SUMMARY OF CHAPTER 8: An Economic Analysis of Financial Structure FACTS ABOUT FINANCIAL STRUCTURE The financial system is complex and contains institutions like: Banks, insurance companies, mutual funds, stock and bond markets. The most important role of the financial markets is to channel funds from savers to people with productive investment opportunities. For the financial structure their are eight basic facts, where the four first emphasize the importance of financial intermediaries and the relative unimportance of securities markets for financing corporations. The first four tells about how stocks and bonds are relatively unimportant in financing corporations. And how indirect financing and financial intermediaries (ex. Bank loans) are by far the most used financing. The next four says how the financial sector is among the most regulated sector (5). How only large and well established companies can benefit from the financial markets (6). I also states that collateral is a common feature in most debt contracts (7). And it says that debt contracts are extremely complicated legal documents, which place many restrictions on the behavior of the borrowers (8). TRANSACTION COST Transaction costs and the size of securities posts are major problems in the financial markets. Only every second household in the states hold securities, which often is undiversified, this because of the size of the security posts and transaction costs. One way to reduce transaction costs is by using financial intermediaries like banks. Savers can also bundle up and buy in large volumes and then achieve economics of scale, reducing costs. This is also done through mutual funds. They sell shares to investors and reinvest the proceeds in shares and bonds, then achieving reduced risk and lower costs. Financial intermediaries also achieve expertise through specializing in trades also creating benefits. ASYMTERIC INFORMATION The analysis of how asymmetric information creates the root of many economical problems is called the agency theory. Asymmetric information is defined as a situation where one party in a trade is lacking information, which unable the parties to make an accurate decision in the trade. The financial market reflects this issue. This theory is trying to explain why the financial structure takes the form it does through looking at the problem of adverse selection and moral hazard. Adverse selection occurs before a transaction and refers to the fact that bad credit risks are the ones most likely to a make a loan. While moral hazard occurs after a transaction and refers to activities the borrowers does, which is undesirable to the lender, but which the lender doesn’t know about. ADVERSE SELECTION AND FINANCIAL STRUCTURE Adverse selection affects the market. Many can relate to it through the pecking order theory and also through a theory called the Lemons Problem. Why does adverse selection create a poorly functioning financial market? By looking at how a company thinks when they issue stock, knowing that if they think they are a good company they will never issue stock at a price anyone will buy for. And if they know they are a bad company, then they will gladly issue a stock price the buyer will pay. The buyer knows the company have more information than him and rationally keeps away. The result explains the basic fact number one and two, showing that the security market is not well functioning.
Knowing the effects of adverse selection, do we know what to do about it? The main problem is an asymmetric information picture. So the focus would be to make the market more transparent. One solution would be to buy information from private company’s specializing in getting this information. This would provide the buyer with a better picture of how to pay the right price for the right company. The problem here comes with something called the free rider problem. Because the market is open, free riders will also buy where they see other people making a profit, without paying for the profit making information. Because of equalization of market prices, the people buying information will loose there advantage and thus not buy information anymore. Another solution could be for the government to impose regulations upon companies, such that that they would have to provide information to the public. This could work well for the buyer. But it will also impose political problems. After scandals like the Enron case we see that there have become more regulations, which also is reflected in the basic fact number five. Further we will we see what financial intermediation provides the market, and why they are so popular. We see that banks become specialists in producing information about firms. This enables them to sort bad companies from good companies. Our question is then: “How come banks can profit from this, and not private companies”. The answer is that financial intermediaries handle private loans, i.e. not publicly traded, so they don’t have to deal with free riders, and thus can keep the profit from their information. This contributes in explaining basic fact three and four. Last but not least we explain the seventh basic fact, about why collateral is used. Collateral simply reduces the effects of adverse selection, simply by minimizing the risk for the lender. MORAL HAZARD, EQUITY & DEBT Moral hazard is an asymmetric information problem occurring after the transaction has taken place. With equity this problem is called the principal – agent problem. This occurs when a manager (the agent) have more information about a firm, and tries to use this to his own personal benefit. This problem would not occur if the owner (the principal) would know the agents activities. There are many ways to try to solve this. One would be to have a third independent part, confirm the agent’s activities to the principal. This works to a degree, but it is costly and might create the same problems as with free riders. Financial intermediation, like venture capital companies are also proving to solve moral hazard. They buy parts of the company, implement people in the management getting all information and they also have the benefit of being totally private not having problems with free riders. The problems with moral hazard are different dealing with debt and equity. Debt contracts have with fixed payments and other constraints. The problem with moral hazard is smaller in the debt markets, this is one of the reasons for the debt market being so much bigger than the equity market. This is not said that there is not moral hazard involved with making loans. The problem with loans is that borrower pays fixed payments each months and keeps the residual, in other words, the profit for him self. This gives the borrower an incentive to increase the risk, the volatility, because the loss for him will be the same, but the gain will be pure profit. One remedy is off course to have the borrower provide some collateral, making the loss become aligned with the banks loss. The next step would be to impose some sort of restrictive covenants upon the lender. In general the covenants are made by ruling out undesirable behavior or by encouraging desirable behavior. An example could be that a company would have to provide a net working capital above 50% of their short term debt, and so on. But here again we see that the asymmetric information problem arises. Who will be the ones the check up on the covenants? This is costly
and creates a source for the free rider problem just as in the equity market. Here we see that financial intermediation makes a better job. They are able to have better information, and given that most their of loans are private, they will avoid free rider problems. CONFLICTS OF INTEREST Big companies with offering multiple services under the same roof often achieve economic of scope, lower costs. But the same companies often have conflict filled roles. Like an auditing company giving advises on how to minimize taxes and at the same time doing the auditing of the same companies books. And also suppose to be the independent third party. Conflicts also arise when investment banks are supposed to make neutral evaluations of companies and at the same time having underwritings of the company they are making the analysis of. We can clearly see the problems arising from these conflicts. Conflicts contributing to increase the information asymmetry in the financial markets, and thus preventing the channeling of funds from going to the most productive investment opportunities. After several severe financial scandals, we in 2002 got the Sarbanes – Oxley Act and the Global Legal Settlement. The Sarbanes – Oxley Act established higher information criteria’s, “beefs up” the criminal charges for white collar crimes and comes with the principal of separation of functions within the companies. The Global Legal Settlement contributed with more or less the same rules as the Sarbanes – Oxley Act, but here aimed toward the big banking firms. FINANCIAL CRISES AND AGGREGATE ECONOMIC ACTIVITY After looking at what asymmetric information can do with the process of channeling funds from savers to productive users, we look at what can cause financial crises: Financial crisis described as major disruptions in financial markets characterized by sharp declines in asset prices and the failures of many financial and no financial firms. There are five known categories of factors that can trigger financial crises. If the interest rate increases, this will lead to an increase in the adverse selection problem. Bad credit risks will want to borrow, will good credit risks don’t. This will lead to fewer loans from the banks side, and thus a decline in lending and aggregate economic activity. If it arises uncertainty in the market this might lead to a financial crisis. Reasons for the uncertainty might be stock market crashes or recessions, this will make it harder for banks screening good from bad borrowers. Increasing the problem of adverse selection and reducing the amount of loans given. The third effect is called the asset market effects on balance sheet. A sharp decline in a company’s stock price means a sharp decline of the company’s net worth. This have two effects, it decreases the collateral to the lenders which again increases problems with adverse selection. On the other side it also increases the chances of moral hazard, giving borrowing firms a better reason to increase there risk, given they have less collateral to loose. Two more problems can deteriorate a firms balance sheet, either that a country’s currency depreciates or again an increase in the rent level. Problems in the banking sector can also create a financial crisis. If banks are suffering an economic downturn, this might lead to a contraction in their lending activities, resulting in a decline in aggregate economic activity and an increase in the rent level. If the bank recession is severe, this might lead to a bank panic. The last factor would be the government having fiscal imbalance. This can lead to fear of the government defaulting on government debt. Which again can lead to the bonds declining in price, which weakens the banks or it can result in exchange crises weakening the domestic currency.