Chapter 8

AnEconomic
AnalysisofFinancial
Structure

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Sources of External Finance in Canada

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Sources of Foreign External Finance

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Puzzles of Financial Structure

1. Stocksarenotmostimportantsourceofexternalfinancefor
businesses
2. Issuingmarketablesecuritiesnotprimaryfundingsourcefor
businesses
3. Indirectfinance(financialintermediation)isfarmoreimportantthan
directfinance
4. Banksaremostimportantsourceofexternalfinance
5. Financialsystemisamongmostheavilyregulatedsectorsofeconomy
6. Onlylarge,wellestablishedfirmshaveaccesstosecuritiesmarkets
7. Collateralisprevalentfeatureofdebtcontracts
8. Debtcontractsaretypicallyextremelycomplicatedlegaldocuments
withrestrictivecovenants

2005 Pearson Education 8-4

Transaction Costs and Financial Structure

Transactioncostshinderflowoffundstopeople
withproductiveinvestmentopportunities
Financialintermediariesmakeprofitsby
reducingtransactioncosts
1. Takeadvantageofeconomiesofscale
Example:MutualFunds
2. Developexpertisetolowertransactioncosts
ExplainsPuzzle3

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Adverse Selection
and Moral Hazard: Definitions
AdverseSelection:
1. Beforetransactionoccurs
2. Potentialborrowersmostlikelytoproduceadverse
outcomesareonesmostlikelytoseekloansandbeselected

MoralHazard:
1. Aftertransactionoccurs
2. Hazardthatborrowerhasincentivestoengagein
undesirable(immoral)activitiesmakingitmorelikelythat
wontpayloanback

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Adverse Selection
and Financial Structure
LemonsProbleminSecuritiesMarkets
1. Ifcantdistinguishbetweengoodandbadsecurities,willing
topayonlyaverageofgoodandbadsecuritiesvalues.
2. Result:Goodsecuritiesundervaluedandfirmswontissue
them;badsecuritiesovervalued,sotoomanyissued.
3. Investorswontwanttobuybadsecurities,somarketwont
functionwell.
ExplainsPuzzle2andPuzzle1.
AlsoexplainsPuzzle6:Lessasymmetricinformationfor
wellknownfirms,sosmallerlemonsproblem

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Tools to Help Solve Adverse
Selection (Lemons) Problem
1. PrivateProductionandSaleofInformation
Freeriderprobleminterfereswiththissolution
2. GovernmentRegulationtoIncreaseInformation
ExplainsPuzzle5
3. FinancialIntermediation
A. Analogytosolutiontolemonsproblemprovidedbyusedcar
dealers
B. Avoidfreeriderproblembymakingprivateloans
ExplainsPuzzles3and4
4. CollateralandNetWorth
ExplainsPuzzle7

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Moral Hazard: Debt versus Equity
MoralHazardinEquity:
PrincipalAgentProblem
1. Resultofseparationofownershipbystockholders(principals)from
controlbymanagers(agents)
2. Managersactinownratherthanstockholdersinterest

ToolstoHelpSolvethePrincipalAgentProblem
1. Monitoring:productionofinformation
2. Governmentregulationtoincreaseinformation
3. Financialintermediation
4. Debtcontracts
ExplainsPuzzle1:Whydebtusedmorethanequity

2005 Pearson Education 8-9

Moral Hazard and Debt Markets

Moralhazard:borrowerwantstotakeontoomuchrisk
ToolstoHelpSolveMoralHazard
1. Networth
2. Monitoringandenforcementofrestrictive
covenants
3. Financialintermediation
Banksandotherintermediarieshavespecial
advantagesinmonitoring
ExplainsPuzzles14.

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Summary: Asymmetric Information
Problems and Tools to Solve Them

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Financial Development
and Economic Growth
FinancialRepressionLeadstoLowGrowth:
Why?
1.Poorlegalsystem
2.Weakaccountingstandards
3.Governmentdirectscredit
4.Financialinstitutionsnationalized
5.Inadequategovernmentregulation

2005 Pearson Education 8-12

Financial Crises

FactorsCausingFinancialCrises
1.Increaseininterestrates
2.Increasesinuncertainty
3.Assetmarketeffectsonbalancesheets
Stockmarketeffectsonnetworth
Unanticipateddeflation
Cashfloweffects
4.Bankpanics
5. Governmentfiscalimbalances

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Events in Financial Crises in Canada

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Events in
Mexican, East
Asian, and
Argentine
Financial Crises

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