Chapter 16

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					Chapter 16
Key Topics
 Analyze the stockholder-lender and
  manager-stockholder conflicts
 Understand the different financial structures
  that limit these conflicts
 Compare and contrast the financial system
  design of Germany, Japan, the United
  Kingdom, and the United States

Financial System
 Two models of financial system in industrialized
  nations are:
    Markets-oriented
       United States and United Kingdom
    Banking-oriented
       Germany and Japan

Common Elements
 Payments system
   Processing of checks
   Electronic transfers
 Specialized Financial Intermediaries
   Organizations or activities designed to perform
    Specific functions within the financial system
 Deposit Insurance
   Protecting individual depositor
 Central Bank
   Responsible for issuing currency and
    implementing monetary policy

 Primarily related to how businesses obtain
 The private ownership of business leads to
  two fundamental problems:
      Stockholder-lender conflict
      Management-stockholder conflict
 These problems are handled differently by
  the financial sectors in the various systems

Stockholder-Lender Conflict

 Adverse selection
   Firm owners (stockholders) have an incentive
    to understate their true riskiness to obtain
    borrowing on a more favorable basis
 Moral hazard
   Firms have an incentive to become riskier after
    their loans are funded
 Magnitude of asymmetric information
   Less for large companies
   Large amounts of publicly available information

Manager-Stockholder Conflict
 Greater with large companies
 Owners (stockholders) delegate the
  management to professional managers
 Owners want manager to operate the firm in
  their best interest
   maximize value of the stock

Manager-Stockholder Conflict

 Unfortunately, the manager may have other
   Minimize their own effort
   Maximize their salaries and perks
   Maximize the firm’s size to increase their
   May give up value-maximizing projects
      Want to preserve their jobs
      Choose excessively safe strategies
      rather than strategies that may involve more risk

Manager-Stockholder Conflict

 Problems
   Difficult and costly to monitor performances
   Difficult to know if poor outcome is due to poor
    performance or bad luck
   Difficult to judge and prove whether an activity
    is in the best interest of the stockholders
   Since there are often a large number of
    stockholders, there is no incentive for any
    owner to monitor the performance

Manager-Stockholder Conflict

 Less problem with Small, closely held firms
  Owner is often the manager, which eliminates the
   stockholder-manager conflict
  A significant amount of stock is held by one investor
     Potential gains of monitoring the performance is much
      greater than the costs
     Major stockholder has a great incentive to monitor the
      manager’s performance
  The owner in a closely held firm often has the
   power to control the firm’s board of directors and
   fire managers

Two conflicts are associated with
external financing

   almost all firms raise funds from outsiders in the
    form of debt or equity
   These two conflicts are dealt with differently in a
    banking-oriented financial system as compared
    to a markets-oriented financial system

Information and System Design

• Conflict Resolution and Financial System
  Design (Cont.)
    • Banking-oriented—banks actually own companies
      they monitor, and the stock and bond markets are
      relatively underdeveloped
    • Markets-oriented—banks do not own companies and
      public bond and stock markets are prominent
    • Figure 16.2 summarizes how banking-oriented
      systems (a) and markets-oriented systems (b) solve
      the stockholder-lender and manager-stockholder
FIGURE 16.2 Financial system
design: conflict resolution.

Information and System Design

• Small Firms: Stockholder-Lender Conflict
  – Both systems treat small firms similarly
  – Small firms borrow from banks and other monitoring-
    intensive financial intermediaries
  – Banks are specialists in information--ideally suited to
    assess borrower risk before making the loan
  – Design loan contracts to minimize the incentive to
    become riskier after the loan is made
• Small firms: Manager-Stockholder Conflict
  – Not a problem in either financial system

Information and System Design

• Large firms: Stockholder-Lender Conflict
  – The two financial systems treat large firms significantly
  – Markets-Oriented System
     • Large firms tend to borrow short term in commercial paper
       market and borrow long term in the bond market
     • Production of information about business risk is delegated to
       bond rating agencies
     • Widespread availability of public information, plus credit ratings,
       enables large firms to develop reputation for not becoming too

Information and System Design

• Large firms: Stockholder-Lender Conflict (Cont.)
  – Banking-Oriented Systems
     • When lender and stockholders are the same (the bank), as is
       often the situation, this problem does not exists
     • No incentive for stockholder to exploit themselves
     • However, it is generally not the case that banks own all of the
       firm’s equity
     • Nevertheless, consolidation of ownership is often large enough
       that the bank owns a controlling interest

Information and System Design

• Large Firms: Manager-Stockholder Conflict
  – Banking-Oriented Systems
    • Solution is driven principally by the bank’s ownership
      of the business
    • Bank has the incentive to monitor the behavior of the
      firm’s management
    • Bank also has control over management so it can
      fire an incompetent manager

Information and System Design

• Large Firms: Manager-Stockholder Conflict
  – Markets-Oriented Systems
     • Because of diffuse ownership, little incentive for individual
       stockholders to monitor performance of managers
     • Often the CEO will influence who is selected to serve on the
       board of directors, which results in ignoring the CEO’s poor
     • Creates a distinct possibility that inefficient managers become
       entrenched and the firm becomes manager-controlled

Information and System Design

• Large Firms: Manager-Stockholder Conflict
  – Markets-Oriented Systems (Cont.)
     • Often this situation is resolved through a corporate takeover
       and new owners replace previous managers
     • Managers will actively resist such a takeover effort
     • Hostile takeover—attempts to takeover a company against
       current management’s wishes
     • To minimize the conflict, management’s compensation
       packages are structured to link compensation to performance
       desired by stockholders

Financial System Design: Summary
of Four Countries

• Germany
  – A strong banking-oriented financial system
  – Hausbank
     • A single bank that is the primary source of external financing,
       both debt and equity
     • The relationship between a business firm and their Hausbank is
       a very powerful one
     • This relationship fosters bank participation in the strategic
       activities of the firm through stock ownership and control, and
       sitting on company supervisory boards

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
  – Hausbank (Cont.)
    • Bank ownership participation is both direct and
       – Direct—bank owns a large share of the stock
       – Indirect—individuals and institutions deposit stock holdings
         in a trust account with a bank and voting rights are
         conveyed to the bank

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
  – Organization of the banking system
    • Commercial banks
       – Comprised of three major banks and a number of regional
         and private banks
       – Active participants in the international markets
    • Savings banks
       – Typically owned by regional or town government which
         operate locally
       – Initially organized as mortgage lenders but now offer full
         commercial banking services

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
  – Organization of the banking system (Cont.)
    • Cooperative banks
       – First established to collect savings and extend credit to
    • Specialized banks
       – Mortgage, consumer lending, small business loan
         guarantees, export financing, and industry-specific

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
  – Dominance of banks in Germany comes at the
    expense of the securities markets
    • Stock, bond, and commercial paper markets are not
      very important
    • Eight regional stock exchanges, dominated by the
      Frankfurt exchange
    • Less than a quarter of the largest German
      companies are listed, and a large proportion are not
      actively traded

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
    • Corporate bond and commercial paper market is
      very small, largely due to taxes and regulations prior
      to 1992 making it very expensive to issue these
    • Therefore, most German companies are highly
      dependent on their banks for credit

Financial System Design: Summary
of Four Countries (Cont.)

• Germany (Cont.)
  – Dominance of banking system is aided by regulations
    that permits universal banking
     • Can engage in a variety of financial service activities
     • Permitted to own nonfinancial companies and underwrite
       corporate securities and insurance
     • Those who advocate giving U.S. banks full underwriting
       privileges cite German universal banking as model of success
     • However, this success might be a result of a poorly developed
       stock and bond market which is not the case in the United

Financial System Design: Summary
of Four Countries (Cont.)

• Japan
  – Keiretsu form of industrial organization
     • A group of companies that are controlled through
       interlocking ownership—companies own stock in
       each other
     • Encourages strong loyalty among the companies,
       including favoritism in customer-supplier
     • Each keiretsu has a main bank that typically owns
       stock in other members of the keiretsu

Financial System Design: Summary
of Four Countries (Cont.)

• Japan (Cont.)
  – Japanese banks may own equity in nonfinancial
    companies, although this is now limited to 5 percent in
    any single firm
  – Organization of the banking system
     • City banks—represent a disproportionately large fraction of the
       world’s biggest banks
     • Regional banks
     • Special-purpose financial institutions—include long-term credit
       banks, specialized small business and industrial institutions

Financial System Design: Summary
of Four Countries (Cont.)

• Japan (Cont.)
  – Historically corporate debt markets have been
    suppressed, further enhancing power of banks
  – The result is a vast majority of debt financing that
    comes from the banking system
  – Unlike Germany, stock market is quite large, however
    extensive cross ownership masks high degree of
    concentration of ownership
  – Adopted laws that separate commercial banking from
    investment banking, however, this separation has been

Financial System Design: Summary
of Four Countries (Cont.)

• United Kingdom
  – Financial system is very much markets-
    oriented, although banks play a very important
  – London serves as both a domestic financial
    center as well as the center of the Eurobond
  – Regulatory environment encourages foreign
    participation and competition in financial
Financial System Design: Summary
of Four Countries (Cont.)

• United Kingdom (Cont.)
  – Organization of the banking system
     • Clearing banks—universal banks, securities activities through
       subsidiaries, extensive branch networks
     • Merchant banks—provide wholesale banking services to large
     • “other” British banks—consisting of institutions similar to
       merchant banks and specialized banks
     • “other” deposit-taking institutions—mostly building societies
       which are similar to savings and loan associations in U.S.

Financial System Design: Summary
of Four Countries (Cont.)

• United Kingdom (Cont.)
  – Banks in the United Kingdom generally do not own
    nonfinancial corporations
     • While not explicitly prohibited, this practice is discourage by
       The Bank of England to promote a safer banking system
  – The Bank of England supervises banks on an informal
    basis, relying on the English tradition—“Old boy
    network” and applying moral suasion to influence the
    banking system

Financial System Design: Summary
of Four Countries (Cont.)

• United States
  – Financial system in the United States has been
    extensively examined in Chapters 11-15
  – Very large stock, bond, and commercial paper markets-
    -model of the markets-oriented system
  – Securitization of residential mortgages and other
    financial assets has further strengthened the traded
    securities markets
  – Banks play a key role in external financing for small and
    midsize companies, not for large firms

Financial System Design and
Conflict Resolution

• Measure differences between banking-oriented
  and markets-oriented systems
  – Figure 16.3 shows the size of the banking market and
    stock market in each of the four countries
  – Banking dominates in Germany and Japan, while
    financial markets dominate in the U.K. and U.S.
  – Large degree of ownership by banks in banking-
    oriented system, much less in markets-oriented
  – Quantitative evidence strongly supports labeling
    Germany and Japan as banking-oriented and the U.S.
    and U.K. as markets-oriented

FIGURE 16.3 Size of banking and stock
markets (percentage of GDP), 2007.

Financial System Design and
Conflict Resolution (Cont.)

• Conflict Resolution in the Big Four
  – How is financial distress managed within the two major
    orientations of the financial system
  – When a company is in financial distress it cannot meet
    its financial obligations
     • For markets-oriented system, during these periods,
       stockholder-bondholder (lender) conflict is extreme since
       owners have very little stake left in their firm and cannot agree
       on a strategy short of bankruptcy
     • In banking-oriented systems it is easier for company to deal
       with conflict under protective wing of its main bank.

Financial System Design and
Conflict Resolution (Cont.)

• Conflict Resolution in the Big Four (Cont.)
  – Dealing with manager-stockholder conflict varies
    between the two systems
     • Concentration of ownership in the banking-oriented system
       gives banks a major incentive to monitor corporate
     • Due to diffusion of concentration in the markets-oriented
       system, little incentive for the individual stockholder to monitor
     • Predictably, there is a much larger volume of mergers and
       acquisitions under the markets-oriented system

Financial System Design and
Conflict Resolution (Cont.)

• And the Winner is. . .
   – Each system has advantages and disadvantages
   – A few conclusions:
      • Banks with substantial ownership are better at solving the
        stockholder-lender or management-stockholder conflict than
        rating agencies or individual stockholders
      • This requires intensive monitoring which is expensive
      • Stocks and bonds issued by firms in banking-oriented systems
        are much less liquid because of poorly developed markets

Financial System Design and
Conflict Resolution (Cont.)

 A few conclusions:
 This raises the cost of raising capital in Germany and
 Therefore, there is a trade-off between the two systems
 Financial innovations and developments in all
  four countries suggest that there might be a good
  compromise between extremes of the two

Financial System Design for Eastern
Europe and other Emerging Economics

 • An initial development in these countries was
   to develop privatization programs which
   transforms government-owned companies
   into privately owned firms
 • Typically involve distribution of shares to
   major stockholders (employees, managers,
   and creditors)
 • Privatization initially focused on small and
   midsize companies

Financial System Design for Eastern
Europe and other Emerging Economics

 • Privatization must occur with
   developments of new securities
   markets—primarily equity markets
 • However, it is likely a banking-oriented
   system may make more sense for these
   formerly planned economies that are
   accustomed to strict governmental

Eastern Europe and other Emerging

• At present, Eastern Europe can be
  regarded as an information-poor
  environment, with little public information
  about large firms
  – Rating agencies do not exist
  – Reputation building is extremely difficult
  – Lack of managerial talent and experience
    suggests that monitoring will be especially
• All these factors indicate that a banking-
  oriented system may be more suitable            16-42