Money and Banking Chapter 8 Financial Structure, Transaction Costs, and Asymmetric Information

Chapter Financial Structure , Transaction Costs , and Asymmetric Information CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe how nonfinancial companies meet their external financing needs . Explain why bonds play a relatively large role in the external financing of companies . Explain why most external finance is channeled through financial intermediaries . Define transaction costs and explain their importance . Define and describe asymmetric information and its importance . Define and explain adverse selection , moral hazard , and agency problems . Explain why the financial system is heavily regulated . URL books 157

The Sources of External Finance LEARNING OBJECTIVE . How can companies meet their external financing needs ?

Thus far , we have spent a lot of time discussing financial markets and learning how to calculate the prices of various types of securities , including stocks and bonds . Securities markets are important , especially in the economy . But you may recall from Chapter The Financial System that the system connects savers to spenders or investors to entrepreneurs in two ways , via markets and via intermediaries . It turns out that the latter channel is larger than the former . That right , in dollar terms , banks , insurance companies , and other intermediaries are more important than the stock and bond markets . The markets tend to garner more media attention because they are relatively transparent . Most of the real action , however , takes place behind closed doors in banks and other institutional lenders . Not convinced ?

Check out Figure Sources of external for companies in four financially and economically developed countries , which shows the sources of external funds for businesses in four of the world most advanced economies the United States , Germany , Japan , and Canada . In none of those countries does the stock market ( equities ) supply more than 12 percent of external . Loans , from banks and companies , supply the vast bulk in three ofthose countries and a majority in , the United States . The bond market supplies the rest , around 10 percent or so of total external ( excluding trade credit ) except in the United States , where bonds supply about a third of the external of businesses . As we learn later , banking has been relatively weak historically , which helps to explain why the bond market and loans from companies are relatively important in the United States . In short , more companies found it worthwhile to borrow from life insurance companies or to sell bonds than to obtain bank loans . Figure ' fin ( uni ! i ( URL books ' 158

As noted above , the numbers in Figure Sources of external for nonfinancial companies in four and economically developed countries do not include trade credit . Most companies are small and most small companies most of their activities by borrowing from their suppliers or , sometimes , their customers . Most such , however , ultimately comes from loans , bonds , or stock . In other words , companies that extend trade credit act , in a sense , as intermediaries , channeling equity , bonds , and loans to small companies . This makes sense because suppliers usually know more about small companies than banks or individual investors do . And information , we see , is key . Also note that the equity are somewhat misleading given that , once sold , a share provides forever , or at least until the company folds or buys it back . The above do not account for that , so a bank loan renewed each year for 20 years would count as of bank loans , while the sale of of equities would count only as . Despite that bias in the methodology , it is clear that most external does not , in fact , come from the sale of stocks or bonds . Moreover , in less economically and developed countries , an even higher percentage of external comes to nonfinancial companies via intermediaries rather than markets . What explains the facts highlighted in Figure Sources of external for nonfinancial companies in four and economically developed countries ?

Why are bank and other loans more important sources of external than stocks and bonds ?

Why does indirect , via intermediaries , trump direct , via markets ?

For that matter , why are most of those loans collateralized ?

Why are loan contracts so complex ?

Why are only the largest companies able to raise URL books 159 funds directly by selling stocks and bonds ?

Finally , why are financial systems worldwide one of the most heavily regulated economic sectors ?

Those questions can be answered in three ways transaction costs , asymmetric information , and the problem . Explaining what those three terms mean , however , will take a little doing . KEY TAKEAWAYS To meet their external financing needs , companies can sell equity ( stock ) and commercial paper and bonds and they can obtain loans from banks and financial institutions . They can also obtain trade credit from suppliers and customers , but most of those funds ultimately come from loans , bonds , or equity . Most external financing comes from loans , with bonds and equities a distant second , except in the United States , where bonds provide about a third of external financing for nonfinancial companies . Bonds play a relatively larger role in the external financing of companies because the banking system has been weak historically . That weakness induced companies to obtain more loans from financial institutions like life insurance companies and also to issue more bonds . URL books 160

Transaction Costs , Asymmetric Information , and the Rider Problem LEARNING OBJECTIVE . Why is most external finance channeled through financial intermediaries ?

