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The Puzzles of the Financial Structure

Financial markets
Financial markets promote economic efficiency by temporarily transferring wealth from lenders - those with assets for which they have little productive use - to borrowers - those with productive uses for funds.

Main Puzzle
Why, in general, does this temporary transfer of funds not occur directly between lenders and borrowers? An alternative way of stating this is: why do we need financial intermediation?

Main Puzzle
Simply put, the market for financial services should be an exchange between those who have funds to lend and those who wish to borrow. What is so complex about that?

Main Puzzle
The complexities that arise are due to: (1) the cost of coordinating borrowers and lenders (transaction costs), and (2) the difficulty of getting certain information about the product: loan contract, the repayment, and the fee

The Puzzles of the Financial Structure


1 Why stocks are not the most important

source of external financing for business? 2 Why issuing marketable debt and equity securities is not the primary way in which businesses finance their operations? 3 Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?

The Puzzles of the Financial Structure


4 Why Banks are the most important source of external funds? 5 Why the financial system is among the most heavily regulated sectors of the economy? 6 Why large, well established corporations have access to securities markets to finance their activities?

The Puzzles of the Financial Structure


7 Why collateral is a prevalent feature of debt contracts? 8 Why Debt contracts are typically extremely complicated legal documents?

The Puzzles of the Financial Structure


The resolution of the first four of these questions leads to the resolution of the remaining four. Hence we focus on the first four, the order that we answer each is specified in each section.

1. Stocks are not most important source of external finance for businesses
The principal-agent problem (a kind of moral hazard problem) naturally arises in equity (stock) financing. The managers might do things that majority shareholders would not want -- e.g., embezzling, slacking off, buying herself expensive company cars and office fixtures etc. But the principal-agent problem is less of a concern with debt contracts, because a typical bond or loan calls for the borrower to pay back fixed dollar amounts at regular intervals. For that reason, the volume of debt financing in the Mauritius is larger than the volume of equity financing, because more savers would be willing to purchase a debt instrument than an equity instrument.

1. Stocks are not most important source of external finance for businesses
Since corporate borrowers must pay off their creditors (bondholders, banks that loaned them money) before their equityholders, corporate debt is a much less risky asset than corporate stock Corporate debt is also less risky because debt securities give you a claim to a fixed stream of income from the corporation, instead of a share of uncertain profits and assets.

1. Stocks are not most important source of external finance for businesses
The adverse selection problem exists here too (this problem is less in bond market and least in Bank loans) The transactions costs of readying a stock (also a bond) offering and marketing it to the public are prohibitively high for most small and medium-sized companies.

2.Issuing marketable securities is not the primary funding source for businesses
Same reason as puzzle 1

3.Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?

Adverse selection: Screening out bad risks can be difficult, and banks are in a much better position than ordinary savers to screen out bad risks and lend savers' money to good credit risks.

3.Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?

Moral hazard: Monitoring somebody after you've loaned him money can be difficult. But banks develop expertise in monitoring borrowers. They also avoid the free-rider problem inherent in, say, a bond issue: If a company finances its operations by selling bonds, then every bondholder wants the company to be monitored somehow, but none of them wants to pay for that monitoring herself. By contrast, a financial intermediary like a bank bears the whole cost of monitoring its borrowers, but it also captures the whole return from that monitoring.

4 Why Banks are the most important source of external funds?


Same reason as Puzzle 3

5 Why the financial system is among the most heavily regulated sectors of the economy?
The financial sector is one of the most heavily regulated sectors of the economy. government regulation (e.g., forcing firms to follow standardized accounting principles, imposing stiff penalties for defrauding stockholders and creditors) is one way to deal with the principal-agent problem. By strictly regulating the banks and other financial institutions, the government can act on behalf of individual depositors, stockholders, and creditors (the principals), who otherwise would lack the ability or the incentive to keep track of what the managers (the agents) are up to.

6.Only large, well established firms have access to securities markets


Adverse Selection Transaction Cost

7. Collateral is prevalent feature of debt contracts


Collateral requirements for borrowers reduce the consequences of adverse selection. They also discourage bad credit risks from attempting to borrow money in the first place.

8. Debt contracts are typically extremely complicated legal documents with restrictive covenants Restrictive covenants, restricting what the borrower can and cannot do during the lifetime of the loan, help to overcome the moral hazard problem.

Market Imperfection: explaining the Puzzles


Puzzle 3

The existence of financial intermediation suggests to us that there are features of direct finance that ensures that the market in direct finance doesn't work. The first of these features is transactions costs.

Market Imperfection: explaining the Puzzles


The per dollar cost of investing directly in securities markets decreases as the size of the investment increases. Thus one role of financial intermediation is to pool investors funds in order to exploit these economies of scale.

Market Imperfection: explaining the Puzzles


The transactions costs are also a function of how diverse your investment strategy is. The more diverse your portfolio the higher the transaction costs. As we know diversification reduces the specific risk component of the risk associated with any investment. Pooling funds also allows the financial intermediaries to diversify away the specific (or unsystematic risk) associated with any investment strategy.

