Chapter 8 An Economic Analysis of Financial Structure Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-3 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) ==> Why? Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-4 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-5 Transaction Costs • Financial intermediaries have evolved to reduce transaction costs [ex: mutual funds]  Economies of scale  Expertise Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-6 Asymmetric Information • Adverse selection occurs before the transaction • Moral hazard arises after the transaction • Agency theory analyses how asymmetric information problems affect economic behavior Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-7 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-8 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 (Equity) Equity = Asset – Liability  Fact 7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-9 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 rather than the profitability of the firm Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-10 Principal-Agent Problem: Solutions • Monitoring (Costly State Verification) => auditor => costy  Free-rider problem (not buy information any more) • Government regulation to increase information  Fact 5 • Financial Intermediation (venture capital firm)  Fact 3 • Debt contract (instead of buy stock, take a debt contract) [...]... 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... 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)... the economic activities… Copyright © 2007 Pearson Addison-Wesley All rights reserved 8-17 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... 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… Copyright © 2007 Pearson Addison-Wesley All rights reserved 8-20 Copyright © 2007 Pearson Addison-Wesley All rights reserved 8-21 END OF CHAPTER Copyright © 2007 Pearson Addison-Wesley All rights reserved 8-22 ... plans put in place by their nonaudit counterparts  Auditors may provide an overly favorable audit to solicit or retain audit business Copyright © 2007 Pearson Addison-Wesley All rights reserved 8-14 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 . 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. Chapter 8 An Economic Analysis of Financial Structure Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8-2 Copyright