Minimum efficient scale in is larger than most individuals can invest . Somebody with 100 , even to invest would have a hard time making any at all , let alone the going return . That is because most of his or her would be eaten up in transaction costs , the opportunity cost ofhis or her time , and liquidity and losses . Many types of bonds come in increments and so are out of the question for many small investors . A single share of some companies , like , costs thousands or tens of thousands of dollars and so is also out of reach . Most shares cost far less , but transaction fees , even after the online trading revolution of the early , are still quite high , especially if an investor were to try to diversify by buying only a few shares of many companies . As discussed in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities , markets are so that arbitrage opportunities are rare and . Those who make a living engaging in arbitrage , like hedge fund Shaw , do so only through scale economies . They need ( read expensive ) computers and nerdy ( read expensive ) employees to operate custom ( read expensive ) programs on them . They also need to engage in transactions . You can making percent on a trade , but you can on a one . What about making loans directly to entrepreneurs or other borrowers ?

The time , trouble , and cash ( for advertisements like that in Figure Need a loan ?

it would take to a suitable borrower would likely wipe out any from interest . The legal fees alone would swamp you ! It helps if you can be your own lawyer , like John . And , as well learn below , making loans isn all that easy . You still occasionally see advertisements like those that used to appear in the eighteenth century , but they are rare and might in fact be placed by predators , people who are more interested in robbing you ( or worse ) than lending to you . A small investor might be URL books 161

able to a relative , colleague , or other acquaintance to lend to relatively cheaply . But how could the investor know if the borrower was the best one , given the interest rate charged ?

What is the best rate , anyway ?

To answer those questions even haphazardly would cost relatively big bucks . And here is another hint friends and relatives often think that a loan is actually a gift , if you catch my Figure ' i a loan ?

Scrivener , In HE molt candid , and Advice in all Cafes of Law and Equity , with every Endeavour , amicably to and . axle any count , or other Matter . between Parties in and to who Property in , readily to recover the fame . on good or Security . whether , Bond , Note , Bills , The Sterling Bills . to the Pounds York Currency . heretofore ) to be Lee on approved Security . of conveyance , and all other in , the , and other . All Maritime as and eve other the general of this Often carefully . and the molt , on fuel ea ! Charge um render of and for which it was , by the ' obedient and very humble Servant , John . er , Law , de . December . From Early American Newspapers , an Archive Collection , published by ( a division , A new type of banking , called banking , might reduce some of those transaction costs . In banking , a facilitator , like or , reduces transaction costs by electronically matching individual borrowers and lenders . Most facilitators screen loan applicants in at least a rudimentary fashion and also provide diversification services , distributing lenders funds to numerous borrowers to reduce the negative impact of any defaults . Although the infant industry is currently growing , the concept is still unproven and there are powerful reasons to doubt its success . Even if the concept succeeds ( and it URL , or books 162

might given its Thomas World Is ) it will only reinforce the point made here about the inability of most individuals to invest profitably without help . Financial intermediaries clearly can provide such help . They have been doing so for at least a millennium ( yep , a thousand years , maybe more ) One key to their success is their ability to achieve minimum scale . Banks , insurers , and other intermediaries pool the resources of many investors . That allows them to diversify cheaply because instead of buying 10 shares of 10 stock and paying for the privilege ( 100 ) they can buy shares for a brokerage fee of maybe ( In addition , intermediaries do not have to sell assets as frequently as individuals ( of course ) because they can usually make payments out of like deposits or premium payments . Their cash , in other words , reduces their liquidity costs . Individual investors , on the other hand , often it necessary to sell assets ( and incur the costs associated therewith ) to pay their bills . As specialists , intermediaries are also experts at what they do . That does not mean that they are from it , as we learned during the crisis that began in they are certainly more efficient at accepting deposits , making loans , or insuring risks than you or I will ever be ( unless we work for a financial intermediary , in which case we likely become incredibly in one or at most a handful of functions ) That expertise covers many areas , from database management to telecommunications . But it is most important in the reduction of asymmetric information . You may recall from Chapter The Financial System that we called asymmetric information the devil incarnate , a scourge of humanity second only to scarcity . That no exaggeration . Asymmetric information makes our markets , and otherwise , less efficient than they otherwise would be by allowing the party with superior information to take advantage with inferior information . Where asymmetric information is high , resources are not put to their most highly valued uses , and it is possible to make outsized by cheating others . Asymmetric information , we believe , is what primarily gives markets , including financial markets , the bad rep they have acquired in some circles . URL books 163

Financial intermediaries and markets can reduce or mitigate asymmetric information , but they can no more eliminate it than they can end scarcity . Financial markets are more transparent than ever before , yet dark corners remain . The government and market participants can , and have , forced companies to reveal important information about their revenues , expenses , and the like , and even follow certain accounting standards . As a CEO in a famous Wall Street Journal cartoon once put it , All these regulations take the fun out of But at the edges of every rule and regulation there is ample room for shysters to play . When managers found that they could not easily manipulate earnings forecasts ( and hence stock prices , as we learned in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities ) for example , they began to backdate stock options to enrich themselves at the expense of stockholders and other corporate stakeholders . What is the precise nature of this great asymmetric evil ?

