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
Where
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)
Observations:
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
Examples:
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
Fraud
Solutions of P-A Problem:
1. Production of information: Monitoring
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.
Example:
iii. Keep collateral in good condition and in possession of borrower
Example:
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: