Analysis of financial structure pot

Chapter 8
An Economic
Analysis of
Financial Structure
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-2
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-3
Eight Basic Facts
1. Stocks are not the most important sources of
external financing for businesses (figure 1)
==> Why?
2. Issuing marketable debt and equity securities
is not the primary way in which businesses
finance their operations (figure 1) ==> Why?
3. Indirect finance is many times more important
than direct finance ((figure 1) ==> Why?
4. Financial intermediaries are the most
important source of external funds (figure 1)
==> Why?
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-4
Eight Basic Facts (cont’d)
5. The financial system is among the most
heavily regulated sectors of the economy
6. Only large, well-established corporations
have easy to issue securities to markets to
finance their activities
7. Collateral is a prevalent feature of
debt contracts
8. Debt contracts are extremely complicated

legal documents that place substantial
restrictive covenants on borrowers
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-5
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.
8-6
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.
8-7
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.
8-8
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.
8-9
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.
8-10
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.
8-11
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.
8-12
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.
8-13
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-14
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.
8-15
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.
8-16
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.
8-17
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.
8-18
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.
8-19
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.
8-20
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.
8-21
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
8-22

END OF CHAPTER