Fundamentals of Financial Institutions PDF

PA RT 3 FUNDAMENTALS OF FINANCIAL INSTITUTION S 7...

PA RT 3 FUNDAMENTALS OF FINANCIAL INSTITUTION S 7 CHAPTER Why Do Financial Institutions Exist? PREVIEW A healthy and vibrant economy requires a financial system that moves funds from peo- ple who save to people who have productive investment opportunities. But how does the financial system make sure that your hard-earned savings get channeled to those with productive investment opportunities? This chapter answers that question by providing a theory for understanding why financial institutions exist to promote economic efficiency. The theoretical analysis focuses on a few simple but powerful economic concepts that enable us to explain fea- tures of our financial markets, such as why financial contracts are written as they are, and why financial intermediaries are more important than securities markets for getting funds to borrowers. 175 M07_MISH5006_09_GE_C07.indd 175 13/10/17 2:51 PM  176 PART 3 Fundamentals of Financial Institutions Basic Facts About Financial Structure Throughout The World The financial system is complex in both structure and function throughout the world. It includes many types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on—all of which are regulated by govern- ment. The financial system channels trillions of dollars per year from savers to peo- ple with productive investment opportunities. If we take a close look at financial structure all over the world, we find eight basic facts, some of which are quite sur- prising, that we need to explain to understand how the financial system works. The bar chart in Figure 7.1 shows how American businesses financed their activities using external funds (those obtained from outside the business itself) in the period 1970–2000 and compares U.S. data with those of Germany, Japan, and Canada. The Bank Loans category is made up primarily of loans from depository institutions; Nonbank Loans is composed primarily of loans by other financial inter- mediaries; the Bonds category includes marketable debt securities such as corpo- rate bonds and commercial paper; and Stock consists of new issues of new equity (stock market shares). % 100 United States 90 Germany 80 Japan Canada 70 60 50 40 76% 78% 30 56% 20 38% 32% 10 18% 18% 15% 11% 8% 12% 10% 8% 7% 9% 0 5% Bank Loans Nonbank Loans Bonds Stock FIGURE 7.1 S  ources of External Funds for Nonfinancial Businesses: A Comparison of the United States with Germany, Japan, and Canada The Bank Loans category is made up primarily of loans from depository institutions; Nonbank Loans is composed primarily of loans by other financial intermediaries; the Bonds category includes market- able debt securities such as corporate bonds and commercial paper; and Stock consists of new issues of new equity (stock market shares). Sources: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and are gross flows as percentages of the total, not including trade and other credit data, which are not available. M07_MISH5006_09_GE_C07.indd 176 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 177 Now let’s explore the eight facts. 1. Stocks are not the most important source of external financing for businesses. Because so much attention in the media is focused on the stock market, many people have the impression that stocks are the most impor- tant sources of financing for American corporations. However, as we can see from the bar chart in Figure 7.1, the stock market accounted for only a small fraction of the external financing of American businesses in the 1970–2000 period: 11%.1 Similarly small figures apply in the other countries presented in Figure 7.1 as well. Why is the stock market less important than other sources of financing in the United States and other countries? 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Figure 7.1 shows that bonds are a far more important source of financing than stocks in the United States (32% versus 11%). However, stocks and bonds combined (43%), which make up the total share of marketable securities, still supply less than one-half of the external funds corporations need to finance their activities. The fact that issuing marketable securities is not the most impor- tant source of financing is true elsewhere in the world as well. Indeed, as we see in Figure 7.1, other countries have a much smaller share of external financing supplied by marketable securities than does the United States. Why don’t businesses use marketable securities more extensively to finance their activities? 3. Indirect finance, which involves the activities of financial interme- diaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Direct finance involves the sale to households of marketable securities such as stocks and bonds. The 43% share of stocks and bonds as a source of external financing for American businesses actually greatly overstates the importance of direct finance in our financial system. Since 1970 less than 5% of newly issued corporate bonds and commercial paper and less than one-third of stocks have been sold directly to American households. The rest of these securities have been bought primarily by financial intermediaries such as insurance companies, pension funds, and mutual funds. These figures indicate that direct finance is used in less than 10% of the external funding of American business. Because in most countries marketable securities are an even less important source of finance than in the United States, direct 1 The 11% figure for the percentage of external financing provided by stocks is based on the flows of external funds to corporations. However, this flow figure is somewhat misleading because when a share of stock is issued, it raises funds permanently, whereas when a bond is issued, it raises funds only tem- porarily until they are paid back at maturity. To see this, suppose that a firm raises $1,000 by selling a share of stock and another $1,000 by selling a $1,000 one-year bond. In the case of the stock issue, the firm can hold on to the $1,000 it raised this way, but to hold on to the $1,000 it raised through debt, it has to issue a new $1,000 bond every year. If we look at the flow of funds to corporations over a 30-year period, as in Figure 7.1, the firm will have raised $1,000 with a stock issue only once in the 30-year period, while it will have raised $1,000 with debt 30 times, once in each of the 30 years. Thus, it will look as though debt is 30 times more important than stocks in raising funds, even though our example indicates that they are actually equally important for the firm. M07_MISH5006_09_GE_C07.indd 177 13/10/17 2:51 PM  178 PART 3 Fundamentals of Financial Institutions finance is also far less important than indirect finance in the rest of the world. Why are financial intermediaries and indirect finance so important in financial markets? In recent years, however, indirect finance has been declining in importance. Why is this happening? 