Money and Banking Chapter 8

Principle Agent Problem

A moral hazard, When managers own only a small fraction of the firm they work for, the stock holders who own a majority of the firm (called the principals) are not the name people as the managers (called the agents). This separation of ownership and control leads managers to act in their own interest rather than in the interest of the stock owners because they have less incentive to maximize profits.

Market Facts: Contracts

Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. Restrictive Covenants: Restrict certain activities the businesses with the loan can take part in

Net Worth

Equity Capital, is the difference between a firms assets and its liabilities. The higher it is the safer the firm is to give loans to because it can absorb large losses.

Expertise

Expertise allows the intermediaries to take advantage of investing software to provide excellent service for customers. They also offer liquidity services, like turning profits on a security into a check.

Market Facts: Financial Intermediaries

Financial Intermediaries, particularly banks, are the most importance source of external funds used to finance businesses. The largest source of external funds for firms comes from loans. Banks play a larger role in developing countries than in industrialized countries.

How Transaction Costs influence Financial Structure

For example, you may have $5000 of savings, but you cannot afford to buy bonds which trade at $10000. Because you only have a small amount of funds available, you can only make a restricted number of investments.

Government Regulation to Increase Information

Government regulate securities markets in a way that encourages firms to reveal information about themselves. The Securities and Exchange Commission requires companies have individual audits from accounting firms and publish that information. However, the firm still have a lot more information than investors, and firms are then incentivized to fudge the papers to look better.

Market Facts: Indirect Finance

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.

Market Facts: Issuing Debt

Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Bonds are far more important.

Economies of Scale to Reduce Transaction Costs

One solution to transaction costs is to bundle the funds of many investors together. This reduces costs for each individual investor.

Market Facts: Size

Only large, well-established corporation have easy access to securities markets to finance their activities. Smaller companies use mostly loans.

Government Regulation to Increase Information for Stock Holders

Prevents the Principal-Agent problem, gov't forces firms to adhere to standard accounting principles that make profit verification easier. There are also stiff penalties to managers who deviate.

Montitoring

Prevents the Principal-Agent problem, involves stock holders gaining more information about the firms activities through auditing. However this is expensive to do, and is called Costly State Verification.

Debt Contracts

Prevents the Principal-Agent problem, the Principal does not care about the Agent hiding information so long as debt payments are made because this implies the firm is healthy and doing well. This also lowers the cost of state verification and these contracts are used more than equity contracts. However, they are subject to moral hazard because borrowers have an inventive to take investment projects that are risker than lenders would like .

Venture Capital Firm

Prevents the Principal-Agent problem, these firms pool resources of their partners to use funds to help budding entrepreneurs start new businesses. They have several of their own staff work with and by the firm to prevent the Agent problem, and they also make it so the equity in the firm is not marketable to anyone but the venture capital firm.

Restrictive Covenenats

Prevents the moral hazard of Debt Contracts Creates restrictive covenants that... 1. Discourage undesirable behavior 2. Encourage desirable behavior 3. Keep collateral valuable 4. Provide information

Net Worth and Collateral

Prevents the moral hazard of Debt Contracts, makes debt contracts incentive compatible; that is, it aligns the incentives of borrowers with lenders because the greater the borrowers net worth pledged then the greater incentive the borrower has to behave in a way that the lender expects.

Collateral

Property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments Collateralized Debt: Is the predominant form of household debt Unsecured Debt: Credit cards etc.

Private Production and Sale of Information

Solves adverse selection problems by getting rid of asymmetric information. Private firms collect information about good and bad firms to subscribed individuals of their services. However this creates a free-rider problem

Market Facts: Stocks

Stocks are not the more important source of external financing for businesses, it accounts for about 11% in the US

Market Facts: Regulation

The financial system is among the most heavily regulated sectors of the economy. This is to promote the provision of information.

Free-rider Problem

When people who do not pay for information take advantage of the information that other people have paid for. This will cause those who do buy information to lose interest because everyone will just copy their investing habits so they cannot make high profits off of buying and selling.

Market Facts: Collateral

Collateral is a prevalent feature of debt contracts for both households and businesses.