Turns out this devil , this , has three heads adverse selection , moral hazard , and . Let lop off each head in turn . KEY TAKEAWAYS Transaction costs , asymmetric information , and the problem explain why most external finance is channeled through intermediaries . Most individuals do not control enough funds to invest profitably given the fact that fixed costs are high and variable costs are low in most areas of finance . In other words , it costs almost as much to buy 10 shares as it does to buy . Also , individuals do not engage in enough transactions to be proficient or expert at it . Financial intermediaries , by contrast , achieve minimum efficient scale and become quite expert at what they do , though they remain far from perfect . Transaction costs are any and all costs associated with completing an exchange . Transaction costs include , but are not limited to , broker commissions dealer spreads bank fees legal fees search , selection , and monitoring costs and the opportunity cost of time devoted to related activities . URL books 164

They are important because they detract from profits , eliminating or greatly reducing them in the case of individuals and firms that have not achieved minimum efficient scale . Transaction costs are one reason why institutional intermediaries dominate external finance . For details , see Options Grow for Investors to Lend , Wall , July 18 , 2007 . World is Flat ?

URL books 165 Adverse Selection LEARNING OBJECTIVE . What problems do asymmetric information and , more specifically , adverse selection cause and how can they be mitigated ?

The classic case selection , the one that brought the phenomenon back to the attention of economists in 1970 , is the lemons , which is to say , automobiles . The lemons story , with appropriate changes , applies to everything from horses to bonds , to lemons ( the fruit ) to construction services . That is because the lemons story is a simple but powerful one . People who offer lemons for sale know that their cars stink . Most people looking to buy cars , though , can tell that a car is prone to breakdown . They might kick the tires , take it for a short spin , look under the hood , all without discovering the truth . The seller has superior information and indeed has an incentive to increase the asymmetry by putting a over any obvious problems . He might , for example , warm the car up thoroughly before showing it , put gasoline in the tank , clean up the oil spots in the driveway , and so forth . He may even explain that the car was owned by his poor deceased grandmother , who used it only to drive to church on Sundays ( for services ) and Wednesdays ( for bingo ) and that she took meticulous care of it . The hapless buyer , the story goes , offers the average price for used cars of the particular make , model , year , and mileage for sale . The seller happily ( and greedily ifyou want to be moralistic about it ) day , week , month , or year later , the buyers learns that he has overpaid , that the automobile he purchased is a lemon . He complains to his relatives , friends , and neighbors , many of whom tell similar horror stories . A consensus emerges that all used cars are lemons . Of course , some used cars are actually peaches , very reliable means of personal transportation . The problem is that owners of peaches can credibly inform buyers of the car quality . Oh , she can say , truthfully , that the car was owned by her poor deceased grandmother who used it only to drive to church on Sundays ( for services ) and Wednesdays ( for bingo ) and that she took meticulous care of it . But that sounds a lot like what the owner of the lemon says too . In fact , we just copied and pasted it from above ! So the asymmetric information remains and the hapless buyer offers the average price URL books 166

for used cars of the particular make , model , year , and mileage for sale . Another copy and paste job ! But this time the seller , instead the , gets and storms ( or at least declines ) So the buyer relatives , friends , and neighbors are half all the used cars for sale are lemons , but those that are bought are ! Now appears our hero , the used car dealer , who is literally a dealer in the same sense a securities dealer is he buys from sellers at one ( bid ) price and then sells to buyers at a higher ( ask ) price . He earns his or spread the by reducing asymmetric information . Relative to the common person , he is an expert at assessing the true value of used automobiles . Or his operation is large enough that he can hire such people and afford to pay them . See the transaction costs section above . So he pays more for peaches than lemons ( of course ) and the used car market begins to function at a much higher level of . Why is it , then , that the stereotype of the used car salesman is not very complimentary ?

