Economic Analysis of Financial Structure: Key Insights for

School

Concordia University**We aren't endorsed by this school

Course

COMM 220

Subject

Communications

Date

Dec 11, 2024

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Uploaded by LieutenantWildcatMaster1154

COMM 220 – notes Chapter 9 – 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 Canadian businesses financed their activities using external funds (those obtained from the business itself) in the period 1970-2000 and compares data with Germany, Japan, and the United States Eight basic facts: 1. Stocks are not the most important sources of external financing from businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance (involving the activities of financial intermediaries) is many times more important than direct finance (raising funds directly from lenders)4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses 5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well-established corporations have early access to securities markets to finance their activities7. A prevalent feature of debt contracts for both households and businesses is collateral - Property pledge to a lender to guarantee payment - Collateralized debt is known as secured debt

8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers Transaction costs Transaction costs are a major problem in financial markets oBrokerage fees, for exampleoInability to diversify will subject you to risk Financial intermediaries have evolved to reduce transaction costs oEconomies of scale oExpertise Asymmetrical information: adverse selection and moral hazard Asymmetric information: one party has insufficient knowledge about the other party involved in a transaction Two types of asymmetric information:1. Adverse selection occurs before the transaction 2. Moral hazard arises after the transaction Agency theory analyses how asymmetric information problems affect economic behaviour Adverse election: the lemons problemGeorge Akerlof, the market for lemons, QJE (1970) 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The lemons problem intuition is very helpful to understand facts 1 and 2 Lemons in the stock and bond markets The lemons problem keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers If investors have trouble distinguishing high-profit/low-risk firms, then we will have a lemons problem How? Owners and managers of good firms have better information than the investors, so they know their securities are undervalued in the market and won’t bother issuing securities in the first place Tools to help solve adverse selection problems Private production and sale of informationoFree-rider problemGovernment regulation to increase information oNot always works to solve the adverse selection problem, explains fact 5

Financial intermediation oExperts in producing information can determine good risks from bad ones, no issue with free ridingoExplains facts 3,4 and 6 Collateral and net worth (or equity capital) oExplains fact 7 How moral hazard affects the choice between debt and equity contacts The principal-agent problem oPrincipal: less information (stockholder) oAgent: more information (manager) Separation of ownership and control of the firm oManagers pursue personal benefits and power rather than the profitability of the firmTools to help solve the principal-agent problem Monitoring (costly state verification)oFree-rider problemoFact 1 (stocks aren’t most common source of financing) Government regulation to increase information oFact 5 (finance is a heavily regulated sector) Financial intermediation oFact 3 (indirect finance more important than direct)Debt contracts oFact 1 (stocks aren’t most common source of financing)How moral hazard influences financial structure in debt markets Borrowers have incentives to take on projects that are riskier than the lender would likeoThis prevents the borrower from paying back the loanTools to help solve moral hazard in debt contracts:Net worth and collateraloMakes debt incentive comparableMonitoring and enforcement of restrictive covenants oDiscourage undesirable behavior, encourage desirable behavior, keep collateral valuable, provide information Financial intermediation oExplains facts 3 and 4 (indirect finance more important than direct; and financialintermediaries are very important) Asymmetric information problems and tools to solve them

Application: Financial development and economic growthMany developing countries experience low rates of economic growth, perhaps due to their underdeveloped financial systemSituation referred to as financial repression Several difficulties keep their financial systems from operating efficiently:- Poorly functioning system of property rights (collateral)

- Poorly developed legal systems (restrictive covenants) - Government allocation of credit (lower incentive to solve the moral hazard and adverse selection problems) - State-owned banks Application: is china a counterexample?China’s financial development is still in early stages- Weak legal system, poor contract enforcement, state allocation of credit, large state-owned banksDespite this, China has enjoyed sustained and rapid growth. How? - Still less than one-fifth the per capita income of the US- Extremely high savings rate (40% appro.), so even while savings are not allocated efficiently, there is a lot of it- As China gets richer, it will likely need to allocate its capital more efficiently, which requires that it improves its financial systems