Analysis of financial structure pot

Asymmetric Information• Adverse selection occurs before the transaction • Moral hazard arises after the transaction • Agency theory analyses how asymmetric information problems affect

Chapter 8

An Economic

Analysis of

Financial Structure

Eight Basic Facts

1 Stocks are not the most important sources of

external financing for businesses (figure 1)

==> Why?

2 Issuing marketable debt and equity securities

is not the primary way in which businesses

finance their operations (figure 1) ==> Why?

3 Indirect finance is many times more important

than direct finance ((figure 1) ==> Why?

4 Financial intermediaries are the most

important source of external funds (figure 1)

Eight Basic Facts (cont’d)

5 The financial system is among the most

heavily regulated sectors of the economy

6 Only large, well-established corporations

have easy to issue securities to markets to finance their activities

7 Collateral is a prevalent feature of

debt contracts

8 Debt contracts are extremely complicated

legal documents that place substantial

restrictive covenants on borrowers

Asymmetric Information

• Adverse selection occurs before

the transaction

• Moral hazard arises after the transaction

• Agency theory analyses how

asymmetric information problems affect economic behavior

Adverse Selection:

The Lemons Problem

• 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

Adverse Selection: Solutions

• Private production and sale of information

• Collateral and net worth (Equity)

Equity = Asset – Liability

 Fact 7

Moral Hazard in Equity Contracts

• Called the Principal-Agent Problem

- Agent: the managers of the firm (own only

small fraction of equity of the firm)

- Principal: owner of the firm (own large fraction

of equity of the firm)

• Separation of ownership and control

of the firm

 Managers pursue personal benefits and power

Principal-Agent Problem: Solutions

• Monitoring (Costly State Verification) =>

auditor => costy

 Free-rider problem (not buy information any more)

• Government regulation to increase information

Moral Hazard in Debt Markets

• Borrowers have incentives to take on

projects that are riskier than the lenders would like

Moral Hazard: Solutions

• Net worth and collateral

 “Incentive compatible”: The greater the borrower equity, the

greater the borrower’s incentive to behave in the way that the lender expects & desires ( and vice versa)

• Monitoring and Enforcement of Restrictive Covenants

 Discourage undesirable behavior => sử dụng vốn vay đúng

 Encourage desirable behavior => mục đích đi vay

 Keep collateral valuable

 Provide information (provide financial statement periodically)

=> However, these solution just reduce moral hazard problem, not eliminate it (p.197)

=> Solution: Financial Intermediation (no free-rider)

Problem in developing contries

1/ Disclosure of information: poor => law

2/ Gov use financial systems to direct credit to themselves

or to favored sectors of the economic

3/ Auditing and Consulting in Accounting Firms

 Auditors may be willing to skew their judgments and opinions to win consulting business

 Auditors may be auditing information systems or tax and financial plans put in place by their nonaudit

counterparts

 Auditors may provide an overly favorable audit to

solicit or retain audit business

Financial Crises

and Aggregate Economic Activity

• Crises can be caused by:

 Increases in interest rates

 Increases in uncertainty

 Asset market effects on balance sheets

 Problems in the banking sector

Increases in Interest Rates

Only riskiest investors willing to pay high interest rate, good credit investor less

likely to borrow => Lender will not longer

to make loan => "Adverse Selection => Decline in investment => Influence

heavily on the economic activities…

Asset Market Effects on Balance

Sheets

1/ Stock market decline => Share price of

corporations fall => Equity (net worth)

decrease & the value of collateral

decrease => Willing to borrow to make

risky investment => Banks will not lend

these corporations => "Adverse Selection"

=> Decline in investment => Influence

heavily on the economic activities…

Asset Market Effects on Balance

Sheets (cont'…)

2/ The economic in inflation: Firms' Asset

decrease meanwhile firms' Liability increase Equity = Asset - Liability

=> Equity decrease => Willing to borrow to make risky investment => Banks will not lend these corporations => "Adverse Selection" =>

Decline in investment => Influence heavily on the economic activities…

Problems in Banking Sector

Interest Rate high: Banks' Asset decrease meanwhile

banks' Liability increase.

Equity = Asset - Liability

=> Equity & Assets decrease => Banks not willing to

lend investors => "Adverse Selection" => Decline in investment => Influence heavily on the economic

activities…

In worse situation: banks start to fail & fear spread from one bank to other => "Bank panic" => people withdraw deposit => no source of capital => no lending =>

Decline in investment => Influence heavily on the

economic activities…

END OF CHAPTER