurs before the transaction. Potential bad credit risks are the ones that most actively seek out loans. Thus the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction. For example, big risk takers or outright crooks might be the most eager to take out a loan because they know that they are unlikely to pay it back. As adverse selection increases the chances that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though there are good credit risks in the marketplace.

Question 21

What is moral hazard?

Answer 21

Moral hazard arises after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that a loan will be paid back. For example, once borrowers have obtained a loan, they may take on big risks (which have possible high returns but also run a greater risk of default) because they are playing with someone else’s money. As moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan.

Question 22

Explain the lemons problem.

Answer 22

Potential buyers of used cars are frequently unable to assess the quality of the car; they cannot tell whether a particular used car is a car that will run well or a lemon that will continually give them grief. The price that a buyer pays must therefore reflect the average quality of the cars in the market, somewhere between the low value of a lemon and the high value of a good car. The owner of a used car, by contrast, is more likely to know whether the car is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to pay, which, being somewhere between the value of a lemon and that of a good car, is greater than the lemon’s value. However, if the car is a peach, the owner knows that the car is undervalued at the price the buyer is willing to pay, and so the owner may not want to sell it. As a result of this adverse selection, few good used cars will come to the market. As the average quality of a used car available in the market will be low and because few people want to buy a lemon, there will be few sales. The used car market will function poorly, if at all.

Question 23

Explain the lemons problem in the security market (debt bond equity stock).

Answer 23

Suppose an investor cannot distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk. In this situation, an investor will be willing to pay only the price that reflects the average quality of firms issuing securities - a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners or managers of a good firm have better information than the investor and know they are a good firm, they know that their securities are undervalued and will not want to sell them to the investor at the price he is willing to pay. The only firms willing to sell the investor securities will be bad firms because his price is higher than securities are worth. The investor will not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. This market will not work very well because few firms will sell securities in it to raise capital. Similarly, the investor will buy a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms trying to sell the debt. The knowledgeable owners of a good firm realise that they will be paying a higher interest rate than they should, so they are unlikely to want to borrow in this market. Only the bad firms will be willing to borrow, and because investors will not be eager to buy bonds issued by bad firms, they will probably not buy any bonds at all. Few bonds are likely to sell in this market, so it will not be a good source of financing. Good securities would be undervalued and firms wont issue them. Bad securities would be undervalued and too many will be issued.

Question 24

What happens in the absence of asymmetric information?

Answer 24

The lemons problem goes away. If buyers know as much about the quality of used cars as sellers, so that all involved can tell a good car from a bad one, buyers will be willing to pay full value for good used cars. The owners of good used cars can now get a fair price, so they will be willing to sell them in the market. Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their securities in the market.

Question 25

What is one way to eliminate asymmetric information?

Answer 25

Have private companies collect and produce information that distinguishes good firms from bad. This furnishes the people supplying funds with full details about the individuals or firms seeking to finance their investment activities. In the US, companies such as Standard & Poor’s, Moody’s and Value Line gather information on firms’ balance sheet positions and investment activities, publish this data, and sell them to subscribers.

Question 26

Why does the system of private production and the sale of information not completely solve the adverse selection problem in the securities market?

Answer 26

The free rider problem. This occurs when people who do not pay for information take advantage of the information that other people have paid for. The increased demand for the undervalued good securities will cause their low price to be bid up immediately to reflect the securities’ true value. As there are free riders, you can no longer buy the securities for less than their true value. Now because you will not gain any profits from purchasing the information, you realise that you never should have paid for this information in the first place. If other investors come to the same realisation, private firms and individuals may not be able to sell enough of this information to make it worth their while to gather and produce it. The weakened ability of private firms to profit from selling information will mean that less information is produced in the marketplace, so adverse selection will still interfere with the efficient functioning of securities markets.

Question 27

How could government regulation increase information?

Answer 27

• It could produce information to help investors distinguish good firms from bad and provide it to the public free of charge. This would however, involve releasing negative information about firms, a practice that could be politically difficult.
• It could regulate securities markets in a way that encourages firms to reveal honest information about them so that investors can determine how good or bad the firms are. In the UK, there is the FSA - auditing prior to lsiting on the stock exchange. However, disclosure requirements do not always work well.
• Although government regulation lessens the adverse selection problem, it does not eliminate it. Even when firms provide information to the public about their sales, assets, earnings, they still have more information than investors; quality is not fully indicated by statistics.
• Bad firms have an incentive to make themselves look like good firms, because this would enable them to fetch a higher price for their securities. Bad firms will slant the information they are required to transmit to the public, thus making it harder for investors to sort out the good firms from the bad.

Question 28

How does financial intermediation solve the adverse selection problem?