That the guy in Figure Shady used car salesman . seems more typical than the guy in Figure used car salesman ?

Several explanations come to mind . The market for used car dealers may be too competitive , leading to many failures , which gives dealers incentives to engage in rent seeking ( ripping off customers ) and to establish relationships . Or the market may not be competitive enough , perhaps due to high barriers to entry . Because sellers and buyers have few choices , dealers that they can engage in sharp business practices land still attract customers as long as they remain better than the alternative , the market . I think the latter more likely because in recent years , many used car salesmen have cleaned up their acts in competition from the likes of and similar companies . Moreover , and similar companies have reduced asymmetric information by tracking vehicle damage using each car unique vehicle identification number ( VIN ) making it easier for buyers to reduce asymmetric information without the aid of a dealer . What does this have to do with the system ?

Plenty , as it turns out . As noted above , adverse selection applies to a wide variety of markets and products , including ones . Let suppose that , like our friend above , you have some money to lend and the response to your URL books ' 167 advertisement is overwhelming . Many borrowers are in the market . Information is can really tell who the safest borrowers are . So you decide to ration the credit as if it were apples , by lowering the price you are willing to give for their bonds ( raising the interest rate on the loan ) Big mistake ! As the interest rate increases ( the sum that the securities seller will accept for his decreases ) the best borrowers drop out of the bidding . After all , they know that their projects are safe , that they are the equivalent of an automotive peach . People with riskier business projects continue bidding until they the cost too high and bow out , leaving you to lend to some knave , to some human lemon , at a very high rate . That , our friend , is adverse selection . Adverse selection also the market for insurance . Safe risks are not willing to pay much for insurance because they know that the likelihood that they will suffer a loss and make a claim is low . Risky firms , by contrast , will pay very high rates for insurance because they know that they will probably suffer a loss . Anyone offering insurance on the basis of premium alone will end up with the stinky end of the stick , just as the lender who rations on price alone will . Like used car dealers , facilitators and intermediaries seek to by reducing adverse selection . They do so by specializing in discerning good from bad credit and insurance risks . Their main weapon here is called screening and its what all and questions are about when you apply for a loan or insurance policy . Potential lenders want to know if you pay your bills on time , if your income minus expenses is large and stable enough to service the loan , if you have any collateral that might protect them from loss , and the like . Potential insurers want to know if you have many insurance claims in the past because that may indicate that you are clumsy not very careful with your possessions or worse , a shyster who makes a living filing insurance claims . They also want to know more about the insured property so they don insure it for too much , a sure inducement to start a or cause an accident . They also need to out how much risk is involved , how likely a certain type of car is to be totaled if involved in an accident , the probability of a house burning to the ground in a given area , the chance of a Rolex watch being stolen , and so forth . Stop and Think Box URL books 168

insurance policies promise to make payments to people who find themselves unemployed or incapacitated . Whenever solicited to buy such insurance , I ( Wright ) always ask how the insurer overcomes adverse selection because there are never any applications or premium schedules , just one rate . Why do I care ?

I care because I a peach of a person . I know that if I lived a more dangerous lifestyle or was employed in a more volatile industry that I snap the policy right up . Given my current situation , however , I don think it very likely that I will become unemployed or incapacitated , so I don feel much urgency to buy such a policy at the same rate as some guy or gal who about to go skydiving instead of going to work . I don want to subsidize them or to deal with a company that doesn know the first thing about insurance . Financial intermediaries are not perfect . They often make mistakes . Insurers like State Farm , for example , underestimated the likelihood of a massive storm like Katrina striking the Gulf Coast . And subprime mortgage lenders , companies that lend to risky borrowers on the collateral of their homes , grossly miscalculated the likelihood that their borrowers would default . Competition between lenders and insurers induces them to lower their screening standards to make the sale . In a famous cartoon in the Wall Street Journal , a clearly nonplussed father asks a concerned mom how their sons imaginary friend got preapproved for a credit card . At some point , though , adverse selection always rears its ugly head , forcing lenders and insurance providers to improve their screening procedures and tighten their standards once again . And , on average , they do much better than you or I acting alone could do . Another way adverse selection is the and sale . Companies like Standard and Poor , Bests , Duff and , Fitch , and Moody used to compile and analyze data on companies , rate the riskiness of their bonds , and then sell that information to investors in huge books . The problem , though , killed off that business model . Specifically , the advent of cheap photocopying induced people to buy the books , photocopy them , and sell them at a fraction of the price that the agencies could charge . The free riders had to pay only the variable costs of publication the rating agencies had to pay the large costs of compiling and analyzing the data . So in the , the agencies began to give their ratings away to investors and instead charged bond for the privilege of being rated . The new model greatly URL books 169

