Financial Institutions Crisis and Response PDF

PART 3: Financial Institutions Crisis and Response: The $700 Billion Bailout Package The Emergency Economic Stabilization Act, passed by the U.S. House of Representatives on October 3, 2008, was a $700 billion b...

PART 3: Financial Institutions Crisis and Response: The $700 Billion Bailout Package The Emergency Economic Stabilization Act, passed by the U.S. House of Representatives on October 3, 2008, was a $700 billion bailout package aimed at addressing the global nancial crisis. The Act allowed the Treasury to purchase troubled mortgage assets from struggling nancial institutions or inject capital into banks. Additionally, to reassure the public, the Act raised the federal deposit insurance limit from $100,000 to $250,000. Initially, the bill faced signi cant opposition and was rejected on September 29 after constituents expressed strong disapproval of what they saw as a bailout for Wall Street executives responsible for the crisis. The debate polarized the nation, contrasting Wall Street with Main Street. Many argued that federal support for nancial institutions ignored the struggles of ordinary Americans facing job losses or unemployment.Despite the backlash, the crucial role of nancial institutions in the economy was overlooked in these discussions. Banks and nancial institutions are essential for moving funds from savers to those with productive investment opportunities. Without restored capital ow, local banks couldn’t lend to small business owners or individuals, such as recent college graduates seeking loans. The nancial crisis underscored the evolving nature of nancial systems through innovations and crises. Subsequent chapters of the text delve deeper into these issues. Chapter 8 explores nancial structures in the U.S. and globally, while Chapter 9 focuses on banking processes. Chapter 10 examines motivations for and challenges of bank regulation, and Chapter 11 discusses the history and internationalization of American banking. Finally, Chapter 12 provides a framework to understand nancial crises, analyzing the 2007–2009 crisis and its lessons, as well as the potential risks posed by the coronavirus pandemic. Chapter 8: An Economic Analysis of Financial Structure Preview A healthy economy relies on a nancial system that ef ciently channels savings from individuals to those with productive investment opportunities. This chapter examines how the nancial system ensures that savings are directed to productive investors, like Paula, rather than to unproductive ones, like Benny. Through an economic analysis, the chapter explores how the nancial structure is designed to enhance economic ef ciency. It highlights key economic concepts that explain why nancial contracts are structured as they are and why nancial intermediaries play a more critical role than securities markets in facilitating the ow of funds to borrowers. BASIC FACTS ABOUT FINANCIAL STRUCTURE THROUGHOUT THE WORLD The nancial system is complex and includes various institutions like banks, insurance companies, mutual funds, and securities markets, all regulated by governments. Its primary function is to channel trillions of dollars annually from savers to individuals or businesses with productive investment opportunities. Understanding the nancial system requires explaining eight key facts about its structure and operation, drawn from data on external nancing of businesses in the U.S., Germany, Japan, and Canada during 1970– 2000. These facts remain relevant today. The Eight Key Facts: 1. Stocks Are Not the Most Important Source of External Financing: Despite media focus on the stock market, stocks accounted for only 11% of external nancing for American businesses during 1970–2000, a pattern also seen in other countries. This highlights that the stock market plays a relatively small role compared to other nancing sources. 2. Marketable Securities Are Not the Primary Way Businesses Finance Operations:Bonds are more signi cant than stocks in the U.S., supplying 32% of external funds compared to stocks’ 11%. However, together, stocks and bonds (43%) still account for less than half of external nancing, with even lower reliance on marketable securities in other countries. 3. Indirect Finance Is Far More Important Than Direct Finance: Indirect nance, where intermediaries like banks, insurance companies, and pension funds acquire securities, dominates over direct nance. In the U.S., less than 10% of external funding comes from direct nance. This trend is even more pronounced globally, though indirect nance’s importance has been declining in recent years. 4. Financial Intermediaries Are the Most Important Source of External Funds:Loans from nancial intermediaries, especially banks, are the primary source of business nancing worldwide. In the U.S., intermediaries provided 56% of external funds; this gure exceeds 70% in Germany and Japan. Banks 1 fl fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fl fi fi fi  play an even larger role in developing economies. However, their contributions have been declining recently. 5. The Financial System Is Heavily Regulated:Governments extensively regulate nancial markets to ensure transparency, provide accurate information, and maintain the system’s stability. This level of regulation is consistent across developed countries. 