Answer 28

Most used cars are nto sold directly by one individual to another. Instead, they are sold by an intermediary, a used car dealer who purchases used cars from individuals and resells them to other individuals. Used car dealers produce information in the market by becoming experts in determining whether a car is a lemon or a peach. Once they know that a car is good, they can sell it with some form of guarantee; either explicit (a warranty) or implicit (in which they stand by their reputation for honesty).
People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to make a profit on the production of information about the quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free riding on the information they produced. Additionally, a bank becomes an expert in producing information about firms so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to good firms. As the bank is able to lend to mostly good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity.

Question 29

How does the bank avoid the free rider problem?

Answer 29

It primarily makes private loans rather than by purchasing securities that are traded in the open market. As a private loan is not traded, investors cannot watch what the bank is doing and bid up the loan’s price to the point that the bank receives no compensation for the information it has produced.

Question 30

When the quality of information about firms is better…

Answer 30

Asymmetric information problems will be less severe and it will be easier for firms to issue securities.

Question 31

As information about firms becomes easier to acquire…

Answer 31

The role of banks decline.

Question 32

The better known a corporation is…

Answer 32

The more information about its activities is available in the marketplace. Thus it is easier for investors to evaluate the quality and whether it is a good or bad firm. As investors have fewer worries about adverse selection with well known corporations, they will be willing to invest directly in their securities.

Question 33

Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults. How does collateral reduce the consequences of adverse selection?

Answer 33

Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you fail to make your mortgage payments, the lender can take title to your house, auction it off, and use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely they will get the loan in the first place and perhaps at a better rate.

Question 34

What is net worth (also called equity capital)?

Answer 34

The difference between a firm’s assets and its liabilities. It can perform a similar role to collateral. If a firm has a high net worth, then even if it engages in investments that cause it to have negative profits and so defaults on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans.

Question 35

Equity contracts are subject to a particular type of moral hazard called…

Answer 35

Principal agent problem. Equity contracts such as stocks, are claims to a share in the profits or assets of a business. When managers own a small fraction of the firm they work for, the stockholders who own most of the firm’s equity (principals) are not the same people are the managers of the firm, who are the agents in control. This separation of ownership and control involves moral hazard, in that managers in control (the agent) may act in their own interest rather than in the interest of the stockholder-owners (principals) because the managers have less incentive to maximise profits than the stockholder-owners do.

Question 36

The principal-agent problem created by equity contracts indicates that managers may…

Answer 36

• Pursue their own personal benefits.
• Pursue corporate strategies that enhance their personal power but do not increase the corporation’s profitability.
• Divert funds for their own personal use.

Question 37

The principal-agent problem would not arise if…

Answer 37

The owners of a firm had complete information about what the managers were up to and could prevent wasteful expenditures or fraud. The principal-agent problem arises only because the managers have more information about their activities than the stockholders do, there is asymmetric information.

Question 38

One way for stockholders to reduce this moral hazard problem is for them to engage in a particular type of…

Answer 38

Information production, the monitoring of the firm’s activities; auditing the firm frequently and checking on what the management is doing.

Question 39

What is the problem with this particular production of information: monitoring?

Answer 39

The process can be expensive in terms of time and money, hence the given name, costly state verification. Costly state verification makes this equity contract less desirable.

Question 40

As with adverse selection, the free rider problem decreases the amount of information production that would reduce the moral hazard (principal-agent) problem. In this example, the free rider problem decreases…

Answer 40

Monitoring. If you know what the other stockholders are paying to monitor the activities of the company you hold shares in, you can take a free ride on their activities. Then you can use the money you save by engaging in monitoring. This means that all stockholders can do this. If no one spends any resources on monitoring the firm, the moral hazard for shares of stock will be severe, making it hard for firms to issue them to raise capital.

Question 41

How could government regulation to increase information solve the principal agent problem?

Answer 41

As with adverse selection, the government has an incentive to try to reduce the moral hazard problem created by asymmetric information.
- They can pass laws to force firms to adhere to standard accounting principles that make profit verification easier.
- They also pass laws to impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits.
However, catching this fraud is not easy; fraudulent managers have the incentive to make it very hard for government agencies to find or prove fraud.

Question 42

How does financial intermediation help solve the principal-agent problem?

Answer 42

Financial intermediaries have the ability to avoid the free rider problem in the face of moral hazard. Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses. In exchange for the use of venture capital firms, the firm receives an equity share in the new business. As verification of earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist on having several of their own people participate as members of the managing body of the firm, the board of directors, so that they can keep a close watch on the firm’s activities. When a venture capital firm supplies start up funds, the equity in the firm is not marketable to anyone except the venture capital firm. Thus investors are unable to take a free ride on the venture capital firm’s verification activities. As a result of this arrangement, the venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incentives to reduce the moral hazard problem.