decreased the effectiveness of the ratings because the new arrangement quickly led to rating similar to grade . Pleasure with the cash . Instead of pleasing investors , the agencies started to please the . After every major crisis , including the subprime mortgage mess of 2007 , academics and former government regulators lambaste agencies for their poor performance relative to markets and point out the incentive built into their business model . Thus far , little has changed , but encrypted databases might allow a return to the model . But then another form of free riding would arise as investors who did not subscribe to the database would observe and mimic the trades of those investors known to have subscriptions . Due to inherent in markets , banks and intermediaries have incentives to create private information about borrowers who are insured . This helps to explain why they trump bond and stock markets . Governments can no more legislate away adverse selection than they can end scarcity by decree . They can , however , give markets and intermediaries a helping hand . In the United States , for example , the Securities and Exchange Commission ( SEC ) tries to ensure that corporations provide market participants with accurate and timely information about themselves , reducing the information asymmetry between themselves and potential and stockholders . Like sellers of lemons , however , bad companies often outfox the SEC ( and similar regulators in other countries ) and investors , especially when said investors place too much confidence in government regulators . In 2001 , for example , a energy trading company named suddenly encountered insurmountable and was forced to for bankruptcy , the largest in American history at that time . Few saw implosion coming because the company hid its debt and losses in a maze of offshore shell companies and other accounting . Some dumbfounded investors hadn bothered watching the energy giant because they believed the government was doing it for them . It wasn . KEY TAKEAWAYS Asymmetric information decreases the efficiency of financial markets , thereby reducing the flow of funds to entrepreneurs and injuring the real economy . Adverse selection is precontractual asymmetric information . URL books 170

It can be mitigated by screening out members of the applicant pool . Financial market facilitators can also become expert specialists and attain minimum efficient scale , but financial markets are hampered by the problem . In short , few firms find it profitable to produce information because it is easy for others to copy and profit from it . Banks and other intermediaries , by contrast , create proprietary information about their borrowers and people they insure . Classical economists like Adam Smith recognized adverse selection and asymmetric information more generally , but they did not label or stress the concepts . shar wiki URL books 171

Moral Hazard LEARNING OBJECTIVE . What is moral hazard and how can it be mitigated ?

Adverse selection is precontractual asymmetric information . Moral hazard is asymmetric information . It occurs whenever a borrower or insured entity ( an approved borrower or policyholder , not a mere applicant ) engages in behaviors that are not in the best interest of the lender or insurer . If a borrower uses a bank loan to buy lottery tickets instead of Treasuries , as agreed upon with the lender , that moral hazard . If an insured person leaves the door of his or her home or car unlocked or lets candles burn all night unattended , that moral hazard . It also moral hazard if a borrower fails to repay a loan when he has the wherewithal to do so , or if an insured driver fakes an accident . We call such behavior moral hazard because it was long thought to indicate a lack or character and in a sense it does . But thinking about the problem in those terms does not help to mitigate it . We all have a price . How high that price is can be easily determined and may indeed change , but offered enough money , every human being ( except maybe Gandhi , prophets , and saints ) will engage in immoral activities for personal gain if given the chance . It tempting indeed to put other people money at risk . As we ve learned , the more risk , the more reward . Why not borrow money to put to risk ?

If the rewards come , the principal and interest are easily repaid . If the rewards don come , the borrower defaults and suffers but little . Back in the day , as they say , borrowers who didn repay their loans were thrown into jail until they paid up . Three problems eventually ended that practice . First , it is to earn money to repay the loan when you re imprisoned ! The original assumption was that the borrower had the money but wouldn cough it up . Second , not everyone defaults on a loan due to moral hazard . Bad luck , a soft economy , poor execution can turn the best business plan to mush . Third , lenders are almost as culpable as the borrowers for moral hazard if they don take steps to try to mitigate it . A locked door , an old adage goes , keeps an honest man honest . Don tempt people , in other words , and most won rob you . There are locks against moral hazard . They are not foolproof but they get the job done most of the time . URL books 172

Stop and Think Box Investment banks engage in many activities , two of which , research and underwriting , have created of interest . The customers of research activities , investors , want unbiased information . The customers of underwriting activities , bond , want optimistic reports . A few years back , problems arose when the interests of bond , who provided with most of their profits , began to supersede the interests of investors . Specifically , managers forced their research departments to avoid making negative or controversial comments about clients . The situation grew worse during the Internet stock mania of the late , when research analysts like Jack ( a Dickensian name but true ! of ( then Salomon Smith Barney ) made outrageous claims about the value of companies . That in itself wasn evil because everyone makes mistakes . What raised hackles was that the private of those same analysts indicated that they thought the companies they were hyping were extremely weak . And most were . What sort of problem does this particular of interest represent ?

