The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Topic 6 (Chapter 8)
An Economic Analysis of
Financial Structure

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Learning Objectives
• LO1: Explain how transaction costs affect financial
intermediaries.
• LO2: Describe why asymmetric information leads to
adverse selection and moral hazard.
• LO3: Identify adverse selection problems and recommend
methods to solve adverse selection.
• LO4: Identify moral hazard problems in equity and debt
contracts and recommend methods for reducing it.

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1. Basic Facts About Financial Structure
• This chapter provides an economic analysis of how our
financial structure is designed to promote economic
efficiency.
• The bar chart in Figure 1 shows how American businesses
financed their activities using external funds (those
obtained from outside the business itself) in the period
1970–2000 and compares U.S. data to those of Germany,
Japan, and Canada.

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Figure 1 Sources of External Funds for Nonfinancial
Businesses: A Comparison of the United States with
Germany, Japan, and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical
Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and
are gross flows as percentage of the total, not including trade and other credit data, which are not available.

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The case of Vietnam (2019)

Source: SSI, 2019

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Figure 2: The Relative Importance of Financing Channels
(Averages for 1990–2013)
Cecchetti & Schoenholtz, 2017

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1. Basic Facts About Financial Structure
1. Stocks are not the most important sources of external
financing for businesses.
2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their
operations.
3. Indirect finance is many times more important than direct
finance
4. Financial intermediaries, particularly banks, are the most
important source of external funds used to finance
businesses.

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1. Basic Facts About Financial Structure
5. The financial system is among the most heavily
regulated sectors of the economy.
6. Only large, well-established corporations have easy
access to securities markets to finance their activities.
7. Collateral is a prevalent feature of debt contracts for both
households and businesses.
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive covenants
on borrowers.

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2. Transaction Costs
• Small investors: with limited amount of money
– Brokerage commissions account for a large proportion of
purchase price.
– Restricted number of investments limits the diversification
capacity
• Financial intermediaries: bundle investors’ funds together, →
reduce transaction costs through
– Economies of scale → Diversification at low cost
– Expertise
• E.g. Mutual fund: financial intermediary that sells shares to
individuals and then invests the proceeds in bonds or stocks.

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3. Asymmetric Information
• Asymmetric information arises when one party’s
insufficient knowledge about the other party involved in a
transaction makes it impossible for the first party to make
accurate decisions when conducting the transaction.”
• Example: borrowers who want to issue bonds and firms
that want to issue stock have better information about their
companies’ performance and prospects than potential
lenders or investors.

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3. Asymmetric Information: Adverse
Selection and Moral Hazard
The presence of asymmetric information leads to adverse
selection and moral hazard problems.
• Adverse selection occurs before a transaction occurs.
– Potential bad credit risks are the ones who most actively
seek out loans and likely to engage in the transaction.
– Lenders can’t distinguish good from bad credit risks
→ discourages transactions from taking place.
• Moral hazard arises after the transaction occurs.
– Borrowers may engage in risk-taking activities ex-post.
• Agency theory is applied to analyse how asymmetric
information problems affect economic behavior.
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3.1. Adverse selection: The Lemons Problem
Example: Suppose there are two second-hand 2015 Honda
City cars available for sale. The first one has been driven and
maintained carefully and the second one was not carefully
driven and has lots of mechanical problems. The shoppers do
not know about this information but are willing to pay $15,000
for the good car and $10,000 for the bad car.
• What will be the price the buyer willing to pay?
• What will happen to the used-car market if buyers cannot
assess the quality of used cars?

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3.1. Adverse selection: The Lemons Problem
• Potential buyers of used cars are unable to assess quality of
used cars
→ Buyers are 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.
• Few sales occur and the market functions poorly.
• This problem explains fact 2 and partially explains fact 1.
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3.1. Adverse selection: The Lemons Problem
Application to bond and stock market:
• A potential buyer of securities can’t distinguish between
good and bad firms.
→ He will be willing to pay only a price that reflects the
average quality of firms issuing securities.
→Good firms do not want to issue securities; and investors do
not want to buy securities since they are mostly issued by
bad firms.
→ Securities market will not work very well because few firms
will sell securities in it to raise capital
• This problem explains fact 2 and partially explains fact 1.
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•
3.1. Adverse selection: Tools to solve
• Private production and sale of information
– Free-rider problem
• Government regulation to increase information
– Not always works to solve the adverse selection
problem, explains Fact 5
• Financial intermediation
– Explains facts 3, 4, & 6
• Collateral and net worth
– Explains fact 7

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Application: The Enron Implosion
• Enron Corporation declared bankruptcy in December
2001, up to that point the largest bankruptcy declaration in
U.S. history
• The Enron collapse illustrates that government regulation
can lessen asymmetric information problems but cannot
eliminate them. The Enron bankruptcy not only increased
concerns in financial markets about the quality of
accounting information supplied by corporations but also
led to hardship for many of the firm’s former employees,
who found that their pensions had become worthless

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3.2. Moral Hazard problem: equity contract
• Called the Principal-Agent Problem:
– Principal: less information (stockholder)
– Agent: more information (manager)
• Separation of ownership and control of the firm
– Managers pursue personal benefits and power rather
than the profitability of the firm.

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3.2. Moral Hazard problem: equity contract

Source: corporatefinanceinstitute.com

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3.2. Moral Hazard problem: Tools to Solve
the Principal-Agent Problem
• Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
• Government regulation to increase information
– Fact 5
• Financial Intermediation
– Fact 3
• Debt Contracts
– Fact 1

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3.2. Moral Hazard problem: Debt contract
• Borrowers have incentives to take on projects that are
riskier than the lenders would like.
– This prevents the borrower from paying back the loan.

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3.2. Moral Hazard problem: Tools to Solve
Moral Hazard in Debt Contracts
• Net worth and collateral
– Incentive compatible
• Monitoring and enforcement of restrictive covenants
– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information
• Financial intermediation
– Facts 3 & 4

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Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them (1 of 2)
Asymmetric Information Tools to Solve It Explains Fact
Problem Number
Adverse selection Private production and sale of information 1, 2
Blank Government regulation to increase 5
information
Blank Financial intermediation 3, 4, 6
Blank Collateral and net worth 7
Moral hazard in equity Production of information: monitoring 1
contracts (principal–agent
problem)
Blank Government regulation to increase 5
information
Blank Financial intermediation 3
Blank Debt contracts 1

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Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them (2 of 2)
Asymmetric Information Tools to Solve It Explains Fact
Problem Number
Moral hazard in debt Collateral and net worth 6, 7
contracts
Blank Monitoring and enforcement of restrictive 8
covenants
Blank Financial intermediation 3, 4

Note: List of facts:

1. Stocks are not the most important source of external financing.
2. Marketable securities are not the primary source of financing.
3. Indirect finance is more important than direct finance.
4. Banks are the most important source of external funds.
5. The financial system is heavily regulated.
6. Only large, well-established firms have access to securities markets.
7. Collateral is prevalent in debt contracts.
8. Debt contracts have numerous restrictive covenants.

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Summary
• Basic facts about financial structure
• Transaction costs
• Asymmetric information:
– Adverse selection and tools to solve
– Moral hazard problem and tools to solve

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