6. Only Large Corporations Have Easy Access to Securities Markets: Well-established businesses dominate securities markets, while smaller rms and individuals rely primarily on banks for nancing. This highlights the barriers faced by less-established entities in accessing marketable securities. 7. Collateral Is a Key Feature of Debt Contracts: Collateralized debt, where property is pledged to secure loans, is prevalent for both households and businesses. Examples include auto loans and mortgages, with collateral ensuring repayment. Collateralized loans are a major part of business borrowing, as seen in commercial mortgages and corporate bonds. 8. Debt Contracts Are Complex and Restrictive:Debt contracts are lengthy legal documents with restrictive covenants that limit borrowers’ actions to protect lenders. These covenants are common in both personal and business loans, ensuring, for example, that purchased assets are insured. The structure of nancial markets is in uenced by transaction and information costs. The economic analysis of these costs provides insights into the eight facts and deepens understanding of the nancial system. The chapter proceeds to examine how transaction and information costs shape nancial structure, addressing the questions raised by these eight facts. TRANSACTION COSTS Transaction costs are a major problem in nancial markets. An example will make this clear. How Transaction Costs In uence Financial Structure Transaction costs signi cantly in uence nancial structure, particularly for small investors. If you have $5,000 to invest in the stock market, buying only a small number of shares means that brokerage commissions will form a large percentage of your purchase, reducing potential returns. Investing in bonds presents an even greater challenge, as their denominations often start at $10,000, exceeding your available funds.This barrier prevents many individuals from using nancial markets effectively, which is evident in the fact that only about half of American households own any securities. Additionally, limited funds constrain your ability to diversify investments. Making multiple small transactions would incur prohibitive costs, forcing you to concentrate your investment in a single option. This lack of diversi cation increases risk, further illustrating how high transaction costs limit access and ef ciency in nancial markets. How Financial Intermediaries Reduce Transaction Costs The challenges posed by transaction costs, such as high brokerage fees or legal costs that prevent small loans, often exclude small savers from accessing nancial markets and bene ting from them. However, nancial intermediaries have developed as a key component of the nancial structure to address these issues. By reducing transaction costs, intermediaries enable small savers and borrowers to participate in and bene t from nancial markets. Economies of Scale. One solution to high transaction costs is leveraging economies of scale, which reduce transaction costs per dollar as the size of transactions increases. By bundling the funds of many investors, nancial intermediaries lower transaction costs for each individual. This is possible because the total cost of a large transaction increases only slightly compared to a small one. For example, arranging the purchase of 10,000 shares of stock costs only marginally more than arranging 50 shares. Economies of scale help explain the rise and signi cance of nancial intermediaries in the nancial structure. A key example is mutual funds, which pool individual investors’ funds to buy large blocks of stocks or bonds. This reduces transaction costs, allowing mutual funds to pass on savings to investors, minus management fees. Mutual funds also offer diversi cation by purchasing a wide portfolio of securities, reducing risk for individual investors. Additionally, economies of scale lower resource costs for nancial institutions. For instance, a large mutual fund's investment in advanced computer or telecommunications systems can serve many transactions at a minimal cost per transaction, further enhancing ef ciency. Expertise. Financial intermediaries develop expertise that helps lower transaction costs and improve services. For example, their pro ciency in computer technology allows them to offer conveniences like 2 fi fi fi fi fi fi fi fi fl fi fl fl fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi  check-writing privileges and toll-free numbers for investment updates.Low transaction costs also enable nancial intermediaries to provide liquidity services which simplify transactions for customers. Money market mutual funds illustrate this by offering shareholders both high-interest rates and the ability to write checks for convenient bill payments. ASYMMETRIC INFORMATIORN: ADVERSE SELECTION AND MORAL HADARD Transaction costs explain part of the signi cance of nancial intermediaries and indirect nance, but to fully understand nancial structure, it is essential to examine the role of asymmetric information in nancial markets. Asymmetric information occurs when one party has insuf cient knowledge about the other, leading to challenges in making informed decisions during transactions. This issue gives rise to two problems: adverse selection and moral hazard. Adverse Selection: This problem occurs before a transaction. It arises when one party possesses hidden information about their characteristics and uses it to their advantage, often at the expense of the less- informed party. For instance, individuals with poor credit or high-risk tendencies are more likely to seek loans, as they know they may not repay. This