ECON248: Money and Banking Ch.5 Dr.

Mohammed Alwosabi

Basic Facts about Financial Structure:

1. Stocks are not the most important source
Ch. 5 of external financing for businesses.
(Ch.8 in the Text) 2. Issuing marketable debt and equity
securities is not the primary way in which
businesses finance their operations.
3 Indirect
3. I di t finance,
fi which
hi h involves
i l the
th
An Economic Analysis off activities of financial intermediaries, is
Financial Structure many times more important than direct
finance, in which businesses raise funds
directly from lenders in financial markets.

1
2

4. Financial intermediaries, particularly 7. Collateral is a prevalent feature of debt

banks, are the most important source of contracts for both households and
external funds used to finance businesses. businesses.
5. The financial system is among the most 8. Debt contracts typically are extremely
heavily regulated sectors of the economy. complicated legal documents that place
6. Only large, well-established corporations substantial restrictions on the behavior of
have easy access to securities market to the borrower.
finance their activities.

3 4

The heavy reliance on intermediated (indirect) Transaction Costs

finance has to do with • Transaction costs are the time and money
1.Transactions Costs spent in carrying out financial transactions.
2.Liquidity Insurance • |They include contracting costs, brokerage
3.Information Costs and Asymmetric fees, commissions, indivisibilities,...etc.
Information • Transaction costs are a major problem in
a. Adverse Selection fi
financial
i l markets.
k t ThThey are too
t high
hi h for
f
b. Moral Hazard ordinary people.
• Financial intermediaries help in reducing
transaction costs and allow small savers
and borrowers to benefit from the existence
of financial markets.
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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

1. One solution to the problem of high • The presence of economies of scale in an

transaction costs is to pool the funds of investment means that the investment is
large enough to purchase a widely
many investors together so that they can diversified portfolio of securities.
take advantage of economies of scale. • The increased diversification for individual
• Economies of scale refer to the reduction investors reduces their risk, making them
in transaction costs per unit of the amount better off.
invested as the size (scale) of transaction 2.Financial intermediaries are also better able
t develop
to d l expertise
ti tot llower transaction
t ti
increases. costs.
• It exists because the total cost of carrying
out a transaction in financial markets
increases only a little as the size of the
transaction grows.
7 8

Liquidity Insurance Asymmetric Information: Adverse Selection

• The ability to provide its customers with and Moral Hazard
liquidity services that make it easier to • As an important aspect of financial markets,
conduct transactions. Asymmetric information is a situation that
arises when one party’s insufficient
knowledge about the other party involved in
a transaction makes it impossible to make
accurate decision when conducting the
transaction.
• e.g. a borrower has better information about
his future income than the lender
• e.g. managers know more about health of
the company than stockholders
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• The presence of asymmetric information How Adverse Selection Influences Financial

leads to adverse selection and moral hazard Structure
problems.
• Adverse selection problem occurs before
• The analysis of how asymmetric information the transaction
problems affect economic behavior is called
agency theory. • Because of asymmetric information problem
of adverse selection the potential buyer of
stocks or bonds can
can’tt distinguish between
good firms with high expected profits and
low risk and bad firms with low expected
profits and high risk. In this situation,

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

• The potential buyer will be willing to pay • The only firms willing to sell at the price
only a price that reflects the average offered will be bad firms because the price
quality of firms issuing securities– a price offered is higher than the securities are
that lies between the value of securities worth.
from bad firms and the value of those from • But the potential buyer is not willing to hold
good firms. securities of bad firms, and hence he will
• If the owners or managers of a good firm decide not to purchase securities in the
have better information that they are sure market.
they have a good firm they will not accept • Therefore, this securities market will not
the undervalued price that is offered by the work very well because few firms will sell
potential buyer. securities in it to raise capital.

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• The analysis is similar if the potential buyer • Only the bad firms will be ready to borrow
considers purchasing a corporate debt but the potential buyer is not willing to buy
instrument in the bond market. bonds issued by them.
• The potential buyer will purchase a bond • Again, few bonds are likely to sell in this
only if its interest rate is high enough to market, so it will not be a good source of
compensate him for the average default risk financing.
of the good and bad firms willing to sell the
debt.
• The owners of the good firm have more
information than the potential buyer that
their firm is going to pay higher interest rate
than the buyer is expecting and hence they
are unlikely willing to borrow in this market.
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• The analysis discussed above explains why Tools to help Reduce Adverse Selection
marketable securities are not the primary Problems
source of financing (fact 2). It also partly • The solution to adverse selection problem in
explains why stocks are not the most financial markets is to eliminate asymmetric
important source of financing (fact 1). information by furnishing the people
supplying funds with full details about the
• The presence of adverse selection problem individuals or firms seeking to finance their
keeps securities markets from being investment activities
activities.
effective in challenging funds from savers to
borrowers

