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Eight Puzzles Concerning Financial StructureThis section summarizes eight puzzles regarding real-world financial structure stressed by Mishkin. The remaining four sections discuss possible resolutions for these puzzles based on an understanding of how transaction costs and information costs affect financial structure.
The financial structure of a business refers to the manner in which the business finances its activities using external funds, i.e., funds obtained from outside the business. There are two important aspects to this financial structure:
Mishkin provides a figure (Figure 1) that shows the mix and source of external funds for nonfinancial businesses in the United States and other countries during the period 1970-2000.
Regarding mix, note that various forms of debt instruments (loans and bonds) accounted for about 89 percent of the external funds whereas equity instruments (stocks) only accounted for about 11 percent of these external funds.
Regarding source, note that loans provided by financial intermediaries accounted for about 57 percent of these external funds while sales of securities (bonds and stocks) accounted for about 43 percent of these external funds.
Mishkin uses the data in this figure as evidence in support of eight "puzzles" regarding financial structures all over the world, as follows.
As seen in Figure 1, the stock market accounted for a relatively small fraction of external financing by U.S. corporations in the depicted period.
As seen in Figure 1, bonds were a far more important source of financing than stocks in the United States during the depicted period 1970-2000 Nevertheless, bonds and stocks together supplied less than a third of the total external funds acquired by U.S. corporations to finance their activities during this period. As seen in Figure 1, this is true elsewhere in the world as well.
As Mishkin notes, in an average year in the United States, more than four times more funds are raised with loans than with stocks, and loans are even more important in other countries of the world -- in Germany and Japan, for example.
As studied in Chapter 2, governments regulate financial markets primarily to promote the provision of information and to ensure the soundness of the financial system. This regulation is extensive in the United States and in all other highly industrialized economies.
As Mishkin notes, individuals and smaller businesses that are not well established rely heavily on banks for external funds; only rarely do they attempt to obtain external funds through bond and stock issue.
Collateral is an asset owned by a borrower that is pledged to the lender in the event the borrower defaults on the loan, i.e., in the event the borrower is unable to meet his debt payment obligations to the lender. For example, when a borrower receives a real estate loan from a bank to finance construction of a house, the collateral is usually the house itself. Ownership of the house reverts to the bank if the borrower defaults on the loan.
Debt contracts between a borrower and lender that involve the use of some kind of collateral to guarantee the loan are referred to as collateralized debt (or secured debt). Debt that is not secured by collateral -- for example, credit card debt -- is referred to as unsecured debt. As Mishkin notes, the majority of household debt in the United States consists of collateralized loans; and borrowing by nonfinancial businesses frequently involves some form of collateral as well.
Throughout the world, debt contracts typically take the form of lengthy legal documents with extensive restrictive covenants, i.e., provisions restricting the behavior of the borrower. For example, a borrower receiving a real estate loan may be required to carry liability insurance covering accidents at his construction site.
As Mishkin notes, the explanations for these eight puzzles regarding real-world financial structuring can in large part be traced to transaction and information costs inherent in financial market activity.
The concept of "transaction costs" is actually quite tricky to define in a manner that is both clear and useful. Roughly speaking, transaction costs are the costs associated with the organization of productive activities, such as the costs arising from the need to search for customers and to prepare contracts for longer-term customer-supplier relationships. In contrast, production costs are the costs arising from the need to pay for direct inputs to production, such as salaries (the price of labor services) and rental payments (the price of capital services generated by rented capital equipment).
The concept of "information costs" is more straightforward. Information costs are the costs incurred when attempts are made to reduce moral hazard and adverse selection problems arising from conditions of asymmetric information.
For example, a debt contract is intended to be a productive activity in the sense that a contractually determined amount of loaned funds (input) is used by a borrower to produce a stream of returns (output) that is expected to cover debt payment obligations (input costs) while leaving some positive net return (profit) for the borrower.
A debt contract entails two distinct types of transaction costs: (a) the organizational costs associated with finding and bringing together the borrower and lender; and (b) the organizational costs associated with the actual writing up and signing of the debt contract. In addition, a debt contract typically involves information costs in that the behavior of the borrower must be monitored in an attempt to ensure that the borrower meets the terms of the debt contract as specified in its payment schedule and restrictive covenants.
The next two sections discuss more carefully how transaction costs and information costs affect the financial structure of businesses in ways that help to explain the above eight listed puzzles. In particular, Mishkin argues that a consideration of transaction costs is particularly helpful for understanding puzzle 3, whereas a consideration of information costs helps to explain all eight puzzles.
Transaction Costs in Relation to Puzzle 3Recall puzzle 3: "Why are financial intermediaries and indirect finance so important in financial markets?"
As previously seen (puzzle 1), businesses in the United States and other countries rely much more heavily on debt financing than on equity financing. Puzzle 3 concerns why financial intermediaries (primary commercial banks) play such a large role in this debt financing. Why don't businesses simply sell debt issue in securities markets rather than going through the hassle of securing loans from financial intermediaries?
As Mishkin notes, part of the explanation for puzzle 3 is that obtaining debt financing through a financial intermediary rather than through a securities market can significantly reduce transaction costs. This reduction occurs for two main reasons.
First, financial intermediaries help to match borrowers and lenders, cutting down on their search costs. For borrowers with special needs and circumstances, these search costs can be very high. [Indeed, as will be clarified below, a borrower whose needs and circumstances are too special may be unable to secure any lending at all through securities markets because of high information costs.]
Second, financial intermediaries engage in asset transformation, which allows them to reduce transaction costs by taking advantage of various "economies of scale."
More precisely, financial intermediaries pool together funds from many different lenders under contractual terms that these lenders find attractive -- e.g., withdrawal upon demand (liquidity). They then use these pooled funds to create new types of loan instruments specifically tailored to the special needs and circumstances of those who borrow from them. This asset transformation can take a wide variety of forms. For example, it may take the form of mutual fund transactions in which many small lenders buy shares of large diversified stock or bond portfolios. Or it may take the form of savings and loan transactions in which the funds from many small deposit accounts are pooled together to finance mortgages.
This pooling generally permits financial intermediaries to significantly reduce transaction costs by taking advantage of economies of scale, a reduction in costs per dollar loaned as the size (scale) of the loan principal increases.
For example, one way in which pooling can lead to a reduction in transaction costs through economies of scale is if the costs incurred in writing up a loan contract (lawyers' fees, title searches, etc.) are fairly insensitive to the size of the loan principal. To illustrate, suppose the cost of writing up a loan contract for $100,000 is the same as the cost of writing up a loan contract for $10,000: namely, $100. Suppose, also, that all such costs are borne by the borrower. Compare the costs paid by the borrower in the following two cases:
In each case (a) and (b), Mr. Jones receives the same total loan principal of $100,000. However, transaction costs are substantially different. In case (a), total transaction costs are only $100 -- only one loan contract is written -- so Mr. Jones only has to pay $100. In case (b), total transaction costs are $100 * 10 = $1000 since ten different loan contracts are written, hence Mr. Jones has to pay $1000.
Another way in which pooling can lead to a reduction in transaction costs through economies of scale is by permitting the spread of equipment and other capital costs over large numbers of borrowers. For example, the cost of installing a sophisticated computer system to keep track of financial transactions (e.g., interest payments) with just one borrower, such as Mr. Jones, might be prohibitive for a lender with no other borrowers. However, a lender (e.g., a financial intermediary) simultaneously transacting with a large pool of borrowers could handle these equipment costs by charging each of the borrowers in his borrowing pool a small fraction of these costs.
Asymmetric Information Problems RevisitedAsymmetric information is said to exist between a buyer and seller of an asset if either agent has information relevant for the exchange that is not available to the other agent. As discussed in Mishkin (Chapter 2), asymmetric information can lead to problems of adverse selection and moral hazard.
This section starts with a brief review of the types of adverse selection and moral hazard problems endemic to financial markets. The importance of these problems as key explanatory factors underlying Mishkin's eight financial structure puzzles is then examined.
Recall from Chapter 2 that adverse selection is a problem that arises for buyers of assets when they have difficulty assessing the quality of these assets in advance of purchase. Consequently, it is a problem that arises because of asymmetric information between buyers and sellers of assets before any purchase agreement takes place.
Specifically, the adverse selection problem is that the steps taken by buyers to protect themselves against purchases of poor quality assets may have the perverse effect of lowering the average quality of the pool of assets that sellers bring to the market. In short, adverse selection is an adverse pool effect.
Adverse selection is a serious problem in financial markets, because financial transactions are intrinsically characterized by asymmetric information. Borrowers (sellers of financial assets) generally have private information that is more accurate than the information possessed by lenders (buyers of financial assets) regarding the attributes and prospects of borrowers. Consequently, a lender may still be uncertain about the default risk of a loan contract even after checking into the standard "five C" risk factors for a borrower -- capacity (to repay), capital, character, collateral, and conditions (of the economy).
If lenders try to protect themselves against default risk by setting their contractual terms in a manner appropriate for the expected (i.e., average) quality of their loan applicants, then -- as explained at some length in Chapter 2 -- they run the risk that high risk borrowers will be encouraged to self-select into their loan applicant pool while at the same time low risk borrowers will be encouraged to self-select out of this pool. The resulting adverse effects on the quality of their loan applicant pool constitutes an example of adverse selection.
As detailed in Chapter 2, Moral hazard is said to exist in the context of a financial market if, after a purchase agreement has been concluded between a buyer and seller of a financial asset:
For example, a moral hazard problem arises if, after a lender has purchased a debt security from a borrower, the borrower increases the risks originally associated with the debt security by investing his borrowed funds in more risky projects than he originally reported to the lender.
Adverse Selection in Relation to Puzzles 1--7Consider the most obvious possible solution to adverse selection in financial markets: elimination of the asymmetry in information that exists between buyers and sellers of financial assets prior to purchase agreements.
It will now be shown why financial intermediaries (in particular banks) are better able than securities markets to accomplish the elimination of this type of asymmetric information, which helps to explain puzzles 1 through 4. Moreover, in the course of this discussion, it will be seen why puzzles 5 through 7 can also be explained in part as the result of attempts to eliminate this type of asymmetric information.
Low-risk borrowers are willing to pay to communicate information about their attributes and prospects, and lenders are willing to pay for information about borrower attributes and prospects. This provides a profit opportunity to those who are willing and able to specialize in gathering this type of information.
Participants in securities markets rely on the provision of information by private investment advisory firms such as Moody's and Standard and Poor's, whose ratings are designed to measure default risk. Private production and sale of information does not completely resolve adverse selection problems in securities markets, however, because of "free-rider" problems.
A free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for by observing and mimicking their behavior. This reduces or even eliminates the ability of people to profit from the purchase of information and hence discourages them from purchasing information in the first place. This, in turn, weakens the ability of private firms to profit by selling information.
As a consequence of free-rider problems, private provision of information in securities markets tends to be underprovided, in the sense that it is insufficient to eliminate adverse selection problems. As a result, many small newly-established firms have a difficult time obtaining external funds in securities markets because lenders lack the information needed to verify their quality (financial soundness). In contrast, large well-established firms have an easier time obtaining external funds in securities markets because lenders are more confident about their quality.
This adverse selection analysis helps to explain puzzles 1, 2, and 6 -- why debt and equity issue in securities markets is not the major source of external funds for most borrowers, especially for individuals and small businesses.
Another possibility is for government to regulate securities markets in such a way that the security issuers, themselves, are encouraged or required to reveal accurate information about their attributes and prospects. This is the approach followed in the United States and in most countries throughout the world. In the United States, the government agency in charge of ensuring information disclosure in securities markets is the Securities and Exchange Commission (SEC).
This helps to explain puzzle 5 -- the fact that the financial sector is one of the most heavily regulated sectors of the economy.
Although government regulations encouraging and requiring information disclosure lessen adverse selection problems, they do not eliminate them. Security issuers still have more information about their financial condition than purchasers, in spite of disclosure regulations, because these disclosure regulations are necessarily written in broad general terms. Moreover, it can be difficult, even for the SEC, to ensure that disclosed information is accurate.
Financial intermediaries such as banks have an easier time ensuring accurate and complete information disclosure and hence the reduction or elimination of adverse selection problems.
Most importantly, banks can profitably specialize in information gathering about particular types of loans, e.g., home mortgage loans, or loans to businesses in a particular type of industry. Free-rider problems are avoided by banks because most of their loans are private, i.e., they are not traded on an open market. Consequently, other traders cannot use the information gathered by a bank to make competing bids for its loans, bidding up prices (i.e., bidding down interest rates) to a point where the bank makes no profits.
Also, banks may be able to force borrowers to reveal their true type (high or low risk) through special loan contract provisions.