How does it injure the economy ?

What can be done to rectify the problem ?

This is an example of asymmetric information and , more , moral hazard . Investors contracted with the for unbiased investment research but instead received extremely biased advice that induced them to pay too much for securities , particularly the equities of weak tech companies . As a result , the efficiency of our markets decreased as resources went to that did not deserve them and could not put them to their most highly valued use . That , of course , injured economic growth . One way to solve this problem would be to allow to engage in securities underwriting or research , but not both . That would make less profitable , though , as doing both creates economies of scope . That why got into the business of selling research in the place . Another solution is to create a Chinese wall within each between their research and underwriting departments . This apparent reference to the Great Wall of China , which despite its grandeur was repeatedly breached by barbarian invaders with help from insiders , also belies that strategy weakness . If the wall is so high that it is impenetrable , then the economies of scope are diminished to the vanishing point . If the wall is low or porous , then the of interest can again arise . Rational expectations and transparency could help here . Investors now know ( or at least should know ) that can provide biased research reports and hence should remain wary . Government regulations could help here by mandating that completely and URL books 0797 ?

173 accurately disclose their interests in the companies that they research and evaluate . That extra transparency would then allow investors to discount rosy prognostications that appear to be driven by underwriting interests . The Global Legal Settlement of 2002 , which was brokered by Eliot ( then New York State Attorney General and New York governor until he ran into a little moral hazard problem himself ! bans spinning , requires investment banks to sever the links between underwriting and research , and slapped a billion on the ten largest . The main weapon against moral hazard is monitoring , which isjust attention ! No matter how well they have screened ( reduced adverse selection ) lenders and insurers can not contract and forget . They have to make sure that their customers do not use the superior information inherent in their situation to take advantage . Banks have a particularly easy and powerful way of doing this watching checking accounts . Banks rarely provide cash loans because the temptation of running off with the money , the moral hazard , would be too high . Instead , they credit the amount of the loan to a checking account upon which the borrower can draw funds . This procedure has a second positive feature for banks called compensatory balances . A loan for , say , million does not leave the bank at once but does so only gradually . That raises the effective interest rate because the borrower pays interest on the total sum , not just that drawn out of the bank . The bank can then watch to ensure that the borrower is using the funds appropriately . Most loans contain restrictive covenants , clauses that specify in great detail how the loan is to be used and how the borrower is to behave . If the borrower breaks one or more covenants , the entire loan may fall due immediately . Covenants may require that the borrower obtain life insurance , that he or she keep collateral in good condition , or that various business ratios be kept within certain parameters . Often , loans will contain covenants requiring borrowers to provide lenders with various types of information , including audited reports , thus minimizing the lenders monitoring costs . Another powerful way moral hazard is to align incentives . That can be done by making sure the borrower or insured has some skin in the game , that he , she , or it will suffer if a loan goes bad or a loss is incurred . That will induce the borrower or insured to behave in the lenders or insurer best interest . Collateral , property pledged for the repayment of a loan , is a good way to URL books 174