Question 43

How do debt contracts solve the principal-agent problem?

Answer 43

A contractual agreement by the borrower to pay the lender fixed monetary amounts at periodic intervals. When the firm has high profits, the lender receives the contractual payments and does not need to know the exact profits of the firm. If the managers are hiding profits or are pursuing activities that are personally beneficial but do not increase profitability, the lender does not care as long as these activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm cannot meet its debt payments, thereby being in a state of default, is there a need for the lender to verify the state of the firm’s profits. The less frequent need to monitor, and thus the lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital.

Question 44

Why are debt contracts still subject to moral hazard?

Answer 44

As a debt contract requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take on investment projects that are riskier than the lenders would like.

Question 45

How does net worth and collateral help solve moral hazard in debt contracts?

Answer 45

When borrowers have more at stake because their net worth is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard will be greatly reduced because the borrowers themselves have a lot to lose in case of default. The solution that high net worth and collateral provide to the moral hazard problem can be described as it makes the debt contract incentive-compatible. This means it aligns the incentives of the borrower with those of the lender. The greater the borrower’s net worth and collateral pledged, then the greater the borrower’s incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is for the firm or household to borrow. Conversely, when the borrower’s net worth and collateral pledged are lower, the moral hazard problem is greater, and it is harder to borrow.

Question 46

How does monitoring and enforcement of restrictive covenants solve the moral hazard in debt contracts?

Answer 46

The lender can write provisions into the debt contract that restrict the borrower’s behaviour. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behaviour or by encouraging desirable behaviour.

• Covenants to discourage undesirable behaviour of undertaking risky investment projects. (e.g. some mandate that a loan can be used only to finance specific activities)
• Covenants to encourage desirable behaviour. This could be engaging in activities that make it more likely that the loan will be paid off. (e.g. requiring the breadwinner in a household to carry life insurance that pays off the mortgage upon that person’s death or a business focusing on keeping its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses)
• Covenants to keep collateral valuable, in good condition and make sure that it stays in possession of the borrower. (e.g. home mortgage recipient must have adequate insurance on the home and must pay off the mortgage when the property is sold)
• Covenants to provide information. (e.g. quarterly accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. Also this covenant may stimulate that the lender has the right to audit and inspect the firm’s books at any time)

Question 47

How does financial intermediation help solve moral hazard in debt contracts?

Answer 47

It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find loopholes in restrictive covenants that make them ineffective. Another problem with restrictive covenants is that have to be monitored and enforced. They are meaningless if the borrower can violate it knowing that the lender will not check up or is unwilling to pay for legal recourse. As monitoring and enforcement of restrictive covenants are costly, the free rider problem arises in the bond market. If you know that other bondholders are monitoring and enforcing restrictive covenants, you can free ride on their monitoring and enforcement. All bondholders can do this so the likely outcome is that not enough resources are devoted to monitoring and enforcing the restrictive covenants. Moral hazard continues to be a problem. As banks primarily make private loans which are not traded, no one can free ride on the intermediary’s monitoring and enforcement of the restrictive covenants. The intermediary thus receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts.

Question 48

How does an underdeveloped financial system lead to a low state of economic development and economic growth?

Answer 48

• The system of property rights (the rule of law, constraints on government expropriation, absence of corruption) functions poorly making it hard to use collateral and restrictive covenants effectively. Where the market is unable to use collateral effectively, the adverse selection problem will be worse, because the lender will need even more information about the quality of the borrower so that it can screen out a good loan from a bad one. The result is that it will be harder for lenders to channel funds to borrowers with the most productive investment opportunities. There will be less productive investment and hence a slower growing economy. Similarly, a poorly developed or corrupt legal system may make it extremely difficult for lenders to enforce restrictive covenants. Thus they may have a much more limited ability to reduce moral hazard on the part of borrowers and so will be less willing to lend. Again the outcome will be less productive investment and a lower growth rate for the economy.
• Bankruptcy procedures are often extremely slow and cumbersome.
• Governments in developing countries often use their financial systems to direct credit to themselves. Private institutions have an incentive to solve adverse selection and moral hazard problems and lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so as they are not driven by the profit motive and thus their directed credit programmes may not channel funds to sectors that will produce high growth for the economy.
• State owned banks’ absence of profit motive and little incentive to allocate their capital efficiently and to productive uses.
• Underdeveloped regulatory apparatus that retards the provision of adequate information to the marketplace, for example, weak accounting standards. As a result asymmetric information problems are more severe.