increases the likelihood of undesirable outcomes, discouraging lenders from making loans, even when reliable borrowers are present in the market. Moral Hazard: This issue emerges after a transaction has taken place. It occurs when the informed party takes hidden actions that harm the less-informed party. For example, a borrower may engage in risky behaviors after obtaining a loan, knowing they are risking someone else’s money. These actions reduce the likelihood of repayment, potentially leading lenders to withhold loans entirely. The study of how asymmetric information affects economic decisions is known as agency theory. This theory helps explain the structure of nancial markets and addresses the issues outlined in the chapter's key facts. THE LEMONS PROBLEM: HOW ADVERSE SELECTION INFLUENCES FINANCIAL STRUCTURE The lemons problem, outlined by Nobel Prize winner George Akerlof, illustrates how adverse selection disrupts market ef ciency, using the example of the used-car market. Buyers often cannot determine whether a used car is a high-quality “peach” or a problematic “lemon.” As a result, they are only willing to pay a price re ecting the average quality of cars in the market—a price between the low value of a lemon and the high value of a peach. However, sellers typically have better knowledge of their car's quality. Owners of lemons are eager to sell because the average market price exceeds the car’s actual value. Conversely, owners of peaches may avoid selling, as the market price undervalues their good car. This dynamic results in fewer high-quality cars entering the market, lowering the average quality of available cars. Because buyers are reluctant to purchase low-quality lemons, the market experiences reduced activity or may fail altogether. Lemons in the Stock and Bond Markets The lemons problem also arises in securities markets, such as the debt (bond) and equity (stock) markets. In this case, investors, like Irving, cannot distinguish between good rms (with high pro ts and low risk) and bad rms (with low pro ts and high risk). As a result, Irving is only willing to pay a price that re ects the average quality of rms’ securities, somewhere between the value of good and bad rms' securities. Owners or managers of good rms, knowing their securities are undervalued, are unwilling to sell them at the market price. Only bad rms, whose securities are priced higher than their actual value, are willing to sell to Irving. As a result, Irving, not wanting to hold securities from bad rms, will refrain from purchasing in the market. A similar issue arises in the bond market. Irving would demand a higher interest rate on bonds to compensate for the risk of both good and bad rms. Good rms, realizing they would have to pay a higher rate than they should, are unlikely to borrow in this market, leaving only bad rms willing to issue bonds. This leads to a lack of demand for bonds, preventing the bond market from functioning effectively. This analysis helps explain why marketable securities (stocks and bonds) are not the primary source of nancing for businesses, as the lemons problem reduces their effectiveness in transferring funds from savers to borrowers. Tools to Help Solve Adverse Selection Problems In the absence of asymmetric information, the lemons problem is resolved. If buyers and sellers have the same information about the quality of used cars, buyers will pay the full value for good cars. As a result, owners of good cars will be willing to sell them, leading to many transactions and a well-functioning market. 3 fi fi fl fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fl  Similarly, if buyers in the securities market can distinguish between good and bad rms, they will pay the full value for securities from good rms. This will allow good rms to sell their securities, effectively channeling funds to the rms with the most productive investment opportunities. Private Production and Sale of Information.To address the adverse selection problem in nancial markets, one solution is to reduce asymmetric information by providing more details about rms or individuals seeking nancing. Private companies, such as Standard & Poor’s, Moody’s, and Value Line, collect and sell information about rms’ nancial positions to saver-lenders. However, this solution is not perfect due to the free-rider problem. Free riders bene t from information without paying for it, undermining the value of purchasing detailed data. If many investors act as free riders, the price of undervalued securities rises, making it no longer pro table for those who paid for the information. This discourages information production and can leave the adverse selection problem unresolved, affecting the ef ciency of securities markets. Government Regulation to Increase Information. The free-rider problem prevents the private market from producing suf cient information to eliminate the asymmetric information that causes adverse selection. Financial markets could bene t from government intervention in two ways: 1. Direct Government Action: The government could produce and provide information to help investors distinguish between good and bad rms, though releasing negative information about rms could face political challenges. 2. Regulation: Governments, like the U.S., require rms to disclose accurate information through mechanisms like the SEC, which mandates independent audits to ensure adherence to standard accounting principles. This regulation aims to encourage rms to provide honest information for investors to assess their quality. However, these measures are not foolproof. Despite government intervention, asymmetric information remains because rms inherently know more about their operations than investors. Bad rms may also manipulate their disclosures to appear better, further complicating investors' ability to differentiate good rms from bad ones. This persistence of adverse selection explains why nancial markets are among the most heavily regulated sectors of the economy. FYI: The Enron Implosion Until 2001, Enron Corporation appeared highly successful, controlling 25% of the energy-trading market and reaching a valuation of $77 billion in August 2000, making it the seventh-largest U.S. corporation. However, by late 2001, Enron collapsed. In October 2001, the company announced a $618 million third-quarter loss and revealed accounting “mistakes”. An SEC investigation uncovered complex transactions that kept signi cant debt off Enron's balance sheet, hiding its nancial struggles. Despite securing $1.5 billion in nancing from J.P. Morgan Chase and Citigroup, Enron declared bankruptcy in December 2001, the largest in U.S. history at the time. The collapse demonstrated that while government regulation can reduce asymmetric information, it cannot fully eliminate it. Managers often have strong incentives to conceal problems, making it dif cult for investors to assess a rm's true value. The bankruptcy raised concerns about the reliability of corporate accounting, caused nancial losses for employees whose pensions became worthless, and led to legal consequences for several Enron executives. Financial Intermediation. The adverse selection problem in nancial markets can be mitigated, though not entirely eliminated, by the private production of information and government regulation. The nancial structure facilitates the ow of funds to individuals with productive investment opportunities despite asymmetric information, as demonstrated by the structure of the used-car market. In the used-car market, private individuals often lack suf cient information about the quality of vehicles. They may consult resources like Consumer Reports or hire a mechanic, but these measures are costly or unreliable. Instead, most used cars are sold through intermediaries, such as used-car dealers, who specialize in assessing vehicle quality. Dealers pro t by identifying high-quality cars (“peaches”) and selling them with guarantees, either explicit (warranties) or implicit (based on their reputation). This approach avoids the free-rider problem, as dealers exclusively bene t from the information they produce. Similarly, nancial intermediaries, particularly banks, address adverse selection in nancial markets. Banks become experts in evaluating rms, distinguishing good credit risks from bad ones, and lending to reliable rms. By doing so, they earn pro ts on loans due to higher returns from good borrowers compared to the interest paid to depositors. Banks avoid 4 fi fi fi fi fi fi fi fi fl fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi  the free-rider problem by focusing on private loans, which are nontraded and thus prevent other investors from undercutting the bank's interest rates. This model explains why banks, holding a large share of nontraded loans, play a crucial role in reducing asymmetric information. This analysis highlights why indirect nance, mediated by nancial intermediaries like banks, is more prevalent than direct nance in corporate funding. It also clari es why banks are more signi cant than securities markets in developing countries. In such economies, gathering information about rms is more challenging, reducing the role of securities markets and amplifying the role of banks. Conversely, as information becomes easier to obtain, as seen with advancements in information technology in the United States over the past 30 years, the role of banks in lending has declined. Lastly, the analysis explains why larger rms are more likely to raise funds through securities markets. Established corporations are better known, making it easier for investors to assess their quality and reducing concerns about adverse selection. Consequently, investors are more willing to purchase their securities directly, creating a “pecking order” where larger, well-known rms rely on direct nance, while smaller rms depend more on banks and intermediaries. Collateral and Net Worth. Adverse selection disrupts nancial markets when lenders face losses due to borrowers defaulting on loans. Collateral, which is property pledged to the lender in case of default, mitigates this issue by reducing potential losses. If a borrower defaults, the lender can seize and sell the collateral to recover the loan amount. For instance, in the case of a mortgage, the lender can auction the borrower’s house to cover the unpaid loan. Collateral encourages lenders to approve loans and motivates borrowers to provide it, as it reduces the lender’s risk and may lead to better loan terms. This explains why collateral is a key element of debt contracts. Net worth, or equity capital—the difference between a rm’s assets and liabilities—serves a similar function. A rm with high net worth provides lenders with additional security, as the rm’s assets can be used to recover losses in case of default. Moreover, rms with substantial net worth are less likely to default because they have a nancial cushion to meet loan obligations. As a result, lenders are more willing to extend credit to rms with higher net worth, reducing the impact of adverse selection. This dynamic underpins the idea that borrowing is often easier for those who already possess signi cant nancial resources. Summary. The concept of adverse selection has been used to explain seven of the eight key facts about nancial structure. These include the dominance of nancial intermediaries over securities markets in corporate nancing, the extensive regulation of nancial markets, the limited access to securities markets for only large, established corporations, and the critical role of collateral in debt contracts. The next section introduces moral hazard, another aspect of asymmetric information, which further explains the importance of nancial intermediaries, the limited role of securities markets, the prevalence of regulation, and the use of collateral. Additionally, moral hazard helps clarify the nal fact: debt contracts are often complex legal agreements that impose signi cant restrictions on borrowers' behavior. HOW MORAL HAZARD AFFECTS THE CHOICE BETWEEN DEBT AND EQUITY CONTRACTS Moral hazard is an asymmetric information issue that arises after a nancial transaction. It occurs when the seller of a security has incentives to withhold information or engage in actions that are harmful to the buyer. This problem signi cantly in uences a rm's ability to raise funds, often making it easier to do so with debt contracts rather than equity contracts. Moral Hazard in Equity Contracts: The Principal-Agent Problem Equity contracts, like common stock, represent claims to a share in a business's pro ts and assets but are subject to moral hazard, speci cally the principal–agent problem. This problem arises when a rm's managers (agents) control its operations but own only a small portion of its equity, while the majority is owned by stockholders (principals). Managers may prioritize their own interests over those of the stockholders, as they have less incentive to maximize pro ts compared to the owners. For example, if Steve asks you to invest $9,000 in his ice-cream store for a 90% ownership stake while he keeps a 10% stake, you depend on Steve to manage the store effectively. If Steve works diligently, the store can earn $50,000 in annual pro ts, leaving $45,000 for you and $5,000 for Steve. However, Steve might decide the extra $5,000 isn’t worth the effort, leading him to mismanage the business by neglecting customers, making unproductive investments, or spending time at the beach. This behavior results in no pro ts for the store, costing you your 5 fi fi fi fi fi fi fi fi fi fi fi fl fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi  $45,000 share. The principal–agent problem worsens if Steve acts dishonestly. In a cash-based business, he could pocket $50,000 in revenue and falsely report zero pro ts, keeping all the earnings for himself while you receive nothing. Such scenarios demonstrate how managers can exploit their control over a rm at the expense of its owners. Historical corporate scandals, such as those involving Enron and Tyco International, reveal the severity of this problem. Managers have been known to divert company funds for personal use or pursue strategies that enhance their power but fail to improve pro tability. The principal–agent problem arises because of asymmetric information—managers like Steve have more knowledge about their actions than stockholders. If owners had complete information or if managers owned the entire business, this issue would not exist. For instance, if Steve owned the ice-cream store outright, he would earn the full $50,000 in pro ts from his hard work, providing him with a direct incentive to manage the store effectively. The separation of ownership and control, combined with asymmetric information, is at the heart of the principal– agent problem. Tools To Help Solve the Principal- Agent Problem Production of Information: Monitoring. The principal–agent problem arises because managers possess more information about their activities and pro ts than stockholders, leading to moral hazard. Stockholders can reduce this issue by monitoring the rm’s activities, such as through frequent audits. However, this process, known as costly state veri cation, is expensive and makes equity contracts less attractive, partially explaining why equity plays a limited role in nancial structures. The free-rider problem further reduces private information production aimed at mitigating the principal–agent problem. Stockholders might avoid monitoring, relying instead on others to do so while saving resources for personal use, such as vacations. If all stockholders act this way, monitoring diminishes or disappears, worsening the moral hazard problem and making it dif cult for rms to issue shares to raise capital. This contributes to the challenges rms face in using equity nancing. Government Regulation to Increase Information. Similar to adverse selection, governments have an incentive to reduce the moral hazard problem caused by asymmetric information, which helps explain why the nancial system is heavily regulated (fact 5). Governments enforce laws requiring rms to follow standard accounting principles to simplify pro t veri cation and impose severe criminal penalties for fraud, such as hiding or stealing pro ts. However, these measures are only partially effective because detecting fraud is challenging. Fraudulent managers are motivated to make it dif cult