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

1. One way to provide information to savers- • However, the system of private production
lenders is through establishing private and sale of information does not completely
companies specialized in collecting and solve the adverse selection problem in
producing information that distinguishes securities market because of the free-rider
good from bad firms and then sell this problem.
information to those who are interested in • The free-rider problem occurs when people
acquiring
q g them. who do not pay for information take
• These firms such as Credit rating agencies advantage of the information that other
Standard and Poor’s, Moody's) gather people have paid for.
information of firms’ balance sheet
positions and investment activities and
then sell them to subscribers.
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• Free-riders watch the investors who have • Because of free-riders, investors who paid
bought the information to make better for information will not have any advantage
decision in purchasing the securities of from purchasing the information and they
good firms that are undervalued, and then wish they should never paid for this
information in the first place.
he buys the same securities that investors
who paid for information. • If many investors face the same problem
and react in the same way, firms selling
• If many free-riders act in the same way, the information will realize that this information
increased demand for the undervalued good producing business is not that profitable
profitable.
securities will lead to an increase in the • This means less information will be
prices of these good firms’ securities. produced and adverse selection problem
will prevail resulting in inefficient
functioning of securities market.

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• Thus, the free-rider problem prevents the 2. Government Regulation to Increase

private market from producing enough Information
information to eliminate all the symmetric • To compensate the shortage of information
information that leads to the adverse production in the private market
selection problem. government intervention is necessary.
• Government regulates securities markets
in a way that forces firm to reveal honest
information about themselves so that
investors can determine how good or bad
the firms are.

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

• Special government agencies require firms • Even when firms provide information to the
selling their securities to have independent public about their sales, assets, or earnings,
audits to certify that the firm is adhering to they still have more information than
standard accounting principles and investors: There is information related to
disclosing accurate information about sales, quality that cannot be provided merely by
assets, and earnings. statistics.
• However, disclosure requirements do not • Furthermore, bad firms have an incentive to
always work well.
well For example,
example the collapse make themselves look like good firms
of Enron, WorldCom and other firms making it hard for investors to sort out good
illustrates that government regulation can firms from the bad ones.
lessen asymmetric information problems of • The adverse selection in financial markets
adverse selection and moral hazard, but helps explain why financial markets are
cannot eliminate them. among the most heavily regulated sectors in
the economy (fact 5).
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3. Financial Intermediation • Financial intermediaries help solve adverse

• As discussed above, private production of selection problems in financial markets.
information and government regulation to • Financial intermediary, such as a bank,
encourage provision of information lessen becomes an expert in producing information
but don not eliminate the adverse selection about firms, so that it can sort out good
problem in financial markets. credit risks from bad ones. Then it can
acquire funds from depositors and lend
them to the good firms, which results in
high profit for the bank.

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• An important element in the bank’s ability to • Since financial intermediaries play a greater
profit from the information it produces is role in moving funds to firms than securities
that it avoids the free-rider problem by markets do, indirect finance is so much
mainly making private loans rather than more important than direct finance and
banks are the most important source of
purchasing securities that are traded in the external funds for financing businesses
open market. (facts, 3 and 4).
• The bank
bank’ss role as an intermediary that hold • Since information about private firms is
mostly non-traded loans is the key to its harder to collect in developing countries
success in reducing asymmetric information than in industrialized countries, there is a
in financial markets. greater role for banks and smaller role for
securities markets.

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

• The larger and more established a firm is, 4. Collateral and Net Worth
the more likely it will be to issue securities • Collateral reduces the consequences of
to raise funds, because investors have adverse selection because it reduces the
fewer worries about adverse selection with lenders losses in the event of a default.
well-known corporations. • Net worth (equity capital) performs a
similar role. If a firm has a high net worth
(equity capital) it is less likely to default
and if it defaults the lender can sell its net
worth to recover its loan.
• Explains Fact 7
• “Only the people who don't need money
can borrow it."
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How Moral Hazard Affects the Choice between Moral Hazard in Equity Contracts: The
Debt and Equity Contracts Principal-Agent Problem
• Moral hazard is the asymmetric information • Equity contracts, such as common stock,
problem that occurs after financial are claims to a share in the profits and
transaction takes place. assets of a business.
• The seller of a security may have incentives • Moral hazard problem in equity contracts is
to hide information and engage in activities called the Principal
Principal-Agent
Agent Problem
Problem.
that are undesirable for the purchaser of the • The stockholders who own most of the
security. firm's equity (the principals) are not the
• Moral hazard has important consequences same people as the managers of the firm
for whether a firm finds it easier to raise who may own only a small fraction of the
funds with debt than with equity contracts. firm they work for (the agents of the
33 owners). 34

