An Economic Analysis of Financial Structure
Eight Basic Facts
1 Stocks are not the most important sources of external financing for businesses
2 Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
3 Indirect finance is many times more important than direct finance
4 Financial intermediaries are the most important source of external funds
5 The financial system is among the most heavily regulated sectors of the economy
6 Only large, well-established corporations have easy access to securities 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
Transaction Costs
Financial intermediaries have evolved to reduce transaction costs
- Economies of scale
- Expertise
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
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7
Conflicts of Interest
Type of moral hazard problem caused by economies of scope
Arise when an institution has multiple objectives and, as a result, has conflicts between those objectives
A reduction in the quality of information in financial markets increases asymmetric information problems
Financial markets do not channel funds into productive investment opportunities
The economy is not as efficient as it could be
Why Do Conflicts of Interest Arise?
Underwriting and Research in Investment Banking
Information produced by researching companies is used to underwrite the securities. The bank is attempting to simultaneously serve two client groups whose information needs differ.
Spinning occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business
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
- Government fiscal imbalances