Market Imperfection: explaining the Puzzles


Finally, transactions costs also incorporate the costs associated with recouping your funds. Thus the liquidity services - such as the ability to write checks on mutual funds - that financial intermediaries offer also reduce transaction costs.

Market Imperfection: explaining the Puzzles


Also, transaction costs (and information costs) in the financial market are continually being reduced by technological advancement and financial innovation.

Information Asymmetry
On their own transaction costs are sufficient to ensure that the market for direct finance doesn't work; however there are costs associated with gathering and monitoring information of investments that compound these problems and which can explain the structure of financial intermediation.

Information Asymmetry
The information problems are caused by the fact that the borrower has more knowledge than the lender regarding the use(s) that the funds being transferred are going to be put to. If there was no risk of default (in terms of returning the funds to the lender at some specified date, or paying the fee for the funds), this asymmetry of information would cause no problem (hence the issues of collateral and complex legal documents in the puzzles: i.e. Puzzles 5, 6, 7 and 8).

Adverse Selection & Moral Hazard


These informational asymmetries can be decomposed into asymmetries that arise before the transfer of funds and those that occur after the transfer of funds, i.e.: Adverse Selection, and Moral Hazard respectively.

Market Imperfection: Adverse Selection


Puzzles 2, 3, 4, and 6 Any market in which information asymmetries exist before the purchase of the product will lead to adverse selection. That is, the invisible hand, i.e. market forces, will drive the market to adversely select the products available.

Market Imperfection: Adverse Selection


This market failure can be resolved with extra information regarding the quality of the product. However, again in both cases, the information required to solve the problem requires specialist knowledge.

Adverse Selection and Financial Structure


Lemons Problem in Securities Markets 1. If cant distinguish between good and bad securities, willing to pay only average of good and bad securities values. 2. Result: Good securities undervalued and firms wont issue them; bad securities overvalued, so too many issued. 3. Investors wont want to buy bad securities, so market wont function well. Explains Puzzle 2 and Puzzle 1. Also explains Puzzle 6: Less asymmetric information for well known firms, so smaller lemons problem 8-31

Tools to Help Solve Adverse Selection (Lemons) Problem


1. Private Production and Sale of Information Free-rider problem interferes with this solution (therefore private firms usually dont produce information) 2. Government Regulation to Increase Information Explains Puzzle 5 3. Financial Intermediation A. Analogy to solution to lemons problem provided by used-car dealers B. Avoid free-rider problem by making private loans Explains Puzzles 3 and 4 4. Collateral and Net Worth Explains Puzzle 7
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Free Rider Problem


If we presume that this specialist knowledge is available, through private production, then we can purchase this information before deciding on the loan. Another form of market failure will occur, again due to the nature of the product.

Free Rider Problem


As direct investment, in the form of securities, involves public trading, the information supplied by the private producers of information can be indirectly observed by observing the trading strategies of people who purchase the private information. Instead of purchasing the information there will be an incentive to free ride, i.e. obtain the information by observing other's behavior. Thus the market for private information will not work.

These facts further explain why intermediation is necessary: In addition to the high transaction costs, private production of information is necessary to solve the problem of asymmetric information.

Puzzle 6
The better known a corporation is, the more information about its activities is available. This information lessens the need for private production for information - as it reduces the asymmetry of information.

Market Imperfection: Moral Hazard


Puzzles 1 ,5, 6, 7 and 8 Any market in which information asymmetries exist after the purchase of the product will lead to moral hazard. This occurs when the seller of a security (the borrower) has an incentive to hide information and undertake activities that are undesirable for the purchaser of the security (the lender).

Why Moral Hazard


The answer is: the separation of ownership and control The Principal-Agent Problem. The stockholders, who own the firm (the Principals), are not the same people as the managers, who run the firm (the Agents). Because the agent has more information about their activities than the principal there will be an informational asymmetry - or Moral Hazard

Dealing with Moral Hazard


Moral hazard is solved by ensuring that the incentives of the agent match that of the principal. This is achieved through: 1 Legal restrictions on activities: restrictive covenants or debt contracts. As legal restrictions on debt contracts reduce the need to monitor activities, the issue of moral hazard explains puzzle 1, why stocks are not the most important source of financing for businesses.

Dealing with Moral Hazard


2 Producing private information regarding the activities of the firm (e.g. venture capital ... venture capitalists remove the free rider problem by providing capital to start-up firms and then ensure that the equity in the firm is not marketable to anyone but them)

Transaction costs and asymmetric information lead to inefficient outcomes in the market for direct finance and thus form the rationale for financial intermediation. The existence of the free-rider problem for traded securities indicates that financial intermediation, particularly by banks, should play a greater role than the securities markets in financing the activities of businesses.

Summary: Asymmetric Information Problems and Tools to Solve Them

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