• The principal-agent problem would not arise • Thus, the managers may
if there were no separation of ownership 1. not provide a quick and friendly service to
and control- that is the owner is the the firm’s customers
manager. 2. spend money unnecessarily on decoration
• This separation of ownership and and artificial issues
management involves moral hazard. 3. waste time in their own personal leisure
• The managers in control (the agents) may 4. not be honest with the firm’s owner
act in their own interest rather than in the
interest of the owners (principals) because 5. divert funds for their own personal use,
the managers have less incentive to 6. pursue corporate strategies that enhance
maximize profits than stockholders do. their own personal power but do not
increase the firm’s profitability.
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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

• The principal-agent problem, which is an Tools to Help Solve the Principal-Agent

example of moral hazard, is a result of lack Problem
of information about the actions of 1.Producing Information through Monitoring
managers; a manager has more information • One way for stockholder to reduce this moral
about his activities than the stockholder hazard problem is to monitor the firm’s
does, asymmetric information. activities through different monitoring
• This problem would not arise if the owners process such as auditing and a continuous
of the firm had complete information about evaluation of management.
what the managers were up to and could • The problem is that monitoring process can
prevent wasteful expenditures and fraud. be costly in terms of time and money; this is
called costly state verification.
• Costly state verification makes equity
37 contract less desirable. 38

• Because it is expensive to monitor, the free • This explains, in part, why equity is not the
rider problem occurs which decreases the most important element in our financial
possibility to monitor the firm properly. structure (Fact 1).
• If you know that other stockholders are
paying to monitor the activities of the firm
you hold shares in, you can take a free ride
on their activities and save yourself some
expenses.
• The problem occurs when every stockholder
think the same. The result is no one will
spend any resources to monitor the firm.

39 40

2. Government Regulation to increase 3. Financial Intermediation

information • Financial intermediation has the ability to
• Governments have laws to force firms to avoid the free-rider problem in the face of
adhere to standard accounting principles moral hazard, and this is another reason
that make profit verification easier (Fact 5). why indirect finance is so important.
• They also impose stiff criminal penalties on • One financial intermediary that helps
people who commit the fraud of hiding and reduce the moral hazard arising from the
stealing profits. principal-agent problem is the venture
• However, these laws and regulations are capital firm.
not fully effective. It is not easy to catch the • Venture capital firm pools the resources of
fraudulent managers because they have their partners and uses the funds to help
incentives to make it very hard for gov. new entrepreneurs to establish a new
agencies to find or prove fraud. 41 business firm. 42

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

• This comes with the condition that the 4. Debt Contracts

venture capital firm receives an equity share • Debt contract is an agreement whereby the
in the new business and puts some of its borrower pays the lender a fixed amount at
own people in the management team of the periodic intervals.
new firm so that they can keep close watch • As long as the lender receives the agreed
on the firm’s activities. amount, he does not care whether the firm
• The equity of the new business firm splits is making profit or suffering a loss
loss- does
only between the entrepreneurs and the not care about moral hazard
venture capital firm and no other investors • The less frequent need to monitor the firm,
are allowed. Thus, the free-rider problem in and thus the lower cost of state verification,
monitoring the firm does not exist. helps explain why debt contracts are used
more frequently than equity contracts to
43 raise capital (Fact1). 44

How Moral Hazard Influences Financial • Because of the potential moral hazard,
Structure in Debt Markets lenders my not make the loan to the
• Even with the advantages over equity borrower.
contact, debt contracts are still subject to
moral hazard.
• Because a debt contract requires the
borrower to pay out a fixed amount and lets
him keep any profits above this amount, the
borrower has an incentive to take on
investment projects that are riskier than the
lenders would like.

45 46

Tools to Help Solve Moral Hazard in Debt • The greater the borrower’s net worth and
Contract collateral, the greater the borrower’s
1.Net Worth and Collateral incentive to behave in the way that the
• When the net worth is high or the collateral lender expects and desires, the smaller the
is valuable, the risk of moral hazard will be moral hazard problem in the debt contract,
highly reduces because the borrower and easier for the borrower to get the loan.
himself have a lot to lose.
lose • It explains fact 7
• Net wroth and collateral make the debt
contract incentive-compatible.
• It makes the incentives of both borrowers
and lenders are the alike.