reduce moral hazard . Borrowers don take kindly to losing , say , their homes . Also , the more equity they their home or business or investment harder they will to keep from losing it . Some will still default , but not purposely . In other words , the higher one net worth ( market value of assets minus market value of liabilities ) the less likely one is to default , which could trigger bankruptcy proceedings that would reduce or even wipe out the borrower net worth . This is why , by the way , it is sometimes alleged that you have to have money to borrow money . That isn literally true , of course . What is true is that owning assets free and clear of debt makes it much easier to borrow . Similarly , insurers long ago learned that they should insure only a part of the value of a ship , car , home , or life . That is why they insist on or . If you will lose nothing if you total your car , you might attempt that trip on icy roads or sign up for a demolition derby . If an accident will cost you 500 ( deductible ) or 20 percent of the costs of the damage ( you will think twice or thrice before doing something risky with your car . When it comes to reducing moral hazard , financial intermediaries have advantages over individuals . Monitoring is not cheap . Indeed , economists sometimes refer to it as costly state Economies of scale give intermediaries an upper hand . Monitoring is also not easy , so specialization and expertise also render intermediaries more efficient than individuals at reducing moral hazard . If nothing else , intermediaries can afford to hire the best legal talent to frighten the devil out of scammers . Borrowers can no longer be imprisoned for defaulting , but they can go to prison for fraud . Statutes against fraud are one way that the government helps to chop at the second head of the asymmetric information . Financial intermediaries also have monitoring advantages over markets . Bondholder A will try to on Bondholder , who will gladly let Bondholder suffer the costs of state , and all of them hope that the government will do the dirty work . In the end , nobody may monitor the bond issuer . KEY TAKEAWAYS Moral hazard is asymmetric information . Moral hazard can be mitigated by monitoring after contracting . URL books 175

Wall of China URL books ( 176 Agency Problems LEARNING OBJECTIVE . What are agency problems and how can they be mitigated ?

is an important subcategory hazard that involves asymmetric information of a type . In many , nay , most instances , principals ( owners ) must appoint agents ( employees ) to conduct some or all of their business affairs on their behalf . Stockholders in corporations , for example , hire professional managers to run their businesses . Those managers in turn hire other managers , who in turn hire supervisors , who then hire employees ( depending on how hierarchical the company is ) The problem arises when any of those agents does not act in the best interest of the principal , for example , when employees managers steal , slack off , act rudely toward customers , or otherwise cheat the company owners . If you ve ever held a job , you ve probably been guilty of such activities yourself . We admit we have , but it best not to get into the details ! If you ve ever been a boss , or better yet an owner , you ve probably been the victim of agency problems . Wright has been on this end too , like when he was eight years old and his brother told him their lemonade stand had revenues of only when in fact it brought in . Hey , that was a lot of money back then ! Stop and Think Box As one of the authors of this textbook and many others have pointed out , investment banks often underprice stock initial public offerings ( In other words , they offer the shares of companies that decide to go public for too little money , as evidenced by the large first day pops or bumps in the stock price in the ( the secondary market ) Pricing the shares of a new company is tricky business , but the was too prevalent to have been honest errors , which one would think would be too high about half of the time and too low the other half . All sorts of reasons were proffered for the systematic , including the fact that many shares could not be or resold for some weeks or months after the . Upon investigation , however , a major cause of turned out to be a of interest called spinning often purposely so that there would be excess demand , so that investors would demand a larger quantity of shares URL books 177

than were being offered . Whenever that occurs , shares must be rationed by mechanisms . The could then dole out the hot shares to friends or family , and , in return for future business , the executives of other companies ! Who does spinning hurt ?

Help ?

Be as as possible . Spinning hurts the owners of the company going public because they do not receive as much from the as they could have if the shares were priced closer to the market rate . It may also hurt investors in the companies whose executives received the shares who , in reciprocation for the hot shares , might not use the best when their companies later issue bonds or stock or attempt a merger or acquisition . Spinning helps the by giving it a tool to acquire more business . It also aids whoever gets the shares . Monitoring helps to mitigate the problem . That what supervisors , cameras , and corporate snitches are for . Another , often more powerful way of reducing agency problems is to try to align the incentives with those by paying wages , commissions , bonuses , stock options , and the like . Caution is the watchword here , though , because people will do precisely what they have incentive to do . Failure to recognize that apparently universal human trait has had adverse consequences for some organizations , a point made in business schools through easily understood case stories . In one story , a major ice cream retailer decided to help out its employees by allowing them to consume , free of charge , any mistakes they might make in the course of serving customers . What was meant to be an environmentally sensitive ( no waste ) little perk turned into a as employee bulged shrank because hungry employees found it easy to make delicious frozen mistakes . Oh , you said chocolate . I thought you said my favorite , mint chocolate chip . Excuse me because I am now on ) In another story , a debt collection agency reduced its efficiency and by agreeing to a change in the way that it compensated its collectors . Initially , collectors received bonuses based on the dollars collected divided by the dollars assigned to be collected . So , for example , a collector who brought in of the million due on his accounts would receive a bigger bonus than a collector who collected only of the same denominator ( Collectors complained , however , that it was not fair to them if one or more of their accounts went bankrupt , rendering collection impossible . The managers of the collection agency agreed and URL books 178