4. Financial intermediaries, particularly banks, are the most impor- tant source of external funds used to finance businesses. As we can see in Figure 7.1, the primary source of external funds for businesses throughout the world comprises loans made by banks and other nonbank financial intermediaries such as insurance companies, pension funds, and finance companies (56% in the United States, but more than 70% in Germany, Japan, and Canada). In other industrialized countries, bank loans are the largest category of sources of external finance (more than 70% in Germany and Japan and more than 50% in Canada). Thus, the data suggest that banks in these countries have the most important role in financing business activi- ties. In developing countries, banks play an even more important role in the financial system than they do in industrialized countries. What makes banks so important to the workings of the financial system? Although banks remain important, their share of external funds for businesses has been declining in recent years. What is driving this decline? 5. The financial system is among the most heavily regulated sectors of the economy. The financial system is heavily regulated in the United States and all other developed countries. Governments regulate financial markets primarily to promote the provision of information and to ensure the soundness (stability) of the financial system. Why are financial markets so extensively regulated throughout the world? 6. Only large, well-established corporations have easy access to secu- rities markets to finance their activities. Individuals and smaller busi- nesses that are not well established are less likely to raise funds by issuing marketable securities. Instead, they most often obtain their financing from banks. Why do only large, well-known corporations find it easier to raise funds in securities markets? 7. Collateral is a prevalent feature of debt contracts for both house- holds and businesses. Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business bor- rowing as well. The majority of household debt in the United States consists of collateralized loans: Your automobile is collateral for your auto loan, and your house is collateral for your mortgage. Commercial and farm mortgages, for which property is pledged as collateral, make up one-quarter of borrowing by nonfinancial businesses; corporate bonds and other bank loans also often involve pledges of collateral. Why is collateral such an important feature of debt contracts? 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. Many students think of a debt contract as a simple IOU that can be written on a single piece of paper. The reality of debt contracts is far different, however. In all countries, bond or loan contracts typically are long legal documents with provisions (called restrictive covenants) that restrict and specify certain M07_MISH5006_09_GE_C07.indd 178 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 179 activities that the borrower can engage in. Restrictive covenants are not just a feature of debt contracts for businesses; for example, personal automobile loan and home mortgage contracts have covenants that require the borrower to maintain sufficient insurance on the automobile or house purchased with the loan. Why are debt contracts so complex and restrictive? As you may recall from Chapter 2, an important feature of financial markets is that they have substantial transaction and information costs. An economic analysis of how these costs affect financial markets provides us with explanations of the eight facts, which in turn enable a much deeper understanding of how our financial system works. In the next section, we examine the impact of transaction costs on the structure of our financial system. Then we turn to the effect of information costs on financial structure. Transaction Costs Transaction costs are a major problem in financial markets. An example will make this clear. How Transaction Costs Influence Financial Structure Say you have $5,000 you would like to invest, and you think about investing in the stock market. Because you have only $5,000, you can buy only a small number of shares. Even if you use online trading, your purchase is so small that the broker- age commission for buying the stock you picked will be a large percentage of the purchase price of the shares. If instead you decide to buy a bond, the problem is even worse because the smallest denomination for some bonds you might want to buy is as much as $10,000, and you do not have that much to invest. You are disap- pointed and realize that you will not be able to use financial markets to earn a return on your hard-earned savings. You can take some consolation, however, in the fact that you are not alone in being stymied by high transaction costs. This is a fact of life for many of us: Only around one-half of American households own any securities. You also face another problem related to transaction costs. Because you have only a small amount of funds available, you can make only a restricted number of investments because a large number of small transactions would result in very high transaction costs. That is, you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk. How Financial Intermediaries Reduce Transaction Costs This example of the problems posed by transaction costs and the example outlined in Chapter 2 when legal costs kept you from making a loan to Carl the Carpenter illustrate that small savers like you are frozen out of financial markets and are unable to benefit from them. Fortunately, financial intermediaries, an important part of the financial structure, have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets. M07_MISH5006_09_GE_C07.indd 179 13/10/17 2:51 PM  180 PART 3 Fundamentals of Financial Institutions Economies of Scale One solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for the individual investors. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. For example, the cost of arranging a purchase of 10,000 shares of stock is not much greater than the cost of arranging a purchase of 50 shares of stock. The presence of economies of scale in financial markets helps explain why financial intermediaries developed and have become such an important part of our financial structure. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial inter- mediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings are then passed on to indi- vidual investors after the mutual fund has taken its cut in the form of management fees for administering their accounts. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification for individual investors reduces their risk, making them better off. Economies of scale are also important in lowering the costs of things such as information technology that financial institutions need to accomplish their tasks. Once a large mutual fund has invested a lot of money in setting up a telecommunica- tions system, for example, the system can be used for a huge number of transactions at a low cost per transaction. Expertise Financial intermediaries are also better able to develop expertise to lower transaction costs. Their expertise in information technology enables them to offer customers convenient services like being able to call a toll-free number for information on how well their investments are doing and to write checks on their accounts. An important outcome of a financial intermediary’s low transaction costs is the ability to provide its customers with liquidity services, services that make it easier for customers to conduct transactions. Money market mutual funds, for example, not only pay shareholders high interest rates but also allow them to write checks for convenient bill paying. Asymmetric Information: Adverse Selection and Moral Hazard The presence of transaction costs in financial markets explains in part why financial intermediaries and indirect finance play such an important role in financial markets (fact 3). To understand financial structure more fully, however, we turn to the role of information in financial markets. Asymmetric information—a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction—is an important aspect of financial markets. For example, managers of a corporation know whether they are M07_MISH5006_09_GE_C07.indd 180 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 181 honest and have better information about how well their business is doing than the stockholders do. The presence of asymmetric information leads to adverse selection and moral hazard problems, which were introduced in Chapter 2. Adverse selection is an asymmetric information problem that occurs before the transaction: Potential bad credit risks are the ones who most actively seek out loans. Thus, the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction. For example, big risk takers or outright crooks might be the most eager to take out a loan because they know that they are unlikely to pay it back. Because adverse selection increases the chances that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though good credit risks can be found in the marketplace. 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 they make it less likely that the loan will be paid back. For example, once borrowers have obtained a loan, they may take on big risks (which have pos- sible high returns but also run a greater risk of default) because they are playing with someone else’s money. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. The analysis of how asymmetric information problems affect economic behavior is called agency theory. We will apply this theory here to explain why financial structure takes the form it does, thereby explaining the facts outlined at the begin- ning of the chapter. In the next chapter, we will use the same theory to understand financial crises. The Lemons Problem: How Adverse Selection Influences Financial Structure A particular aspect of the way the adverse selection problem interferes with the GO ONLINE efficient functioning of a market was outlined in a famous article by Nobel Prize Access http://www.nobelprize winner George Akerlof. It is called the “lemons problem” because it resembles the.org/nobel_prizes/economic- problem created by lemons in the used-car market.2 Potential buyers of used cars sciences/laureates/2001/ and find a complete discus- are frequently unable to assess the quality of the car; that is, they can’t tell whether sion of the lemons problem a particular used car is one that will run well or a lemon that will continually give on a site dedicated to Nobel them grief. The price that a buyer pays must therefore reflect the average quality Prize winners. of the cars in the market, somewhere between the low value of a lemon and the high value of a good car. The owner of a used car, by contrast, is more likely to know whether the car is a peach or a lemon. If the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to pay, which, being somewhere between the value of a lemon and a good car, is greater than the lemon’s value. However, if the car is a 2 George Akerlof, “The Market for ‘Lemons’: Quality, Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84 (1970): 488–500. Two important papers that have applied the lemons problem analysis to financial markets are Stewart Myers and N. S. Majluf, “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have,” Journal of Financial Economics 13 (1984): 187–221; and Bruce Greenwald, Joseph E. Stiglitz, and Andrew Weiss, “Information Imperfections in the Capital Market and Macroeconomic Fluctuations,” American Economic Review 74 (1984): 194–199.  182 PART 3 Fundamentals of Financial Institutions peach, the owner knows that the car is undervalued at the price the buyer is willing to pay, and so the owner may not want to sell it. As a result of this adverse selection, few good used cars will come to the market. Because the average quality of a used car available in the market will be low and because few people want to buy a lemon, there will be few sales. The used-car market will function poorly, if at all. Lemons in the Stock and Bond Markets A similar lemons problem arises in securities markets—that is, the debt (bond) and equity (stock) markets. Suppose that our friend Irving the investor, a potential buyer of securities such as common stock, can’t distinguish between good firms with high expected profits and low risk and bad firms with low expected profits and high risk. In this situation, Irving will be willing to pay only a price that reflects the aver- age quality of firms issuing securities—a price that lies between the value of securi- ties from bad firms and the value of those from good firms. If the owners or managers of a good firm have better information than Irving and know that they have a good firm, they know that their securities are undervalued and will not want to sell them to Irving at the price he is willing to pay. The only firms willing to sell Irving securities will be bad firms (because his price is higher than the securities are worth). Our friend Irving is not stupid; he does not want to hold securities in bad firms, and hence he will decide not to purchase securities in the market. In an out- come similar to that in the used-car market, this securities market will not work very well because few firms will sell securities in it to raise capital. The analysis is similar if Irving considers purchasing a corporate debt instru- ment in the bond market rather than an equity share. Irving will buy a bond only if its interest rate is high enough to compensate him for the average default risk of the good and bad firms trying to sell the debt. The knowledgeable owners of a good firm realize that they will be paying a higher interest rate than they should, so they are unlikely to want to borrow in this market. Only the bad firms will be willing to bor- row, and because investors like Irving are not eager to buy bonds issued by bad firms, they will probably not buy any bonds at all. Few bonds are likely to sell in this market, so it will not be a good source of financing. The analysis we have just conducted explains fact 2—why marketable securities are not the primary source of financing for businesses in any country in the world. It also partly explains fact 1—why stocks are not the most important source of financing for American businesses. The presence of the lemons problem keeps secu- rities markets such as the stock and bond markets from being effective in channel- ing funds from savers to borrowers. Tools to Help Solve Adverse Selection Problems In the absence of asymmetric information, the lemons problem goes away. If buyers know as much about the quality of used cars as sellers, so that all involved can tell a good car from a bad one, buyers will be willing to pay full value for good used cars. Because the owners of good used cars can now get a fair price, they will be willing to sell them in the market. The market will have many transactions and will do its intended job of channeling good cars to people who want them. Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their M07_MISH5006_09_GE_C07.indd 182 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 183 securities in the market. The securities market will then be able to move funds to the good firms that have the most productive investment opportunities. Private Production and Sale of Information The solution to the adverse selection problem in financial markets is to eliminate asymmetric information by furnishing the people supplying funds with full details about the individuals or firms seeking to finance their investment activities. One way to get this material to saver-lenders is to have private companies collect and produce information that distinguishes good from bad firms and then sell it. In the United States, companies such as Standard & Poor’s, Moody’s, and Value Line gather information on firms’ balance sheet positions and investment activities, publish these data, and sell them to subscribers (individuals, libraries, and financial intermediaries involved in purchasing securities). The system of private production and sale of information does not completely solve the adverse selection problem in securities markets, however, because of the free-rider problem. The free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for. The free-rider problem suggests that the private sale of information will be only a partial solution to the lemons problem. To see why, suppose that you have just pur- chased information that tells you which firms are good and which are bad. You believe that this purchase is worthwhile because you can make up the cost of acquir- ing this information, and then some, by purchasing the securities of good firms that are undervalued. However, when our savvy (free-riding) investor Irving sees you buying certain securities, he buys right along with you, even though he has not paid for any information. If many other investors act as Irving does, the increased demand for the undervalued good securities will cause their low price to be bid up immedi- ately to reflect the securities’ true value. Because of all these free riders, you can no longer buy the securities for less than their true value. Now because you will not gain any profits from purchasing the information, you realize that you never should have paid for this information in the first place. If other investors come to the same realization, private firms and individuals may not be able to sell enough of this infor- mation to make it worth their while to gather and produce it. The weakened ability of private firms to profit from selling information will mean that less information is produced in the marketplace, so adverse selection (the lemons problem) will still interfere with the efficient functioning of securities markets. Government Regulation to Increase Information The free-rider problem prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. Could financial markets benefit from government intervention? The government could, for instance, produce information to help investors distinguish good from bad firms and provide it to the public free of charge. This solution, however, would involve the government in releasing negative information about firms, a practice that might be politically difficult. A second possibility (and one followed by the United States and most governments throughout the world) is for the government to regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are. In the United States, the Securities and Exchange Commission (SEC) is the government agency that requires firms selling their securities to have independent audits, in which accounting firms certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings. Similar regulations are found M07_MISH5006_09_GE_C07.indd 183 13/10/17 2:51 PM  184 PART 3 Fundamentals of Financial Institutions in other countries. However, disclosure requirements do not always work well, as the collapse of Enron and accounting scandals at other corporations, such as WorldCom and Parmalat (an Italian company), suggest (see the Mini-Case box, “The Enron Implosion”). The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy (fact 5). Government regulation to increase information for inves- tors is needed to reduce the adverse selection problem, which interferes with the efficient functioning of securities (stock and bond) markets. Although government regulation lessens the adverse selection problem, it does not eliminate it. Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors: A lot more is involved in knowing the quality of a firm than statistics can provide. Furthermore, bad firms have an incentive to make themselves look like good firms because this would enable them to fetch a higher price for their securities. Bad firms will slant the information they are required to transmit to the public, thus making it harder for investors to sort out the good firms from the bad. Financial Intermediation So far we have seen that private production of information and government regulation to encourage provision of information lessen, but do not eliminate, the adverse selection problem in financial markets. How, then, can the financial structure help promote the flow of funds to people with productive investment opportunities when asymmetric information exists? A clue is provided by the structure of the used-car market. An important feature of the used-car market is that most used cars are not sold directly by one individual to another. An individual who considers buying a used car might pay for privately produced information by subscribing to a magazine like MINI-CASE The Enron Implosion Until 2001 Enron Corporation, a firm that specialized as much as $1.5 billion of new financing from J. P. in trading in the energy market, appeared to be spec- Morgan Chase and Citigroup, the company was forced tacularly successful. It had a quarter of the energy- to declare bankruptcy in December 2001, up to that trading market and was valued as high as $77 billion point the largest bankruptcy in U.S. history. in August 2000 (just a little over a year before its col- The Enron collapse illustrates that government reg- lapse), making it the seventh-largest corporation in the ulation can lessen asymmetric information problems United States at that time. However, toward the end of but cannot eliminate them. Managers have tremen- 2001, Enron came crashing down. In October 2001, dous incentives to hide their companies’ problems, Enron announced a third-quarter loss of $618 million making it hard for investors to know the true value of and disclosed accounting “mistakes.” The SEC then the firm. engaged in a formal investigation of Enron’s financial The Enron bankruptcy not only increased concerns dealings with partnerships led by its former finance in financial markets about the quality of accounting chief. It became clear that Enron was engaged in a information supplied by corporations but also led to complex set of transactions by which it was keeping hardship for many of the firm’s former employees, who substantial amounts of debt and financial contracts off found that their pensions had become worthless. Out- its balance sheet. These transactions enabled Enron rage against the duplicity of executives at Enron was to hide its financial difficulties. Despite securing high, and several of them were sent to jail. M07_MISH5006_09_GE_C07.indd 184 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 185 Consumer Reports to find out if a particular make of car has a good repair record. Nevertheless, reading Consumer Reports does not solve the adverse selection problem because even if a particular make of car has a good reputation, the specific car someone is trying to sell could be a lemon. The prospective buyer might also take the used car to a mechanic for an inspection. But what if the prospective buyer doesn’t know a mechanic who can be trusted or if the mechanic would charge a high fee to evaluate the car? Because these roadblocks make it hard for individuals to acquire enough infor- mation about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee, in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealer’s guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced informa- tion, they avoid the problem of other people free-riding on the information they produced. Just as used-car dealers help solve adverse selection problems in the automo- bile market, financial intermediaries play a similar role in financial markets. A finan- cial intermediary, such as a bank, becomes an expert in producing information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity. An important element in the bank’s ability to profit from the information it pro- duces is that it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and bid up the loan’s price to the point that the bank receives no compensation for the information it has produced. The bank’s role as an intermediary that holds mostly nontraded loans is the key to its success in reducing asymmetric information in financial markets. Our analysis of adverse selection indicates that financial intermediaries in general—and banks in particular, because they hold a large fraction of nontraded loans—should play a greater role in moving funds to corporations than securities markets do. Our analysis thus explains facts 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses. Another important fact that is explained by the analysis here is the greater importance of banks in the financial systems of developing countries. As we have seen, when the quality of information about firms is better, asymmetric information problems will be less severe, and it will be easier for firms to issue securities. Information about private firms is harder to collect in developing countries than in industrialized countries; therefore, the smaller role played by securities markets leaves a greater role for financial intermediaries such as banks. A corollary of this M07_MISH5006_09_GE_C07.indd 185 13/10/17 2:51 PM  186 PART 3 Fundamentals of Financial Institutions analysis is that as information about firms becomes easier to acquire, the role of banks should decline. A major development in the past 30 years in the United States has been huge improvements in information technology. Thus, the analysis here suggests that the lending role of financial institutions, such as banks in the United States, should have declined, and this is exactly what has occurred (see Chapter 19). Our analysis of adverse selection also explains fact 6, which questions why large firms are more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route. The better known a corporation is, the more information about its activities is available in the market- place. Thus, it is easier for investors to evaluate the quality of the corporation and determine whether it is a good firm or a bad one. Because investors have fewer worries about adverse selection with well-known corporations, they will be willing to invest directly in their securities. Our adverse selection analysis thus suggests that a pecking order for firms that can issue securities should be in place. The larger and more established a corporation is, the more likely it will be to issue securities to raise funds, a view that is known as the pecking order hypothesis. This hypoth- esis is supported in the data and is what fact 6 describes. Collateral and Net Worth Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults. Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you fail to make your mortgage payments, the lender can take the title to your house, auc- tion it off, and use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely they will get the loan in the first place and perhaps at a better loan rate. The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts (fact 7). Net worth (also called equity capital), the difference between a firm’s assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to that of collateral. If a firm has a high net worth, then even if it engages in invest- ments that cause it to have negative profits and so defaults on its debt payments, the lender can take title to the firm’s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans. This analysis lies behind the often-heard lament, “Only the people who don’t need money can borrow it!” Summary So far we have used the concept of adverse selection to explain seven of the eight facts about financial structure introduced earlier: The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; the fifth, that financial markets are among the most heavily regulated sectors of the economy; the sixth, that only large, M07_MISH5006_09_GE_C07.indd 186 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 187 well-established corporations have access to securities markets; and the seventh, that collateral is an important feature of debt contracts. In the next section, we will see that the other asymmetric information concept of moral hazard provides additional reasons for the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations, the prevalence of government regulation, and the importance of collateral in debt contracts. In addition, the concept of moral hazard can be used to explain our final fact (fact 8): why debt contracts are complicated legal documents that place substantial restrictions on the behavior of the borrower. How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral hazard is the asymmetric information problem that occurs after the financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts. Moral Hazard in Equity Contracts: The Principal–Agent Problem Equity contracts, such as common stock, are claims to a share in the profits and assets of a business. Equity contracts are subject to a particular type of moral haz- ard called the principal–agent problem. When managers own only a small fraction of the firm they work for, the stockholders who own most of the firm’s equity (called the principals) are not the same people as the managers of the firm, who are the agents of the owners. This separation of ownership and control involves moral haz- ard, in that the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the manag- ers have less incentive to maximize profits than the stockholder-owners do. To understand the principal–agent problem more fully, suppose that your friend Steve asks you to become a silent partner in his ice cream store. The store requires an investment of $10,000 to set up and Steve has only $1,000. So you purchase an equity stake (stock shares) for $9,000, which entitles you to 90% of the ownership of the firm, while Steve owns only 10%. If Steve works hard to make tasty ice cream, keeps the store clean, smiles at all the customers, and hustles to wait on tables quickly, after all expenses (including Steve’s salary), the store will have $50,000 in profits per year, of which Steve receives 10% ($5,000) and you receive 90% ($45,000). But if Steve doesn’t provide quick and friendly service to his customers, uses the $50,000 in income to buy artwork for his office, and even sneaks off to the beach while he should be at the store, the store will not earn any profit. Steve can earn the additional $5,000 (his 10% share of the profits) over his salary only if he works hard and forgoes unproductive investments (such as art for his office). Steve might decide that the extra $5,000 just isn’t enough to make him expend the effort to be a good manager; he might decide that it would be worth his while only if he earned an extra $10,000. If Steve feels this way, he does not have enough incentive to be a good manager and will end up with a beautiful office, a good tan, and a store that M07_MISH5006_09_GE_C07.indd 187 13/10/17 2:51 PM  188 PART 3 Fundamentals of Financial Institutions doesn’t show any profits. Because the store won’t show any profits, Steve’s decision not to act in your interest will cost you $45,000 (your 90% of the profits if he had chosen to be a good manager instead). The moral hazard arising from the principal–agent problem might be even worse if Steve were not totally honest. Because his ice cream store is a cash business, Steve has the incentive to pocket $50,000 in cash and tell you that the profits were zero. He now gets a return of $50,000 and you get nothing. Further indications that the principal–agent problem created by equity con- tracts can be severe are provided by past scandals in corporations such as Enron and Tyco International, in which managers were found to have diverted funds for their personal use. Besides pursuing personal benefits, managers might also pursue corporate strategies (such as the acquisition of other firms) that enhance their per- sonal power but do not increase the corporation’s profitability. The principal–agent problem would not arise if the owners of a firm had com- plete information about what the managers were up to and could prevent wasteful expenditures or fraud. The principal–agent problem, which is an example of moral hazard, arises only because a manager, such as Steve, has more information about his activities than the stockholder does—that is, information is asymmetric. The principal–agent problem would not occur if Steve alone owned the store and owner- ship and control were not separated. If this were the case, Steve’s hard work and avoidance of unproductive investments would yield him a profit (and extra income) of $50,000, an amount that would make it worth his while to be a good manager. Tools to Help Solve the Principal– Agent Problem Production of Information: Monitoring You have seen that the principal–agent problem arises because managers have more information about their activities and actual profits than stockholders do. One way for stockholders to reduce this moral hazard problem is for them to engage in a particular type of information production, the monitoring of the firm’s activities: auditing the firm frequently and checking on what the management is doing. The problem is that the monitoring process can be expensive in terms of time and money, as reflected in the name economists give it, costly state verification. Costly state verification makes the equity contract less desirable, and it explains, in part, why equity is not a more important element in our financial structure. As with adverse selection, the free-rider problem decreases the amount of information production undertaken to reduce the moral hazard (principal–agent) problem. In this example, the free-rider problem decreases monitoring. If you know that other stockholders are paying to monitor the activities of the company you hold shares in, you can take a free ride on their activities. Then you can use the money you save by not engaging in monitoring to vacation on a Caribbean island. If you can do this, though, so can other stockholders. Perhaps all the stockholders will go to the islands, and no one will spend any resources on monitoring the firm. The moral hazard problem for shares of common stock will then be severe, making it hard for firms to issue them to raise capital (providing an additional explanation for fact 1). Government Regulation to Increase Information As with adverse selection, the government has an incentive to try to reduce the moral hazard problem created M07_MISH5006_09_GE_C07.indd 188 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 189 by asymmetric information, which provides another reason why the financial system is so heavily regulated (fact 5). Governments everywhere have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also pass laws to impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits. However, these measures can be only partly effective. Catching this kind of fraud is not easy; fraudulent managers have the incentive to make it very hard for government agencies to find or prove fraud. Financial Intermediation Financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard, and this is another reason that indirect finance is so important (fact 3). One financial intermediary that helps reduce the moral hazard arising from the principal–agent problem is the venture capital firm. Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses. In exchange for the use of the venture capital, the firm receives an equity share in the new business. Because verification of earnings and profits is so important in eliminating moral hazard, venture capital firms usually insist on having several of their own people participate as members of the managing body of the firm, the board of directors, so that they can keep a close watch on the firm’s activities. When a venture capital firm supplies start-up funds, the equity in the firm is private, that is, not marketable to anyone except the venture capital firm.3 Thus, other investors are unable to take a free ride on the venture capital firm’s verification activities. As a result of this arrangement, the venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incentives to reduce the moral hazard problem. Venture capital firms have been important in the development of the high-tech sector in the United States, which has resulted in job creation, economic growth, and increased international competitiveness. Debt Contracts Moral hazard arises with an equity contract, which is a claim on profits in all situations, whether the firm is making or losing money. If a contract could be structured so that moral hazard would exist only in certain situations, the need to monitor managers would be reduced, and the contract would be more attractive than the equity contract. The debt contract has exactly these attributes because it is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. When the firm has high profits, the lender receives the contractual payments and does not need to know the exact profits of the firm. If the managers are hiding profits or are pursuing activities that are personally beneficial but don’t increase profitability, the lender doesn’t care as long as these activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm cannot meet its debt payments, thereby being in a state of default, is there a need for the lender to verify the state of the firm’s profits. Only in this situation do lenders involved in debt contracts need to act more like equity holders to get their fair share; now they must know how much income the firm has. 3 Private equity firms also engage in private equity investment and solve the free-rider problem in a similar way to venture capital firms. Venture capital firms invest in new businesses, and then when the company matures, sell shares to the public. However, in contrast to venture capital firms, which take new companies public, private equity firms take older public companies private; that is, they purchase all the publicly traded shares and retire them. They then exercise control over the company using similar methods to those of venture capital firms. M07_MISH5006_09_GE_C07.indd 189 13/10/17 2:51 PM  190 PART 3 Fundamentals of Financial Institutions The less frequent need to monitor the firm, and thus the lower cost of state verification, helps explain why debt contracts are used more frequently than equity contracts to raise capital. The concept of moral hazard therefore helps explain fact 1, why stocks are not the most important source of financing for businesses.4 How Moral Hazard Influences Financial Structure in Debt Markets Even with the advantages just described, debt contracts are still subject to moral hazard. Because a debt contract requires the borrowers to pay out a fixed amount and lets them keep any profits above this amount, the borrowers have an incentive to take on investment projects that are riskier than the lenders would like. For example, suppose that because you are concerned about the problem of verifying the profits of Steve’s ice cream store, you decide not to become an equity partner. Instead, you lend Steve the $9,000 he needs to set up his business and have a debt contract that pays you an interest rate of 10%. As far as you are concerned, this is a surefire investment because demand for ice cream in your neighborhood is strong and steady. However, once you give Steve the funds, he might use them for purposes other than what you intended. Instead of opening up the ice cream store, Steve might use your $9,000 loan to invest in chemical research equipment because he thinks he has a 1-in-10 chance of inventing a diet ice cream that tastes every bit as good as the premium brands but has no fat or calories. Obviously, this is a very risky investment, but if Steve is successful, he will become a multimillionaire. He has a strong incentive to undertake the riskier invest- ment with your money because the gains to him would be so large if he succeeded. You would clearly be very unhappy if Steve used your loan for the riskier investment because if he were unsuccessful, which is highly likely, you would lose most, if not all, of the money you gave him. And if he were successful, you wouldn’t share in his success—you would still get only a 10% return on the loan because the principal and interest payments are fixed. Because of the potential moral hazard (that Steve might use your money to finance a very risky venture), you would probably not make the loan to Steve, even though an ice cream store in the neighborhood is a good investment that would provide benefits for everyone. Tools to Help Solve Moral Hazard in Debt Contracts Net Worth and Collateral When borrowers have more at stake because their net worth (the difference between their assets and their liabilities) is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard— the temptation to act in a manner that lenders find objectionable—will be greatly reduced because the borrowers themselves have a lot to lose. Another way to say this is that if borrowers have more “skin in the game” because they have higher net worth or pledge collateral, they are likely to take less risk at the lender’s expense. 4 Another factor that encourages the use of debt contracts rather than equity contracts in the United States is our tax code. Debt interest payments are a deductible expense for American firms, whereas dividend payments to equity shareholders are not. M07_MISH5006_09_GE_C07.indd 190 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 191 Let’s return to Steve and his ice cream business. Suppose that the cost of setting up either the ice cream store or the research equipment is $100,000 instead of $10,000. So Steve needs to put $91,000 (instead of $1,000) of his own money into the business in addition to the $9,000 supplied by your loan. Now if Steve is unsuccessful in inventing the no-calorie nonfat ice cream, he has a lot to lose—the $91,000 of net worth ($100,000 in assets minus the $9,000 loan from you). He will think twice about undertaking the riskier investment and is more likely to invest in the ice cream store, which is more of a sure thing. Hence, when Steve has more of his own money (net worth) in the business, and hence more skin in the game, you are more likely to make him the loan. Similarly, if you have pledged your house as collateral, you are less likely to go to Las Vegas and gamble away your earnings that month because you might not be able to make your mortgage payments and might lose your house. One way of describing the solution that high net worth and collateral provides to the moral hazard problem is to say that it makes the debt contract incentive compatible; that is, it aligns the incentives of the borrower with those of the lender. The greater the borrower’s net worth and collateral pledged, the greater the bor- rower’s incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is for the firm or household to borrow. Conversely, when the borrower’s net worth and col- lateral are lower, the moral hazard problem is greater, and it is harder to borrow. Monitoring and Enforcement of Restrictive Covenants As the example of Steve and his ice cream store shows, if you could make sure that Steve doesn’t invest in anything riskier than the ice cream store, it would be worth your while to make him the loan. You can ensure that Steve uses your money for the purpose you want it to be used for by writing provisions (restrictive covenants) into the debt contract that restrict his firm’s activities. By monitoring Steve’s activities to see whether he is complying with the restrictive covenants and enforcing the covenants if he is not, you can make sure that he will not take on risks at your expense. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. There are four types of restrictive covenants that achieve this objective: 1. Covenants to discourage undesirable behavior. Covenants can be designed to lower moral hazard by keeping the borrower from engaging in the undesirable behavior of undertaking risky investment projects. Some cov- enants mandate that a loan can be used only to finance specific activities, such as the purchase of particular equipment or inventories. Others restrict the borrowing firm from engaging in certain risky business activities, such as purchasing other businesses. 2. Covenants to encourage desirable behavior. Restrictive covenants can encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. One restrictive covenant of this type requires the breadwinner in a household to carry life insurance that pays off the mortgage upon that person’s death. Restrictive covenants of this type for businesses focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive covenants typi- cally specify that the firm must maintain minimum holdings of certain assets relative to the firm’s size. M07_MISH5006_09_GE_C07.indd 191 13/10/17 2:51 PM  192 PART 3 Fundamentals of Financial Institutions 3. Covenants to keep collateral valuable. Because collateral is an impor- tant protection for the lender, restrictive covenants can encourage the bor- rower to keep the collateral in good condition and make sure that it stays in the possession of the borrower. This is the type of covenant ordinary people encounter most often. Automobile loan contracts, for example, require the car owner to maintain a minimum amount of collision and theft insurance and prevent the sale of the car unless the loan is paid off. Similarly, the recipient of a home mortgage must have adequate insurance on the home and must pay off the mortgage when the property is sold. 4. Covenants to provide information. Restrictive covenants also require a borrowing firm to provide information about its activities periodically in the form of quarterly accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. This type of covenant may also stipulate that the lender has the right to audit and inspect the firm’s books at any time. We now see why debt contracts are often complicated legal documents with numerous restrictions on the borrower’s behavior (fact 8): Debt contracts require complicated restrictive covenants to lower moral hazard. Financial Intermediation Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it. It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find loopholes in restrictive covenants that make them ineffective. Another problem with restrictive covenants is that they must be monitored and enforced. A restrictive covenant is meaningless if the borrower can violate it know- ing that the lender won’t check up or is unwilling to pay for legal recourse. Because monitoring and enforcement of restrictive covenants are costly, the free-rider prob- lem arises in the debt securities (bond) market just as it does in the stock market. If you know that other bondholders are monitoring and enforcing the restrictive covenants, you can free-ride on their monitoring and enforcement. But other bond- holders can do the same thing, so the likely outcome is that not enough resources are devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues to be a severe problem for marketable debt. As we have seen before, financial intermediaries—particularly banks—have the ability to avoid the free-rider problem as long as they make primarily private loans. Private loans are not traded, so no one else can free-ride on the intermediary’s monitoring and enforcement of the restrictive covenants. The intermediary making private loans thus receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts. The concept of moral hazard has provided us with additional reasons why financial intermediaries play a more important role in channeling funds from savers to borrowers than mar- ketable securities do, as described in facts 3 and 4. Summary The presence of asymmetric information in financial markets leads to adverse selec- tion and moral hazard problems that interfere with the efficient functioning of those markets. Tools to help solve these problems involve the private production and sale of information, government regulation to increase information in financial markets, M07_MISH5006_09_GE_C07.indd 192 13/10/17 2:51 PM  Chapter 7 Why Do Financial Institutions Exist? 193 the importance of collateral and net worth to debt contracts, and the use of monitor- ing and restrictive covenants. A key finding from our analysis is that the existence of the free-rider problem for traded securities such as stocks and bonds indicates that financial intermediaries—particularly banks—should play a greater role than securities markets in financing the activities of businesses. Economic analysis of the consequences of adverse selection and moral hazard has helped explain the basic features of our financial system and has provided solutions to the eight facts about our financial structure outlined at the beginning of this chapter. To help you keep track of all the tools that help solve asymmetric information problems, Table 7.1 summarizes the asymmetric information problems and tools that help solve them. In addition, it notes how these tools and asymmetric informa- tion problems explain the eight facts of financial structure described at the begin- ning of the chapter. TABLE 7.1 Asymmetric Information Problems and Tools to Solve Them SUMMARY Asymmetric Information Explains Fact Problem Tools to Solve It Number Adverse selection Private production and 1, 2 sale of information Government regulation to 5 increase information Financial intermediation 3, 4, 6 Collateral and net worth 7 Moral hazard in equity contracts Production of information: 1 (principal–agent problem) monitoring Government regulation to 5