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

2. Monitoring and Enforcement of Restrictive • There are four types of restrictive

Covenants covenants:
• Lenders can ensure that the borrower uses 1.Covenants to discourage undesirable
the fund for the purpose it has been agreed behavior,
upon by writing provisions (restrictive 2.Covenants to encourage desirable behavior,
covenants) into the debt contract that 3.Covenants to keep collateral valuable,
restrict the borrower’s
borrower s activities in order to
reduce moral hazard. 4.Covenants to provide information
• Then the lenders can monitor the • This explains why debt contacts are so
borrower’s activities to see whether he is complicated
complying with the restrictive covenants or
not.
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• Restrictive covenants must be monitored 3. Finance intermediation

and enforced. • Although restrictive covenants help reduce
• Monitoring and enforcement is costly. Thus, the moral hazard problem, they do not
the free-rider problem arises in debt market, eliminate it completely. It is almost
and moral hazard continues to be high. impossible to write covenants that rule out
every risky activity.
• Furthermore,
Furthermore borrower may be clever
enough to find loopholes in restrictive
covenants that make them ineffective.

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• Financial intermediaries-particularly banks- Conflicts of Interest (Reading)

have the ability to avoid the free-rider • Besides economies of scale, financial
problem as they make primarily private intermediaries offer economies of scope.
loans. 1.Bank lends and sells your bonds for you
• Private loans are not traded, so no free-rider 2.Investment banks researches and
problem exists. underwrites
• 3.Auditors check your books and do
management consulting
• May lead to conflicts of interest (a moral
hazard-type problem) such as

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

1. an institution has multiple objectives and Conflicts of Interest: Investment Banking

has conflicts between those objectives • Investment banks have three sources of
2. Incentives to conceal information income
3. Leads to more asymmetric information 1.Brokerage: research companies for
problems The economy is not as efficient security-buying investors
as it could be 2.Corporate finance: underwrite securities for
4 The
4. Th systemt off Chinese
Chi walls.
ll security-selling
it lli firms
fi + merger advice
d i
3.Proprietary trading

55 56

1. Corporate finance vs. brokerage: 2. Proprietary trading vs. brokerage.

• Morgan Stanley memo: “Our objective ... is • Incentives to use best information for own
to adopt a policy, fully understood by the trading activities.
entire firm, including the Research 3. Spinning occurs when an investment bank
Department, that we do not make negative allocates hot, but underpriced, IPOs to
or controversial comments about our executives of other companies in return for
clients as a matter of sound business their companies future business
practice.“ Ö Optimism bias.
• Underwriter's recommendations
systematically underperform non-
underwriter's recommendations.

57 58

Auditing Firms The Enron Implosion

• Auditing: Provide independent" verification • Enron specialized in trading in the energy
of corporate financial statements market.At one point the 7th largest
• Client services: Internal financial consulting, corporation in the US.
tax advice, management consulting and • Enron was hiding debt and inflating profits.
business strategy • October 2001. Huge losses and disclosure
1 M skew
1.May k th
their
i judgments
j d t and d opinions
i i to
t off accounting
ti mistakes".
i t k " Formal
F l
win consulting business investigation by SEC
2.Auditors are auditing information systems • Bankrupt by December 2001.
or tax and financial plans put in place by • Enron led to general concerns about quality
their nonaudit departments of information provided by US corporations.
3.Auditors may provide an overly favorable • ... and the demise of Arthur Andersen. 60
audit to solicit or retain audit business 59

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

Regulatory Response 5. Beefs up criminal charges for white-collar

• Sarbanes-Oxley Act of 2002 (Public crime and obstruction official
Accounting Return and Investor Protection investigations
Act, SOX, SARBOX) 6. Requires the CEO and CFO to certify that
1.Increases supervisory oversight to monitor financial statements and disclosures are
and prevent conflicts of interest accurate
2 E t bli h a Public
2.Establishes P bli Company
C Accounting
A ti 7 Requires members of the audit committee
7.
Oversight Board to be independent
3.Increases the SECs budget
4.Illegal for accounting firms to provide any
nonaudit service together with an
impermissible audit
61 62

Global Legal Settlement of 2002 Perils of Regulation

1.Investment banks to sever the link between • Reduce conflicts but also economies of
research and securities underwriting scope.
2.Bans spinning • Red tape
3.Imposes $ 1.4 billion in fines on accused 1.Sarbanes-Oxley Act has drawn a lot of
investment banks criticism
4.Requires investment banks to make their 2.Imposes high accounting costs and
analysts recommendations public burdensome information requirements
5.Over a 5-year period, investment banks are 3.Lead to numerous securities lawsuits and
required to contract with at least 3 settlements
independent research firms that would
provide research to their brokerage
63 64
customers

• Results:
1.More and more firms go private".
2.US financial markets less competitive:
London, Hong Kong, Dubai,... expand.

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ECON248: Money and Banking Ch.5 Dr. Mohammed Alwosabi

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