Econ 423 Michael SalemiEconomic Analysis of Financial StructureNotes to Complement Chapter 8 of Mishkin1. Mishkin begins by setting out eight puzzling facts about financial structure in the UnitedStates and developed world. They are:a. Stocks are not the most important source of external financing for businesses.b. Issuing marketable debt and equity securities is not the primary way forbusinesses to finance their operations.c. Indirect finance is far more important than direct finance for businesses.d. Banks are the most important source of external funds for businessese. The financial system is among the most heavily regulated sectors of the economy.f. Only large, well-established corporations have easy access to securities-marketfunding.g. Collateral is a prevalent feature of debt contracts for both households andbusinesses.h. Debt contracts typically place substantial restrictions on the behavior of theborrowers.2. The distinction between direct and indirect finance (Chapter 2) is important.Function of Financial Markets3. Mishkin explains how these puzzling facts can be explained once one understands theeffects of making economic decisions in the presence of asymmetric information.a. Asymmetric information is said to occur when one party in a transaction hassubstantially more relevant knowledge than another.i. The person buying life or health insurance has more complete andaccurate knowledge about his life style than the seller of insurance.ii. The seller of a car has more complete knowledge about the car than thebuyer. In a famous paper (“The Market for ‘Lemons’: Quality,Uncertainty, and the Market Mechanism,” George Akerlof introduced thelemons problem using the example of used car sales.iii. The borrower of funds has more complete knowledge about how the fundswill be used than the lender.b. There are two types of problems that fall under the heading of asymmetricinformation.i. Adverse selection occurs before the transaction. As the name suggests,the existence of asymmetric information often selects participants into amarket in a perverse way. The example on the next page makes this clear.ii. Moral hazard occurs after the transaction. The existence of asymmetricinformation provides one party with an incentive to behave differentlyafter the transaction than they promised to behave before the transaction.c. Moral hazard influences the choice between equity and debt contracts.i. Firm managers (agents) may face weak incentives to manage their firms inways that make maximum profits for shareholders (principals).ii. Once a lender has approved a loan, the borrower has an incentive to takegreater risks with the funds than indicated on the loan application. If theborrower is fortunate, the extra returns are his. If the borrower isunfortunate, the lender suffers the loss. 4. Some financial market remedies for asymmetric information.a. Private firms produce and sell information pertaining to the profitability andcredit worthiness of firms and other borrowers. Unfortunately, those who do notpay for this information can often benefit from it by observing the behavior ofthose who do pay. When those who do not pay for information neverthelessbenefit from it, a “free rider” problem is said to occur. Because of free riderproblems, too little information about firms and their credit worthiness is madeavailable in the market place. b. Financial firms obtain relief from asymmetric information problems by designingcontracts that are incentive compatible and individually rational. Such contractsare often called “truth telling” contracts.i. The standard debt contract provides some relief against the adverseselection problem. The standard debt contract allows the borrower todeclare whether or not the “project” for which funds were borrowed hasbeen successful. If the borrower declares the project a success, the lenderreceives a fixed fee (interest plus principal) no matter how successful theproject was and the lender does not spend funds to monitor the project. Ifthe borrower declares the project a failure, the lender monitors the projectto determine how much it paid and then takes everything.ii. Co-payments are a strategy used by insurance companies as remedies forasymmetric information.c. The existence of specialists and arrangements that allows the specialists to profitfrom their ability to assess risk provides relief from asymmetric informationproblems.i. Commercial banks specialize in assessing the credit worthiness orpotential borrowers, and in the design of covenants and collateralarrangements that reduce moral hazard. Commercial bank loans areprivate so that the bank has opportunity to profit from its expertise andinformation.ii. Venture capital firms specialize in assessing the potential of start-upcompanies and in creating financial arrangements that keep free ridersfrom profiting from the venture capital firm’s expertise.d. Firms pay managers sufficiently large salaries and provide performance-basedincentives to avoid moral hazard. The salaries and incentives help align theinterests of the managers (agents) with the interests of the owners (principals).e. Financial institutions prefer to give loans to firms that put up collateral.f. Lenders frequently impose restrictive covenants on borrowers.5. How does the existence of asymmetric information explain the eight puzzling facts?Econ 423 Michael SalemiAdverse Selection ExerciseIn this exercise, students will work with the concepts of “adverse selection” and “incentive compatibility”to learn how insurance companies design insurance contracts when they are not able to identify theriskiness of potential clients before the fact.Consider a world with many agents. Agents are alike in all respects except one. Each agent is an expected utility maximizer. Each agent has the Bernoulli state-specific utility functionlog (W/W0) where W is state-specific wealth and W0 is initial wealth. Each agent has initial wealth of$1000. Each agent faces the risk of an accident which will cost the agent $500. Because agents are riskaverse, they are willing to buy insurance.Type G agents are low-risk agents who have a .05 probability of an accident. Type B agents are high-risk agents who have a .20 probability of an accident. The population contains 80 percent Type G agents and 20 percent and Type B agents.1. Suppose, first, that an insurance company can identify G and B agents when they apply for insurance.