Economics 330

Fall 2001

Lecture 6


I.  Financial Structure

            A.  Sources of External funding

            B. Observations about financial structure

            C.  Transactions Costs

            D.  Asymmetric Information

                        1.  Adverse Selection

                        2.  Moral Hazard

            E.  Financial Crisis




Economic Analysis of Financial Structure:




Sources of External Funds for Nonfinancial businesses in the U.S. 1970-1985



Loans are primarily bank loans, also loans made by other financial intermediaries


Bonds are marketable debt securities:  for example, corporate bonds and commercial paper


Other refers to government loans, loans by foreigners, trade debt (loans made by businesses to other businesses when they purchase goods)



  1. Stocks are not an important source of finance for American businesses (2.1%)
  2. Issuing marketable securities is not the primary way businesses finance their operations (stocks and bonds = 31.9%)
  3. Indirect finance is much more important than direct finance (figures indicate that direct finance is used in less than 5% of external financing of American businesses
  4. Banks are the most important source of external funds to finance businesses
  5. Financial system is among the most heavily regulated sectors of the economy:  this is true throughout the world
  6. Only large, well-established corporations have access to securities markets to finance their activities:  other corporations and businesses get their funds through banks
  7. Collateral is a prevalent feature of debt contracts for both HH and businesses:  85% of HH debt in the U.S. is collateralized
  8. Debt contracts are usually complicated legal documents:  substantial restrictions places on the behavior of the borrower (e.g., restrictive covenants)



Transactions Costs and their Effect on Financial Structure

Transactions costs refers to the time and money spent trying to exchange goods and services


The Case of the single investor:


High transaction costs relative to amount of funds they will invest


Can’t diversify as well, so they are exposed to more risk


Financial Intermediaries:


Reduce transactions costs:

a.  Economies of scale:  as the size or the scale of the transactions increases, there is a decrease in transactions costs per dollar of investment (e.g., mutual fund)

b.  Development of expertise:  as expertise is developed this reduces transactions costs in areas such as

1.  Legal costs

2.  Computer technology

Outcome of lower transactions costs is that financial intermediaries can provide customers with liquidity services.  These are services that facilitate consumer transactions.


Asymmetric Information:  Adverse Selection and Moral Hazard


Asymmetric Information:  inequality of information that each party has.  This lack of information creates problems before and after the transaction


Adverse Selection:  this is a problem due to asymmetric information before the transaction occurs.  In financial markets this is a situation where the potential borrowers who are most likely to produce undesirable (adverse) outcomes (bad credit risks) are the ones who are most likely to seek out loans.  They are therefore more likely to be selected for loans.


Adverse Selection can occur when a buyer or seller enters into an exchange with another party who has more info.


Example 1: The lazy versus the energetic worker





Example 2:  The used car market




Example 3:  Insurance market




Moral Hazard:  this is a problem due to asymmetric information after the transaction occurs.  In financial markets this is when the lender is subjected to the hazard of the borrower engaging in activities that are undesirable (immoral) from the lender’s point of view since these activities lower the likelihood that the loan will be paid back.  The problem arises because the borrower faces incentives that encourage these activities.


Moral hazard arise when one party to a contract passes the cost of his or her behavior on to the other party to the contract


Example 1:  Borrowing the car



Example 2:  Car Insurance




Example 3:  Apartment leases




Example 4:  Life Insurance and suicide




Example 5:  Fire insurance and smoke detectors




Moral hazard occurs because there are divergent interests and it results in a need to make decision makers to some degree insured against the consequences of their actions. 


Monitoring and enforcement is imperfect, but needed, when there is a potential problem of moral hazard


More Examples:










***The decision makers do not bear the full impact of their decision.***


One way to deal with moral hazard is to introduce incentive or performance contracts:

Piece rates

Pay linked to sales:  commissions

Pay linked to productivity improvements

Pay and profits linked together


Example of the Air Traffic Controllers in the 1970s









“Incentives are the essence of economics.”  Edward Lazear


“Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace.”  Frederick Taylor, the “Father of Scientific Management”


How do adverse selection and moral hazard issues affect financial structure?


1.  In stock and bond markets


Since there are both good and bad firms in the market, the price of securities in the market will be the price that reflects the average quality of the firms’ issuing securities


***Few firms will use these markets to raise capital for this reason


**Stocks are not an important source of finance for American businesses


**Issuing marketable securities is not the primary way business finance their operations


How do you correct for adverse selection:  get rid of asymmetric information

1.      Private production and sale of information

a.       Information about those seeking funds




b.  Free rider problem




2.      Government regulation to increase information in securities markets







**Explains why financial sector is among the most heavily regulated sectors of the economy

3.      Financial Intermediation







      **Explains the importance of indirect finance

      **Explains why banks are the most important source of external

funds to finance businesses

**Only large, well-established corporations have access to securities markets to finance their activities:  everyone else uses banks

4.      Collateral and net worth

Collateral:  property promised to lender if borrower defaults










Collateral reduces the consequences of adverse selection because it reduces lender’s losses in the case of a default


**Explains why collateral is a prevalent feature of debt contracts


Net Worth = Equity Capital = Assets (what is owned or is owed) – liabilities (what it owes)


Net worth plays a similar role to the role of collateral


Effect of moral hazard on choice of debt versus equity


Principal-Agent Problem:  when managers own only a small fraction of the firm they work for, stockholders who own most of the firm’s equity (the principals) are separate from the managers of the firm (who act as the agents to the owners)


Moral hazard problem:  manager in control (the agents) may act in their own self-interest rather than in the interest of stockholder-owners (principals) because managers have less incentive to maximize profits than stockholder-owners do


P-A Problem arises because owners do not have full information about what managers are doing and therefore can’t prevent wasteful expenditures or fraud


Examples of P-A:  S & L Debacle of the 1980s

Design of the deposit insurance program

Lax regulation

Deposit insurance plus low capital requirements encouraged excessive risk taking



Solutions of P-A Problem:

1.  Production of information:  Monitoring





Costly State Verification




**Cost involved helps explain why equity contracts are less desirable


Free Rider Problem:  expect someone else to pay for the good or service


                        2.  Government regulation to increase information


3.  Financial Intermediation:  way to avoid free rider problem


Example:  Venture Capital Firm




4.  Debt contracts


Equity contract poses moral hazard problem at all times since it is a claim on firm’s profits


Debt contract reduces moral hazard problem since lender does not need to know firm’s profits:  lender only needs to receive his contractual payment periodically.  Requires costly state verification only if borrower defaults



Effect of Mora Hazard on Financial Structure of Debt Markets


Solution to moral hazard in debt contracts


1.  Net Worth

            Incentive Compatible:





            High net worth



2.      Monitoring and enforcement of restrictive covenants

Rule out undesirable behavior or encourage desirable behavior


i.  Prevent undertaking of risky investment projects


ii.  Encourage borrower to engage in activities that make it more likely loan will be paid off. 






iii.  Keep collateral in good condition and in possession of borrower







iv.  Quarterly accounting and income reports




**Debt contracts are often complicated legal documents with many restrictions on borrower’s behavior


3.      Financial Intermediation


Moral Hazard and Adverse Selection:  Financial Crisis


Financial Crisis:  major disruption in finance markets that are characterized by sharp declines in asset prices and failures of many financial and nonfinancial firms


Past financial crisis in the United States:  1819, 1837, 1857, 1873, 1884, 1893, 1907, 1929-33


Financial crisis occurs when adverse selection and moral hazard problems in financial markets become so much worse that finance markets are unable to efficiently channel funds from savers to those with productive investment opportunities>>>>sharp contraction in economic activity


Factors underlying financial crisis:

1)      Increases in interest rates





2)      Stock Market Declines





3)      Unanticipated Decline in Price level





4)      Increases in Uncertainty





5)      Bank Panics






Diagram of Financial Crisis: