Chapter 8: An Economic Analysis of Financial Structure
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78 Terms
Why are transaction costs important in financial markets?
High transaction costs
can prevent small savers and borrowers
from participating efficiently
in financial markets
How can a money market mutual fund provide liquidity services?
can allow investors
to earn interest
while providing cheque-writing privileges
for payments
What is the lemons problem?
A situation where:
buyers cannot distinguish high-quality goods or securities
from low-quality ones
causing good-quality sellers to leave the market
Why does the lemons problem cause good cars to leave the market?
Buyers offer an average price
because they cannot identify quality
which is too low for owners of good cars
How does the lemons problem affect securities markets?
Investors may:
undervalue good firms' securities
because they cannot distinguish
good firms from bad firms
Why might good firms avoid issuing securities in a lemons market?
securities may be undervalued
so they receive less financing
than the securities are actually worth
Why might bad firms issue securities in a lemons market?
securities may be valued
above their true quality
making financing attractive to them
How can government regulation reduce adverse selection?
Government can require firms to:
disclose accurate information
follow accounting & auditing standards
Why can banks avoid the free-rider problem?
Banks gather information for private loans
so other investors cannot
copy the bank's information for free
Why are financial intermediaries especially important in developing countries?
Information about firms
is often harder to obtain
making intermediaries' screening
and monitoring especially valuable
Why do large established firms have easier access to securities markets?
They have more:
publicly available information
established reputations
often greater net worth
How does collateral reduce lender risk?
lender can claim the collateral
if the borrower defaults
reducing the potential loss
How does high net worth reduce adverse selection?
Borrowers with more assets
have more at stake
and are generally
less risky to lenders
What is agency theory?
study of how
asymmetric information
affects relationships
between principals and agents
What is an equity contract?
contract
giving an investor
a share of a firm's
profits and assets
What is the principal-agent problem?
moral hazard problem
in which managers may act
in their own interests
rather than in the interests of shareholders
Why does the principal-agent problem occur?
Managers have more information
about their actions
and may have different incentives
from shareholders
What is separation of ownership and control?
situation where
owners of a firm
are different from
the people who manage it
How can monitoring reduce the principal-agent problem?
Shareholders can monitor managers
through audits
financial reports
oversight
How can performance-based compensation reduce moral hazard?
links managers' rewards
to firm performance
aligning their incentives
with shareholders
How can government regulation reduce the principal-agent problem?
Accounting rules
disclosure requirements
penalties for fraud
can limit managers' ability
to hide harmful actions
How can the threat of takeover reduce the principal-agent problem?
Poorly managed firms
may become takeover targets
creating pressure for managers
to improve performance
How can venture-capital firms reduce moral hazard?
actively monitor
firms they invest in
and can closely oversee management
How can debt contracts reduce the principal-agent problem?
Lenders receive fixed payments
and generally need
intensive monitoring
mainly when borrowers
default or violate the contract
What is moral hazard in a debt contract?
A situation where:
a borrower takes excessive risks
because the borrower receives
much of the upside
while the lender bears
much of the downside
Why might a borrower take excessive risk after receiving a loan?
borrower gains
if the risky project succeeds
while the lender bears
much of the loss if it fails
What are restrictive covenants?
Clauses in debt contracts
that restrict the borrower's activities
to protect the lender
How do restrictive covenants discourage undesirable behaviour?
can prohibit borrowers
from using funds
for certain risky activities
How do restrictive covenants encourage desirable behaviour?
can require borrowers
to maintain financial conditions
such as minimum net worth
How do restrictive covenants protect collateral?
can require borrowers
to maintain insurance
or keep collateral in good condition
How do restrictive covenants provide information?
can require borrowers
to provide
regular financial statements
to lenders
Why do lenders monitor restrictive covenants?
ensure borrowers
follow the contract
and reduce moral hazard
How do financial intermediaries reduce moral hazard in debt markets?
monitor borrowers
and enforce
restrictive covenants
through private lending relationships
Why are debt contracts often complicated legal documents?
contain restrictions
designed to protect
lenders
and control borrower behaviour
Why is the financial system heavily regulated?
Regulation helps:
increase information
protect participants
improve financial-system stability
Why are stocks not the most important source of external financing?
Businesses obtain
much of their external financing
from sources other than
issuing stocks
especially financial intermediaries
Why are marketable securities not the primary source of business financing?
businesses
especially smaller firms
rely more on financial intermediaries
than on issuing stocks and bonds
Why is indirect finance more important than direct finance?
Financial intermediaries
reduce transaction costs
and information problems
making indirect financing
efficient
Why are banks especially important financial intermediaries?
Banks:
reduce transaction costs
screen borrowers
monitor loans
help solve information problems
Why do small businesses rely more on financial intermediaries?
They often:
lack the size
reputation
and information availability
needed for
easy access to securities markets
What is screening?
gathering information
to identify
and evaluate
potential borrowers
before making a loan
What is monitoring?
observing a borrower
after a loan is made
to ensure the borrower
follows the agreement
What is the purpose of screening?
reduce adverse selection
by identifying
safer and riskier borrowers
before lending
What is the purpose of monitoring?
reduce moral hazard
by detecting
undesirable borrower behaviour
after lending
What is financial repression?
Conditions in which:
weak institutions
or government policies
restrict the financial system
and reduce efficient capital allocation
How can weak property rights increase financial problems?
make it harder for
lenders to protect their claims
and recover assets after default
How can weak legal systems increase asymmetric information problems?
financial contracts
harder to enforce
and increase lenders' risks
How can weak accounting standards affect financial markets?
reduce the quality
and reliability
of information available
to lenders and investors
Why can government-directed lending reduce economic efficiency?
Governments direct funds
toward favoured sectors
rather than
most productive investments
Why can state-owned banks allocate credit inefficiently?
may make lending decisions
based on government objectives
rather than profitability
and productive investment
What contributed to China's rapid economic growth?
High savings
capital accumulation
the movement of labour into higher-productivity activities
What financial weaknesses did China face?
Weak legal enforcement
weak accounting standards
state-owned banks
developing financial regulation
Why are financial intermediaries important for capital allocation?
help direct funds
toward productive borrowers
by screening and monitoring them
What is the main purpose of restrictive covenants?
limit borrower behaviour
that could increase
the lender's risk
What is the main purpose of financial regulation in financial markets?
improve information
and reduce problems
caused by asymmetric information