Chapter 8: An Economic Analysis of Financial Structure

adverse selection

occurs before a transaction occurs: potential bad credit risks are the ones who most actively seek out loans

free-rider problem

occurs when people who do not pay for information take advantage of the information that other people have paid for

venture capital firm

pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses 1. usually insist on having several of their own people as members of the board of directors so they can keep a close eye on the new firm's activities 2. the equity in the firm is private when they supply the start up funds thus eliminating the free-rider problem by not allowing other investors to participate

collateral

property that is pledged to a lender to guarantee payment in the even that the borrower is unable to make debt payments 1. collateralized debt: secured debt vs. unsecured debt such as credit card debt which is not collaterized

restrictive covenants

provisions in a debt contract that restrict and specify certain activities that the borrower can engage in

agency theory

the analysis of how asymmetric information problems affect economic behavior

costly state verification

the costly monitoring process; makes the equity contract less desirable and explains in part why equity is not a more important element in our financial structure

net worth (equity capital)

the difference between a firm's assets (what it owns or is owed) and its liabilities (what it owes) 1. can perform a similar role to that of collateral in that if a firm has a high net worth, then even if it engages in investments that lead to negative profits and defaults it can still recoup some of the losses from the loan by using its net worth

incentive-compatible

the moral hazard problem aligns the incentives of the borrower with those of the lender

asymmetric information

a situation that rises when one party's insufficient knowledge about the other party involved in a transaction makes it impossible for the first party to make accurate decisions when conducting the transaction

principal-agent problem

a type of moral hazard; when managers own only a small fraction of the firm they work for, the stockholders who own most of the firm's equity (the principals) are not the same people as the managers of the firm (the agents) 1. the managers may act in their own interest rather than in the interest of the stockholder-owners because the managers have less incentive to maximize profits than the stockholder-owners do

four types of restrictive covenants that achieve reducing moral hazard

1. covenants to discourage undesirable behavior 2. covenants to encourage desirable behavior 3. covenants to keep collateral valuable 4. covenants to provide information

solutions to the moral hazard in debt contracts

1. net worth and collateral 2. monitoring and enforcement of restrictive covenants 3. financial intermediation

solutions to adverse selection problems

1. private production and sale of information 2. government regulation to increase information 3. financial intermediation 4. collateral and net worth

solutions to the principal-agent problem

1. production of information: monitoring 2. government regulation to increase information 3. financial intermediation 4. debt contracts

Basic facts about financial structure throughout the world

1. stocks are not the most important source 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, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raises funds directly from lenders in financial markets 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 easy access to securities markets to finance their activities 7. collateral is a prevalent feature of debt contracts for both households and businesses. 8. debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.

moral hazard

arises after the transaction occurs: the lender runs the risk that the borrower will engage in activities that are undesirable from the lender's point of view, because such activities make it less likely that the loan will be paid back