began to deduct the value of bankrupt accounts from the collectors . Under the new incentive scheme , a collector who brought in would receive a bigger bonus than his colleague if , say , of his accounts claimed bankruptcy ( 800 200 , which is ) Soon , the collectors transformed themselves into bankruptcy counselors ! The new scheme inadvertently created a perverse incentive , that is , one diametrically opposed to the collection agency interest , which was to collect as many dollars as possible , not to help debtors for bankruptcy . In a competitive market , pressure from competitors and the incentives of managers would soon rectify such mishaps . But when the incentive structure of management is out of kilter , bigger and deeper problems often appear . When managers are paid with stock options , for instance , they are given an incentive to increase stock prices , which they almost invariably do , sometimes by making their companies more efficient but sometimes , as investors in the US . stock market in the late learned , through accounting legerdemain . Therefore , corporate governance looms large and requires constant shareholders , business , and government regulators . however , makes it to coordinate the monitoring activities that keep agents in line . If Stockholder A watches management , then Stockholder doesn have to but he will still reap the of the monitoring . Ditto with Stockholder A , who sits around hoping Stockholder will do the dirty and costly work of monitoring executive pay and perks , and the like . Often , nobody ends up monitoring managers , who raise their salaries to obscene levels , slack off work , go building , or all three ! This governance conundrum helps to explain why the sale of stocks is such a relatively unimportant form of external worldwide . Governance becomes less problematic when the equity owner is actively involved in management . That is why investment banker . Morgan used to put his people ( principals in . Morgan and Company ) on the boards of companies in which Morgan had large stakes . A similar approach has long been used by Warren . Venture capital also insist on taking some management control and have the added advantage that the equity of startup does not , indeed can not , trade . It does only after it holds an or direct public offering ) So other investors can not on its costly state verification . The recent interest in private equity , funds URL books 179

invested in privately owned ( versus publicly traded ) companies , stems from this dynamic as well as the desire to avoid costly regulations like . Stop and Think Box Investment banks are not the only financial services that have recently suffered from of interest . Accounting that both audit ( the accuracy and appropriateness of ) corporate statements and provide tax , business strategy , and other consulting services found it to reconcile the inherent in being both the creator and the inspector of businesses . Auditors were too soft in the hopes of winning or keeping consulting business because they could not very well criticize the plans put in place by their own consultants . One of the big five accounting , Arthur , actually collapsed after the market and the SEC discovered that its auditing procedures had been compromised . How could this type of of interest be reduced ?

In this case , simply informing investors of the problem would probably not work . Financial statements have to be correct the problem ensures that no investor would have an incentive to verify them or herself . The traditional solution to this problem was the auditor and no better one has yet been found . But the question is , How to ensure that auditors do their jobs ?

One answer , enacted in the Act of 2002 ( aka SOX and ) is to establish a new regulator , the Public Company Accounting Oversight Board ( to oversee the activities of auditors . The law also increased the SEC budget ( but it still tiny compared to the grand scheme of things ) made it illegal for accounting to offer audit and services simultaneously , and increased criminal charges for crimes . The most controversial provision in SOX requires corporate executive ( CEOS ) and corporate financial ( to certify the accuracy of corporate statements and requires corporate boards to establish unpaid audit committees composed of outside directors , that is , directors who are not members of management . The jury is still out on SOX . The consensus so far appears to be that it is overkill that it costs too much given the benefits it provides . Government regulators try to reduce asymmetric information . Sometimes they succeed . Often , however , they do not . Asymmetric information is such a major problem , however , that their efforts will likely continue , whether all businesses like it or not . URL books 180

KEY TAKEAWAYS Agency problems are a special form of moral hazard involving employers and employees or other relationships . Agency problems can be mitigated by closely aligning the incentives of the agents ( employees ) with those of the principal ( employer ) Regulations are essentially attempts by the government to subdue the of asymmetric information . Some government regulations , like laws against fraud , are clearly necessary and highly effective . Others , though , like parts of , may add to the costs of doing business without much corresponding gain . URL books 181

Suggested Reading Allen , Franklin , and Douglas Gale . Comparing Financial Systems . Cambridge , MA MIT Press , 2001 . and Ross Levine . Financial Structure and Economic Growth A Comparison of Banks , Markets , and Development . Cambridge , MA MIT Press , 2004 . and David . The Theory of Incentives The . Princeton , Princeton University Press , 2001 . URL books i 182