Lesson 3

An Economic
Analysis of
Financial
Structure
 Learning Outcomes
Student able to

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-2

 Basic Facts About Financial
Structure Throughout the World
• One of the main requirements for a healthy
economy is an efficient financial system
that channel funds from savers to investors.
• 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

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-3

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

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-4

 Eight Basic Facts
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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-5

 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 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
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-6
 Transaction Costs

• Financial intermediaries have evolved

to reduce transaction costs
– Take advantage of economies of scale
(example: mutual funds)
– Develop expertise to lower transactions
costs
• Also provides investors with liquidity, which
explains Fact # 3

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-7

 Transaction Costs
• Transaction costs are a major problem in
financial markets. Transaction costs are too
high for ordinary people.
• Financial intermediaries help in reducing
transaction costs and allow small savers and
borrowers to benefit from the existence of
financial markets.
• One solution to the problem of high
transaction costs is to package the funds of
many investors together so that they can
take advantage of economies of scale.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-8

 Transaction Costs
• Economies of scale refer to the reduction
in transaction costs per unit of the amount
invested as the size (scale) of transaction
increases.
– It exist because the total cost of carrying out a
transaction in financial markets increases only a
little as the size of the transaction grows.
• The presence of economies of scale in
financial markets helps explain why financial
intermediaries developed and have become
such an important part of financial structure.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-9

 Transaction Costs
• An additional benefit for individual investor is that
the presence of economies of scale in an
investment means that the investment is large
enough to purchase a widely diversified portfolio of
securities. The increased diversification for
individual investors reduces their risk, making them
better off.
• Financial intermediaries are also better able to
develop expertise to lower transaction costs.
• Another important outcome of a financial
intermediary’s low transaction costs is the ability to
provide its customers with liquidity services that
make it easier to conduct transactions.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-10

 Asymmetric Information
• Asymmetric information is a situation
that arises when one party’s insufficient
knowledge about the other party
• Asymmetric information involved in a
transaction makes it impossible to make
accurate decision when conducting the
transaction is an important aspect of
financial markets.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-11

 Asymmetric Information
• Asymmetric information lead to:
1. Adverse selection arises before the
transaction occurs. How do I
– Lenders need to know
which is
know how to better?

distinguish good
credit risks from
bad.
2. Moral hazard occurs after the transaction.
– Will borrowers use the money as
they claim?
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-12
 Asymmetric Information: Adverse
Selection and Moral Hazard
• Adverse selection occurs before the
transaction
– Potential bad credit risks are the ones who most
actively seek out loans. Because adverse
selection increases the chances that a loan might
be made to a bad credit risk, lenders might
decide not to make any loans, even though there
are good credit risks in the marketplace.
– Potential borrowers most likely to produce
adverse outcome are ones most likely to seek
loan and be selected

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-13

 Asymmetric Information: Adverse
Selection and Moral Hazard
• Moral hazard arises after the transaction
occurs.
– The lender runs the risk that the borrower will engage
in activities that are undesirable from the lenders
point of view because they make it less likely that the
loan will be paid back. Because moral hazard lowers
the chance that the loan will be paid back, lenders
may decide that they would rather not make loans.
– Hazard that borrower has incentives to engage in
undesirable (immoral) activities making it more likely
that won't pay loan back

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-14

 Asymmetric Information: Adverse
Selection and Moral Hazard
• Agency theory analyses how asymmetric
information problems affect economic
behavior
– Agency theory is the branch of financial
economics that looks at conflicts of interest
between people with different interests in the
same assets
• shareholders and managers of companies
• shareholders and bond holders
• We will now use these ideas of adverse
selection and moral hazard to explain how
they influence financial structure.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-15
 Asymmetric Information

Adverse Selection

Asymmetric
Principal Agent
information

Moral Hazard

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-16

 Adverse
Selection

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-17

 The Lemons Problem: How Adverse
Selection Influences Financial Structure

• 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 ©2015 Pearson Education, Inc. All rights reserved. 7-18

 The Lemons Problem: How Adverse
Selection Influences Financial Structure
• Lemons Problem in Used Cars
• George Akerlof (Nobel Prize winner)
1. If we can't distinguish between ― good and ―
bad (lemons) used cars, we are willing pay only
an average of good and bad car values
2. Result: Good cars won’t be sold, and the used
car market will function inefficiently.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-19

 The Lemons Problem: How Adverse
Selection Influences Financial Structure

• Lemons Problem in Securities

Markets
1. If we can't distinguish between good and
bad securities, willing pay only average
of good and bad securities’ value
2. Result: Good securities undervalued and
firms won't issue them; bad securities
overvalued so too many issued

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-20

 The Lemons Problem: How Adverse
Selection Influences Financial Structure
• Lemons Problem in Securities
Markets…
3. Investors won't want buy bad securities,
so market won't function well
• Explains Fact # 1 and # 2

• Also explains Fact # 6: Less asymmetric info for

well known firms, so smaller lemons problem

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-21

 Tools to Help Solve Adverse Selection
Problems
• Private production and sale of information
- have private companies collect & produce info
that distinguishes good from bad firms & then sell
it.
- Eg: In US, Standard & Poor’s, Moody’s

– Free-rider problem
• A free-rider is someone who doesn’t pay the cost to get
the benefit of a good or service.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-22

 Tools to Help Solve Adverse Selection
Problems
• Government regulation to increase
information
– Standard accounting principles make profit
verification easier, thereby reducing adverse
selection and moral hazard problems in financial
markets, hence making them operate better.
– Standardized accounting principles make it
easier for investors to screen out good firms from
bad firms, thereby reducing the adverse selection
problem in financial markets.

– Not always works to solve the adverse selection

problem, explains Fact # 5.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-23
 Tools to Help Solve Adverse Selection
Problems
• Financial intermediation
– Analogy to solution to lemons problem provided by used
car dealers
– Expert in producing information
– Bank avoids free-rider problem by making private loans
rather than purchasing securities that are traded in open
market.
• Other investor cannot watch what the bank is doing and bid up
the loan’s price to the point that bank receives no
compensation for the information
– Explains facts # 3, 4, & 6.

• Collateral and net worth

– Explains fact # 7.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-24

 Collateral and Net Worth
• Collateral is something of value pledged by a
borrower to the lender in the event of the
borrower’s default.
– It is said to back or secure a loan.
– Ex: Cars, houses
• The net worth is the owner’s stake in a firm - the
value of the firm’s assets minus the value of its
liabilities.
– Net worth serves the same purpose as collateral
– If a firm defaults on a loan, the lender can make a claim
against the firm’s net worth.
• From the perspective of the mortgage lender, the
homeowner’s equity serves exactly the same
function as net worth in a business loan.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-25

 Moral Hazard

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-26

 How Moral Hazard Affects the Choice
Between Debt and Equity Contracts

• Moral hazard is the asymmetric

information problem that occurs after the
financial transaction takes place.
• Moral hazard has important consequences
for whether a firm finds it easier to raise
funds with debt than with equity contracts.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-27

 Moral Hazard in Equity Contracts:
The Principal-Agent Problem

• Equity contracts are claims to a share in the

profits and assets of a business.
• The Principal-Agent Problem
– Principal: less information (stockholder)
– Agent: more information (manager)
• Separation of ownership and control
of the firm
– Moral Hazard: Managers pursue personal benefits
and power rather than the profitability of the firm

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-28

 Moral Hazard in Equity Contracts: The
Principal-Agent Problem
Example
• Suppose you become a silent partner in an ice
cream store, providing 90% of the equity capital
($9,000). The other owner, Steve, provides the
remaining $1,000 and will act as the manager.
– If Steve works hard, the store will make $50,000
after expenses (including Steve’s salary), you are
entitled to $45,000 of it and Steve receives
$5,000.
– If Steve think that the extra $5,000 isn’t enough
to make effort to be a good manager, he doesn’t
work hard (sneaks off to the beach) & store show
no profit.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-29
 Moral Hazard in Equity Contracts:
Tools to Help Solve the Principal-
Agent Problem

• Production of Information: Monitoring

– Costly State Verification
– Free-rider problem
– Fact #1
• Government regulation to increase
information
– Standardized accounting principles make it
harder for managers to over- or understate
profits, thereby reducing the principal-agent
(moral hazard) problem.
– Fact #5
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-30
 Moral Hazard in Equity Contracts:
Tools to Help Solve the Principal-
Agent Problem

• Financial Intermediation
– Fact #3
– e.g, venture capital usually participate in
managing the firm

• Debt Contracts
– Fact #1
– Why debt is used more than equity

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-31

 How Moral Hazard Affects the Choice
Between Debt and Equity Contracts
• Debt contract – the borrower to pay the lender
fixed dollar amounts at periodic intervals.
– When the firm has high profits, the lender receives the
contractual payments;
• the lender does not need to know the exact profits of the firm
• doesn’t care if the manager pursuing personal benefit.
– Only when the firm cannot meet its debt payments (in a
state of default), the lender need to verify the state of the
firm’s profits.
• The less frequent need to monitor the firm, thus the
less cost of state verification, explain why debt
contracts are used more frequently than equity
contracts to raise capital.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-32

 How Moral Hazard Influences Financial
Structure in Debt Markets

• Even with the advantages just described,

debt is still subject to moral hazard.
• Borrowers have incentives to take on
projects that are riskier than the lenders
would like.
– This prevents the borrower from paying back the
loan.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-33

 How Moral Hazard Influences
Financial Structure in Debt Markets
• Most debt contracts require the borrower to pay a
fixed amount (interest) and keep any cash flow
above this amount.
• For example, what if a firm owes $100 in interest,
but only has $90? It is essentially bankrupt. The
firm ― has nothing to lose by looking for ― risky
projects to raise the needed cash.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-34

 How Moral Hazard Influences
Financial Structure in Debt Markets
• For example, you lend Steve $9,000 with interest
rate of 10% to open an ice cream store in the
neighbourhood.
– For you this is a good investment because the demand for
ice cream is strong and steady in your neighbourhood.
• Instead of opening up the ice cream store, he
invests in chemical research equipment to invent a
no fat ice cream.
– Steve has strong incentive to undertake it because if
successful, he will be multimillionaire.
– You are unhappy if Steve used your loan for the riskier
investment, because if he fails, which is highly likely, you
would lost all of your money. And if he success, you
wouldn’t share.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-35
 Tools to Help Solve Moral Hazard in
Debt Contracts
• Net worth and collateral
• Monitoring and Enforcement of Restrictive
Covenants
– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information
• Financial Intermediation
– banks and other intermediaries have special
advantages in monitoring
– Facts 3 & 4
– Explains Facts # 1–4

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-36

 Summary Table 1 Asymmetric Information
Problems and Tools to Solve Them

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-37

 Summary
• Eight Basic Facts About Financial Structure
• Transaction costs freeze many small
savers and borrowers out of direct
involvement with financial markets.
• Financial intermediaries can take
advantage of economies of scale and are
better able to develop expertise to lower
transaction costs, thus enabling their savers
and borrowers to benefit from the existence
of financial markets.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-38

 Summary
• Asymmetric information results in two
problems: adverse selection, which occurs
before the transaction, and moral hazard,
which occurs after the transaction.
• Adverse selection refers to the fact that
bad credit risks are the ones most likely to
seek loans, and moral hazard refers to the
risk of the borrower’s engaging in activities
that are undesirable from the lender’s point
of view.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-39

 Summary
• Adverse selection interferes with the efficient
functioning of financial markets.
• Tools to help reduce the adverse selection problem
include private production and sale of information,
government regulation to increase information,
financial intermediation, and collateral and net
worth.
• The free-rider problem occurs when people who
do not pay for information take advantage of
information that other people have paid for. This
problem explains why financial intermediaries,
particularly banks, play a more important role in
financing the activities of businesses than securities
markets do.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-40
 Summary
• Moral hazard in equity contracts is known as the
principal-agent problem, because managers (the
agents) have less incentive to maximize profits than
stockholders (the principals).
• The principal-agent problem explains why debt
contracts are so much more prevalent in financing
markets than equity contracts.
• Tools to help to reduce the principal-agent problem
include monitoring, government regulation to
increase information, and financial intermediation.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-41

 Summary
• Tools to help to reduce the hazard problem
in debt contracts include net worth,
monitoring and enforcement of restrictive
covenants, and financial intermediation.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-42