for government agencies to uncover or prove fraudulent activities. Financial Intermediation. Financial intermediaries can avoid the free-rider problem in addressing moral hazard, highlighting the importance of indirect nance (fact 3). Venture-capital and private-equity rms are speci cally designed to mitigate the principal–agent problem. Venture-capital rms pool resources to fund new businesses, while private-equity rms invest in existing corporations by purchasing shares. In exchange for capital, they obtain equity shares in the businesses. To eliminate moral hazard, these rms emphasize pro t and earnings veri cation by placing their own representatives on the board of directors, closely monitoring the rm’s activities. A key characteristic of these rms is that the equity they acquire is private and not marketable to others, preventing free-rider issues. This setup allows them to fully bene t from their veri cation efforts and provides proper incentives to reduce moral hazard. Venture-capital rms have been instrumental in developing the high-tech sector in the U.S., while private-equity rms have enhanced corporate ef ciency. Both have contributed to economic growth and international competitiveness. Debt Contracts. Moral hazard arises with equity contracts because they claim pro ts in all situations, whether the rm is making or losing money, requiring constant monitoring of managers. A debt contract, however, reduces moral hazard by structuring payments as xed amounts at regular intervals. The lender does not need to verify the rm’s exact pro ts unless the rm defaults on its debt payments. Only in default does the lender need to act like an equity holder and verify the rm’s income to secure their share.This reduced need for monitoring, and therefore lower costs of state veri cation, makes debt contracts more attractive than equity contracts for raising capital. This explains why stocks are not the primary source of business nancing (fact 1). 6 fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi  HOW MORAL HAZARD INFLUENCES FINANCIAL STRUCTURE IN DEBT MARKETS Debt contracts, despite their advantages, are still subject to moral hazard. Borrowers, who pay a xed amount under a debt contract, may be tempted to take on riskier investment projects to maximize their potential pro ts beyond the xed payment. For example, instead of becoming an equity partner in Steve’s ice-cream store, you lend him $9,000 under a debt contract with a 10% interest rate. You view this as a safe investment due to the steady local demand for ice cream. However, once Steve receives the funds, he might use them for riskier purposes, such as investing in chemical research to develop a revolutionary diet ice cream. This venture has a low probability of success but could make Steve a multimillionaire if it works. Steve has a strong incentive to pursue the riskier investment because he stands to gain signi cantly if successful, while you, as the lender, would still only receive the xed 10% return. If Steve fails, which is likely, you could lose most or all of your loan. This potential for moral hazard—Steve using the funds for a high-risk venture—would likely deter you from making the loan, even though the ice-cream store is a sound investment that could bene t everyone. Tools to Help Solve Moral Hazard in Debt Contracts Net Worth and Collateral. When borrowers have high net worth or valuable collateral, the risk of moral hazard decreases because they have more to lose. This “skin in the game”discourages risky behavior and aligns the borrower's incentives with the lender's. For example, if Steve must invest $91,000 of his own money in a $100,000 project, he is less likely to take risky ventures and more likely to choose a safer option, like opening an ice-cream store. High net worth and collateral make debt contracts incentive-compatible, reducing moral hazard and making it easier to borrow. Conversely, low net worth or collateral increases moral hazard and borrowing dif culty. Monitoring and Enforcement of Restrictive Covenants. To reduce moral hazard, lenders use restrictive covenants in debt contracts to ensure borrowers act as expected. These covenants achieve this goal in four ways: 1. Discouraging undesirable behavior: Covenants prevent risky activities by restricting the loan's use to speci c purposes or prohibiting risky ventures, like acquisitions. 2. Encouraging desirable behavior: Covenants promote actions that improve repayment likelihood, such as requiring rms to maintain a certain asset level or households to carry life insurance to cover mortgages. 3. Keeping collateral valuable: Covenants ensure collateral remains in good condition, properly insured, and in the borrower’s possession, such as with car loans or mortgages. 4. Providing information: Borrowers must share periodic reports or allow audits, helping lenders monitor compliance and reduce risk. Thus, debt contracts include complex covenants to manage borrower behavior and mitigate moral hazard. Financial Intermediation. Restrictive covenants reduce moral hazard but cannot eliminate it entirely. It is dif cult to draft covenants that address every risky activity, and borrowers might exploit loopholes. Additionally, covenants require costly monitoring and enforcement to be effective. In the bond market, the free-rider problem arises because individual bondholders rely on others to monitor and enforce covenants, leading to insuf cient oversight and persistent moral hazard. Financial intermediaries, particularly banks, mitigate this issue by issuing private loans instead of marketable debt. Private loans are not traded, preventing free-riding and allowing intermediaries to fully bene t from their monitoring and enforcement efforts. This reduces moral hazard and explains why nancial intermediaries play a larger role in connecting savers to borrowers than marketable securities. Summary Asymmetric information in nancial markets leads to adverse selection and moral hazard, which disrupt market ef ciency. Tools to address these issues include: The private production and sale of information Government regulation to enhance transparency The use of collateral and net worth in debt contracts Monitoring and restrictive covenants The free-rider problem in traded securities like stocks and bonds highlights the critical role of nancial intermediaries, especially banks, which are better equipped to mitigate these problems compared to securities 7 fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi  markets. Economic analysis of asymmetric information helps explain key features of the nancial system, including the eight facts about nancial structure discussed earlier in the chapter. A summary table links these tools and issues to the eight facts, providing a concise overview of their interplay. APPLICATION: Financial Development and Economic Growth Many developing and transition countries, like Russia, experience low economic growth due to underdeveloped nancial systems, a condition called nancial repression. Their nancial systems face key challenges: 1. Weak property rights: Poor legal systems, government expropriation, and corruption make tools like collateral and restrictive covenants ineffective. This worsens adverse selection, as lenders struggle to identify good borrowers, leading to less productive investment and slower economic growth. Poor enforcement of covenants increases moral hazard, further discouraging lending. 2. Government intervention: Governments often direct credit to themselves or favored sectors, set arti cially low interest rates, or create state-run nancial institutions. Unlike private institutions driven by pro t, governments have little incentive to address adverse selection and moral hazard, resulting in inef cient investments and slower growth. 3. State-owned banks: These banks prioritize lending to governments rather than productive sectors, further misallocating capital and limiting economic development. 4. Weak regulatory frameworks: Inadequate accounting standards and poor regulation hinder transparency and exacerbate asymmetric information, reducing the nancial system's ability to channel funds to productive investments. Overall, a poor institutional environment—marked by weak legal systems, inadequate regulation, and government control—explains why many countries remain poor while others achieve sustained economic growth. FYI: The Tyranny of Collateral In developing countries, obtaining legal title to property, such as land or capital, is extremely costly and time-consuming. For example, in the Philippines, it took up to 25 years and 168 bureaucratic steps to legally claim ownership of urban land. Without legal title, property cannot be used as collateral, making it dif cult for people to secure loans. Even when legal title is obtained, the inef ciency of the legal system means collateral is often useless. The process of seizing collateral after a loan default can take years, and by then, the collateral may be stolen or damaged. Additionally, governments may block foreclosures in politically powerful sectors, further hindering lenders' ability to recover funds. This lack of effective collateral worsens the adverse selection problem, as lenders need more information to assess the quality of borrowers. Consequently, lending, especially for mortgages, is very limited. For example, in Peru, the value of mortgage loans is less than 1/20th of that in the United States. The poor face an even greater challenge, as they cannot legally claim property or offer collateral, leading to what is called the “tyranny of collateral.” Even with good business ideas, the poor often cannot secure nancing, making it hard for them to escape poverty. APPLICATION: Is China a Counterexample to the Importance of Financial Development? Despite its early-stage nancial development, China has experienced rapid economic growth over the past 30 years, driven by an extremely high savings rate (around 40%) and signi cant capital accumulation. This allowed China to shift labor from low-productivity subsistence agriculture to higher-productivity sectors, contributing to substantial growth. However, China's nancial system remains underdeveloped, with a weak legal system, lax accounting standards, and state-owned banks dominating the banking sector. As China becomes wealthier, this growth model may become unsustainable, as seen in the Soviet Union, which faced a slowdown after exhausting its labor shift from agriculture and failing to develop institutions to ef ciently allocate capital. For continued growth, China needs to improve its nancial system, including making nancial contracts more enforceable and privatizing state-owned banks. While the Chinese government is working on these reforms, it remains uncertain whether China can successfully develop a robust nancial system to sustain its growth and join the ranks of developed economies. 8 fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi fi