8 ; An economic analysis of financial structure

Asymmetric information in transition and developing countries

"Financial repression created by an institutional environment characterized by : - Poor system of property rights (unable to use collateral efficiently) - Poor legal system (difficult for lender to enforce restrictive convenants) - Weak accounting standards (less access to good information) - Government intervention through directed credit programs and state owned banks (less incentive to proper channel funds to its most productive use)

Transaction costs

Financial intermediaries have evolved to reduce transaction costs - Economies of scale : i.e. hedge funds that sell share to individuals and then invest that income in bonds and stocks - Expertise : in gathering market data, in using computer technology efficiently and offering low cost customer servie

Application : Financial developement and economic growth

The financial systems in developing and transition countries face several difficulties that keep them from operating efficiently. Serious problems associated with asymmetric information. In many developing countries, the system of property rights functions poorly, making it hard to use these two tools effectively. There will be less productive investment which makes the economies of those countries to grow more slowly.

Tools to help solve the principal-agent problem

- Monitoring -> is expensive, because it takes money and time (costly state verification) -> free-rider problem decreases the amount of monitoring -> explains fact1 - Government regulation increases information, which decreases the principal-agent problem. Explains fact 5 - The use of financial intermediation like venture capital firms to finance new firms with a growth potential. Explains fact 3 - The use of debt contracts instead of equity finance -> in the case of debt the investor has less need to monitor the firm, because the compensation is a fixed amount of money -> debt interest payment are a deductible expense for american firms unlike dividend payments. This encourages the use of debt contracts rather than equity contracts. Explains fact 1

Tools to help Solve Moral Hazard in debt contracts

- Net worth and collateral -> Makes the debt contract incentive compatible, that is it alings the incentives of the borrower with those of the lender. Explains fact 6,7 - Monitoring and enforcement of restrictive covenants -> discourage undesirable behavior -> encourage desirable behavior -> keep collateral valuable -> provide information -> explains fact 8 - Using financial intermediation, especially banks, which have information concering borrower's earlier money spending habits. Explains fact 3 & 4

How Moral Hazard affects the choice between debt and equity contracts (Principal-Agent Problem)

- Principal : less information (stockholder) - Agent : more information (manager) Seperation of ownership and control of the firm - Managers pursue personal benefits and power rather than the profatibility of the firm

Tools to help Adverse Selection problems

- Private production and sale of information by rating agencies improves market efficiency and hence there will be more investment by external finance -> Free rider problem in which people do not pay for the information take adventage of the information that other people have paid for. It may lead to a market situation, where gathering and selling information is not profitable. Explains Fact 1,2 - Government regulation to increase information -> Not always works to solve the adverse selection problem. I.e. there may be probleme with auditing companies. Explains fact 5 - Using financial intermediation which gathers firm specific information and give credit rating to firms. Explains facts 3 and 4 - It is easier to get information concerning bigger firms that have been in the market for a longer time period. Easier evaluation makes it possible for those firms to receive external finance with a reasonable price. Explains fact 6. - Collateral and high enough value for net worth decrease the losses associated with a possible adverse selection problem. Explains fact 7

The Lemons Problem : How Adverse Selection influences financial structure

-If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality - Sellers of good quality itmes 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 fact 1. Only firms with low expected profits and high risk would pay high interest rate, but investors are not willing to buy bonds issued by those firms. Also estimating the correct stock price is difficult.

Eight basis facts

1. Stocks are most important sources of external financing for businesses. 2. Issuing marketable debt and equity securities is not primary way in which businesses finance their operations. 3. Indirect finance is many time more important than direct finance 4. Financial intermediaries, particularly banks, are the most important source of external founds 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 securitites markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses 8. Debt contracts are extermely complicated legal documents that place substantial restrictive covenants on borrowers

How Moral Hazard influences financial structure in debt markets

Borrowers have incentives to take on projects that are riskier than the lenders would like -> This prevents the borrower from paying back the loan, if the project was not successfull

Asymmetric information : Adverse selection and Moral hazard

Adverse selection occurs before the transaction. Especially those persons and corporations ask for a loan that will later on have more problems of paying back the loan Moral hazard arises after the transaction. After receiving the loan, the recipients take too much risk, because they are plaing with someone else's money and not with their own money Agency theory analyses analytically how asymmetric information problems affect economic behavior.