Chapter 9

Question 1

One of the main requirements for a healthy economy is …

Answer 1

One of the main requirements for a healthy economy is an efficient financial system that channel funds from savers to investors.

Question 2

Basic facts about financial structure in Canada:

1.

2.

3.

4.

5.

6.

7.

8.

Answer 2

Basic facts about financial structure in Canada:

1. Stocks are not the most important source of external financing for businesses; (Fact 1)
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations; (Fact 2)
3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets; (Fact 3)
4. Financial intermediaries, particularly banks. Are the most important source of external funds used to finance businesses; (Fact 4)
5. The financial system is among the most heavily regulated sectors of the economy; (Fact 5)
6. Only large, well-established corporations have easy access to securities markets to finance their activities; (Fact 6)
7. Collateral is a prevalent feature of debt contracts for both households and businesses; (Fact 7)
8. Debt contracts typically are extremely complicated legal documents that place; (Fact 8) substantial restrictions on the behavior of the borrower.

Question 3

Sources of External funds for non financial business

Answer 3

Sources of External funds for non financial business

Bank loans 56%; nonbank loans 18%; bonds 15%; stock 12%

Question 4

Collateral+Debt+Debt contract

Answer 4

Collateral: property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments.

Debt: collateral debt (e.g. mortgage) unsecured debt (credit card debt)

Debt contract: restrictive covenants

Question 5

Major problems in financial market:

1.

1. 1. 2. 3.
2. 1. 2. 3.

Answer 5

Major problems in financial market:

1. Transaction costs
2. The problem associated with the transaction costs
   
   1. Limitation in diversifying the investment portfolio
   2. Limited choices due to limited fund
   3. High costs associated with small amount of investment (e.g. commissions)
3. How financial intermediaries reduce transaction costs
   
   1. ​ Economies of scale (e.g. mutual fund)
   2. Expertise (e.g. cheque writing privileges).
   3. Lower transaction costs enable financial intermediaries to provide their customers with liquidity services (services that make it easier for customers to conduct transactions) (Fact 3)

Question 6

Major problems in financial market:

.2.

1. 2. 1. 1. 2. 1. 1. 2. 3.
            3. 1. T
            4. F
               
               1. T
            5. 1. C
               2. I
2. )
   
   1. T
      
      1. F
         
         1. a.
         2. b.
         3. c.
         4. d. ;
         5. e.
         6. f.
         7. g.
         8. h
      2. 3. T

Answer 6

Major problems in financial market:

.2.Asymmetric information: Adverse selection and moral hazard

1. Asymmetric information: a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible for the first party to make accurate decisions when conducting the transaction
2. Adverse selection: an asymmetric information problem that occurs before a transaction occurs. (potential bad credit risks are the ones who most actively seek out loans. Thus the parties who are most eager to take out a loan because they know they are unlikely to pay it back.)
   
   1. The lemons problem: how adverse selection influences financial structure Lemons problem (first introduced by George Akerlof). The lemons problem is first discussed in the second car market, where bad cars are the “lemons”. Potential buyers of second cars do not have sufficient information to distinguish between good and bad cars. Therefore, the buyers pay the average quality of the cars in the market. This price is somewhere between the low value of a lemon (bad car) and the high value of a good car (peach)
      
      1. In the stock and bond markets (securities markets): buyers are only willing to pay a price that reflects the average quality of firms issuing securities (a price that lies between the value of securities from bad firms and the value of those from good firms). As a result, the owners of managers of a good firm that have full information about the performance of the firm will be unwilling to sell to these buyers, because the securities are undervalued by the potential buyers. Only firms with bad credit risks are willing to sell to these buyers.
         
         1. As a consequence, the securities markets will not work very well because few firms will sell securities in it to raise capital. This explains why marketable securities are not the primary source of financing for business in any countries in the world. (Fact 2) It also explains why stocks are not the most important source of financing for Canadian businesses. (Fact 1) b. Tools to help solve adverse selection problems: REDUCE ASYMMETRIC
      2. Tools to help solve adverse selection problems: REDUCE ASYMMETRIC INFORMATION
         
         1. Private production and sale of information (institutions: Standard and Poor’s and the Dominion Bond Rating service)
            
            1. Problem associate with this: free-rider problem: people who do not pay for information take advantage of the information that other people have paid for.
            2. The free-rider problem prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection.
            3. 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 again start to interfere with the efficient functioning of securities markets
         2. Government Regulation to Increase Information: The government 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. (e.g. Audits) (fact 5)
            
            1. The adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors of the economy. (Fact 5)
         3. Financial Intermediation: Financial intermediaries in general, and banks in particular, because they hold a large fraction of non-traded loans, should pay a greater role in moving funds to corporations than securities markets do. This explains 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. (Fact 3 and Fact 4, and Fact 6)
            
            1. The larger and more established a corporation is, the more likely it will be to issue securities to raise funds, (cheaper, and less possibility for adverse selection)
         4. Collateral and Net Worth (Fact 7)
            
            1. Collateral reduces the consequences of adverse selection because it reduces the lenders losses in the event of a default. Lenders are more willing to make loans secured by collateral, and borrowers are willing to supply collateral in order to get the loan and at better rate.
            2. If a firm has a high net worth (equity capital) it is less likely to default and if it defaults the lender can sell its net worth to recover its loan. When firm seeking credit has high net worth, adverse selection problem will not be severe and lenders are more willing to make loans.
3. ) 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
   
   1. The principal-Agent Problem: When managers own only a small fraction of the firm they work for the stockholders who own most of the firms equity (principals) are not the same people as the managers of the firm. Thus the managers are the agents of the owners. This separation of ownership and control involves moral hazard, in that the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owner (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do.
      
