CHAPTER 8 An Economic Analysis of Financial Structure Why financial institutions exist and how they promote economic efficiency Basic Facts about Financial Structure Throughout the World External funding Bank Loans Nonbank Loans Bonds Stock 8 Basic Facts of Financial Structure 3 1 Stocks are not the most important source of external financing for businesses Issuing marketable debt and equity securities is not the primary way in which 2 businesses finance their operations Indirect finance times more important than direct finance in which businesses raise funds directly from lenders in financial markets external funds used to finance businesses particularly banks are the most important source of which involves the activities of financial intermediaries is many 4 Financial intermediaries 5 The financial system is among the most heavily regulated sectors of economy 6 Only large well established corporations have easy access to securities markets 7 Collateral is a prevalent feature of debt contracts direct finance to finance their activities businesses substantial restrictions on the behavior of the borrowers 8 Debt contracts are typically extremely complicated legal documents that place for both households and Why is Indirect Finance so Important Transactions Costs Information Costs Information Costs Asymmetric Information Symmetric Information the case where all parties to a transaction or contract have the same information Many situations it isn t the case Information isn t the same Refer to this imbalance in information as asymmetric information Adverse Selection Occurs when one party in a transaction has better information than the other party Occurs before the transaction occurs In financial markets potential borrowers most likely to produce adverse outcome are the ones most likely to seek loan o 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 the average quality The buyer will decide not to buy at all because all that is left in the market is poor quality items The Lemons Problem Used cars come in good repair peaches and bad shape lemons The sellers know the quality of the cars Used car shoppers would be prepared to pay 20 000 for a good one and 10 000 for a lemon If buyers had the information to tell good from bad they could strike fair trades with the sellers 20 000 for good car and 10 000 for the lemon If buyers don t have good information and cannot tell the quality difference there will be only one market for all used cars Buyers will pay only the average price of a good car and a lemon or 15 000 This is below the 20 000 that good car owners require so they will exit the market leaving only bad cars o Result when bad quality pushes good quality from the market because of an information gap is known as adverse selection o Lemons Problem in securities markets Investors cannot distinguish between good and bad securities willing to pay only the average of the good and bad securities values Result Good securities undervalued and firms won t issue them bad securities overvalued so too many issued o Actions to Help Solve Adverse Selection Problems i Government regulation to increase information fact 5 ii Private production and sale of information free rider problem interferes with this solution iii Financial Intermediation Analogy to solution to lemons problem provided by used car dealers Avoid free rider problem FIs make private loans and keep information private Fact 3 4 6 Collateral and Net Worth Fact 7 Moral Hazard a Occurs when one party has an incentive to behave differently once an agreement is made between parties b Occurs after transaction occurs c Hazard that borrower has incentives to engage in undesirable activities making it more likely that won t pay loan back How Moral Hazard Affects the Choice between Debt and Equity Contracts a Called the Principal Agent Problem i Principal less information stockholder ii Agent more information manager b Separation of ownership and control of the firm i Managers pursue personal benefits and power rather than the profitability of the firm Actions to help Solve the Principal Agent Problem Government regulation to increase information Monitoring o Expensive o Fact 5 Financial Intermediation management Use Debt o Venture capital firms provide the equity and place their own people in o Reduces the need to monitor as long as borrower is performing Explains Fact 1 why debt is used more than equity How Moral Hazard Influences Financial Structure in Debt Markets Even with the advantages just described debt is still subject to moral hazard o Debt may create an incentive to take on very risky projects Suppose a firm owes 100 but only has 90 It is essentially bankrupt The firm has nothing to lose by looking for risky projects to raise the needed cash Lenders Need to Find Ways to Ensure that Borrower s do not take on too Much Risk A good legal contract Bonds Loans often carry restrictive covenants o Restrict how funds are used Require minimum net worth collateral bank balance credit rating Financial intermediaries have special advantages in monitoring Fact 3 and 4 CHAPTER 3 WHAT IS MONEY Money Anything that is generally accepted in payment for goods or services or in the repayment of debts A stock concept An asset that can be used to make transactions Different from Wealth the total collection of pieces of property that serve to store value Money is a component of wealth Different from Income flow of earnings per unit of time A flow concept Money is a Medium of Exchange The alternative is a barter system For economic changes to occur using barter Coincidence of Wants must exist 3 Functions of Money 1 Medium of Exchange a Eliminates the trouble of finding a double coincidence of needs Reduces transaction costs b Promotes specialization c A medium of exchange MUST i Be easily standardized ii Be widely accepted iii Be divisible iv Be easy to carry v Not deteriorate quickly 2 Unit of Account 3 Store of Value a Used to measure value in the economy a Used to transfer purchasing power over time Other assets b Money is the most liquid of all assets but loses value during are too inflation Inseparability of the Store of Value and Medium of Exchange Functions Hyperinflation Example During hyperinflation individuals and firms frantically attempt to get