An Economic Analysis of Financial Structure

Chapter 8
An Economic
Analysis of
Financial
Structure
Basic Facts about Financial Structure

Throughout the World
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 19702000 and compares U.S.
data to those of Germany, Japan, and Canada
8-2
2013 Pearson Education, Inc. All rights reserved.
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 19702000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.
8-3
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.
8-4
Eight Basic Facts (contd)

5.
6.
7.
8.
8-5
The financial system is among the most heavily

regulated sectors of the economy
Only large, well-established corporations have
easy access to securities markets to finance their
activities
Collateral is a prevalent feature of debt contracts
for both households and businesses.
Debt contracts are extremely complicated legal
documents that place substantial restrictive
covenants on borrowers
Transaction Costs
Financial intermediaries have evolved to
reduce transaction costs
Economies of scale
Expertise
8-6
Asymmetric Information: Adverse

Selection and Moral Hazard
Adverse selection occurs before the
transaction
Moral hazard arises after the transaction
Agency theory analyses how asymmetric
information problems affect economic
behavior
8-7
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
8-8
Tools to Help Solve Adverse Selection

Problems
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.
8-9
How Moral Hazard Affects the Choice

Between Debt and Equity Contracts
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
8-10
Tools to Help Solve the PrincipalAgent 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
8-11
How Moral Hazard Influences

Financial Structure in Debt Markets
Borrowers have incentives to take on
projects that are riskier than the lenders
would like.
This prevents the borrower from paying back the
loan.
8-12
Tools to Help 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
8-13
Summary Table 1 Asymmetric

Information Problems and Tools to Solve
Them
8-14
Asymmetric Information in Transition

and Developing Countries
Financial repression created by an
institutional environment characterized by:
Poor system of property rights (unable to use
collateral efficiently)
Poor legal system (difficult for lenders to enforce
restrictive covenants)
Weak accounting standards (less access to good
information)
Government intervention through directed credit
programs and state owned banks (less incentive
to proper channel funds to its most productive
use).
8-15
Application: Financial Development

and Economic Growth
The financial systems in developing and transition
countries face several difficulties that keep them
from operating efficiently
In many developing countries, the system of
property rights (the rule of law, constraints on
government expropriation, absence of corruption)
functions poorly, making it hard to use these two
tools effectively
8-16

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Chapter 8

Basic Facts about Financial Structure

2013 Pearson Education, Inc. All rights reserved.

Figure 1 Sources of External Funds for

2013 Pearson Education, Inc. All rights reserved.

Eight Basic Facts

2013 Pearson Education, Inc. All rights reserved.

Eight Basic Facts (contd)

The financial system is among the most heavily

2013 Pearson Education, Inc. All rights reserved.

2013 Pearson Education, Inc. All rights reserved.

Asymmetric Information: Adverse

2013 Pearson Education, Inc. All rights reserved.

The Lemons Problem: How Adverse

2013 Pearson Education, Inc. All rights reserved.

Tools to Help Solve Adverse Selection

Government regulation to increase information

Not always works to solve the adverse selection problem,

Collateral and net worth

2013 Pearson Education, Inc. All rights reserved.

How Moral Hazard Affects the Choice

Separation of ownership and control

2013 Pearson Education, Inc. All rights reserved.

Tools to Help Solve the PrincipalAgent Problem

Government regulation to increase information

2013 Pearson Education, Inc. All rights reserved.

How Moral Hazard Influences

2013 Pearson Education, Inc. All rights reserved.

Tools to Help Solve Moral Hazard in

Monitoring and Enforcement of Restrictive

Discourage undesirable behavior

2013 Pearson Education, Inc. All rights reserved.

Summary Table 1 Asymmetric

2013 Pearson Education, Inc. All rights reserved.

Asymmetric Information in Transition

2013 Pearson Education, Inc. All rights reserved.

Application: Financial Development

2013 Pearson Education, Inc. All rights reserved.

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