      1. For instance: managers diverted corporate funds for their own personal use. Managers might also pursue corporate strategies that enhance their personal power but do not increase the corporation’s profitability. Agents (managers in control) may:
         
         1. a. Have different goals than the owners;
         2. b. Have less incentives to maximize firm’s profit;
         3. c. Not provide a quick and friendly service to the firm’s customers;
         4. d. Spend money unnecessarily on decoration and artificial issues;
         5. e. Waste time in their own personal leisure;
         6. f. Not be honest with the firm’s owners;
         7. g. Diverting funds for their own personal use;
         8. h. Pursue corporate strategies that enhance their own personal power but do not increase the firm’s profitability.
      2. The principal-agent problem would not arise if the owners of a firm had complete information about what the managers were up to and could prevent wasteful expenditures or fraud.
      3. The principal-agent problem could not happen when the ownership and control were not separated.

Question 7

How to solve the principal-agent problem/Tolls to help solve moral hazard in debt contract:

i. S

• • F.
• G
• F
• D
  
  • H
    
    • U

ii. T

• N
• M
  
  • C
  • C
  • C
  • C
• F

T

How to solve the principal-agent problem/Tolls to help solve moral hazard in debt contract:

i. Solving the principal-agent problem:

• Production of information: monitoring; (The monitoring process can be expensive in terms of money and time. (costly state verification), and this makes the equity contract less desirable and explains in part why equity is not a more important element in our financial structure.) (Fact 1)
  
  • Free-rider problem decreases monitoring also. As a result the moral hazard problem may arise, making it hard for the firms to issue them to raise capital.
• Government regulation to increase information (e.g. law to force firms to adhere to standard accounting principles that make profit verification easier) (Fact 5)
• Financial intermediation (e.g. venture capital firm pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses; the equity of the new business firm splits only between the entrepreneurs and the venture capital firm and no other investors are allowed. Thus, the free-rider problem in monitoring the firm does not exist.) (Fact 3)
• Debt contract- less moral hazard (this is why debt contracts are used more frequently than equity contracts to raise capital). (Fact 1)
  
  • How moral hazad influences financial structure in debt markets:
    
    • Under debt contract, there is still possibility for moral hazard, because borrowers want to chase for higher return, therefore, the borrowers will invest in projects are riskier than the lender would like

ii. Tolls to help solve moral hazard in debt contract:

• Net worth and collateral: it makes the debt contract incentive-compatible: it aligns the incentives of the borrower with those of the lender. (fact 6 and 7)
• Monitoring and enforcing Restrictive covenant (provisions). (Fact 8)
  
  • Covenants to discourage undesirable behavior: keeping the borrower from engaging in the undesirable behavior of undertaking risky investment projects
  • Covenants to encourage desirable behavior: encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. (e.g. the borrowing firm must maintain minimum holdings of certain assets relative to the firm’s size)
  • Covenants to keep collateral valuable: encourage the borrower to keep the collateral in good condition and make sure that it stays the possession of the borrower. (e.g. automobile loan contracts)
  • Covenants to provide information
• Financial Intermediation (fact 3,4)

The analysis of how asymmetric information problems affect economic behavior is called agency theory.

Answer 7

How to solve the principal-agent problem/Tolls to help solve moral hazard in debt contract:

i. Solving the principal-agent problem:

• Production of information: monitoring; (The monitoring process can be expensive in terms of money and time. (costly state verification), and this makes the equity contract less desirable and explains in part why equity is not a more important element in our financial structure.) (Fact 1)
  
  • Free-rider problem decreases monitoring also. As a result the moral hazard problem may arise, making it hard for the firms to issue them to raise capital.
• Government regulation to increase information (e.g. law to force firms to adhere to standard accounting principles that make profit verification easier) (Fact 5)
• Financial intermediation (e.g. venture capital firm pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses; the equity of the new business firm splits only between the entrepreneurs and the venture capital firm and no other investors are allowed. Thus, the free-rider problem in monitoring the firm does not exist.) (Fact 3)
• Debt contract- less moral hazard (this is why debt contracts are used more frequently than equity contracts to raise capital). (Fact 1)
  
  • How moral hazad influences financial structure in debt markets:
    
    • Under debt contract, there is still possibility for moral hazard, because borrowers want to chase for higher return, therefore, the borrowers will invest in projects are riskier than the lender would like

ii. Tolls to help solve moral hazard in debt contract:

• Net worth and collateral: it makes the debt contract incentive-compatible: it aligns the incentives of the borrower with those of the lender. (fact 6 and 7)
• Monitoring and enforcing Restrictive covenant (provisions). (Fact 8)
  
  • Covenants to discourage undesirable behavior: keeping the borrower from engaging in the undesirable behavior of undertaking risky investment projects
  • Covenants to encourage desirable behavior: encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. (e.g. the borrowing firm must maintain minimum holdings of certain assets relative to the firm’s size)
  • Covenants to keep collateral valuable: encourage the borrower to keep the collateral in good condition and make sure that it stays the possession of the borrower. (e.g. automobile loan contracts)
  • Covenants to provide information
• Financial Intermediation (fact 3,4)

The analysis of how asymmetric information problems affect economic behavior is called agency theory.