For example, borrowers may be required to pledge some of their own assets as collateral, which the bank can claim if the borrower defaults. Since, in general, only low risk types are willing to offer substantial collateral, the amount of collateral pledged in a loan contract acts as a signal to the bank regarding the quality of the borrower.
In addition, collateral provisions reduce the consequences of adverse selection for banks because they reduce the losses incurred by the banks in case of default. The net worth (or equity capital) of a borrower -- defined as the difference between what he owns (his assets) and what he owes (his liabilities) -- can play a similar role to collateral in reducing the default risk for a bank to the extent that the bank is permitted by law to take title to the borrower's assets in case of default. Since bankruptcy regulations typically permit borrowers to protect at least some of their assets from seizure by creditors, however, collateral provisions provide more security to banks than borrower net worth per se.
This adverse selection analysis helps to explain puzzle 7 -- why collateral is a prevalent feature of debt contracts for both households and businesses.
In addition, this adverse selection analysis suggests why financial intermediaries in general, and banks in particular, play a greater role in the provision of external funds for businesses than do debt and equity securities markets. Consequently, it helps to explain puzzles 3 and 4.
Moral Hazard in Relation to Puzzles 1-5 and 7-8As reviewed above, moral hazard arises in a financial market after a financial transaction has taken place, when the seller of a financial asset has an incentive to conceal information and to act in a way that may not reflect the interests of the buyer of the financial asset. As will now be seen, moral hazard has important consequences for financial structure that help to explain puzzles 1-5 and 7-8.
Puzzle 1 concerns why businesses do not make more extensive use of equity (stock) issue to raise external funds. One reason inhibiting this use is a particular type of moral hazard associated with the ownership of common stock.
When a business is organized in corporate form, its owners are its common stockholders. In general, the managers of a corporation own only a small fraction of the outstanding common stock shares of the corporation. Consequently, there is a separation of ownership from control. That is, the owners of the corporation (called the principals) are not the same people as the managers of the corporation (called the agents of the owners).
Except in times of extreme duress, the common stockholders (principals) of a corporation usually do not actively manage the day-to-day operations of the corporation. Consequently, the equity stake of common stockholders makes them more comparable to lenders than to active owners, and the managers (agents) are essentially borrowers of the stockholders' equity capital.
This separation of ownership from control constitutes a special form of moral hazard, referred to in economics as a principal-agent problem. The objectives of the managers (e.g., increase salaries now) may differ from the objectives of the common stockholders (e.g., increase investment now to ensure higher profits later) to the extent that the managers are compensated through salaries rather than through bonuses tied to profit performance. In this case, the managers have an incentive to behave in ways that are not in the best interests of the common stockholders.
The day-to-day use of funds by managers tends to be hidden from public view. If the profit performance of the corporation were directly related to managerial effort, there would be no information problem because managerial effort could be discerned from profit outcomes. In general, however, corporations are subject to positive and negative shocks from external sources that make it difficult to attribute profit performance solely to managerial effort.
Consequently, common stockholders have an incentive to monitor the activities of managers to protect themselves against principal-agent problems. However, this monitoring is costly in terms of both time and resources. Indeed, as Mishkin notes in Chapter 8, economists refer to monitoring activities as costly state verification.
Moreover, when ownership of the corporation is widely dispersed, free-rider problems make it particularly difficult to carry out effective monitoring. Although owners of common stock are entitled to vote at stockholder meetings on matters of corporate management, most common stockholders of widely held corporations do not bother to attend stockholder meetings in person, or even to read the annual reports of the corporation. Instead, they count on being able to free-ride on the efforts of other stockholders who do attend these meetings and who do read these reports. Thus, the amount of information generated through monitoring of managers tends to be insufficient to eliminate principal-agent problems.
For these reasons, common stockholding is less desirable than it would be in the absence of principal-agent problems, making it harder for businesses to raise external funds through equity issue. In contrast, debt securities are structured to pay the holder a fixed amount at periodic intervals regardless of profit performance (except in the extreme case of bankrupcty). Consequently, holders of corporate debt are less vulnerable to principal-agent problems and have less frequent need to monitor the activities of managers than do common stockholders.
This moral hazard analysis helps to explain puzzle 1 with regard to common stocks -- i.e., why common stocks are not the most important source of external financing for businesses.
As with adverse selection, the persistence of principal-agent problems due to free-rider problems gives government an incentive to regulate financial markets. For example, most countries have laws that require corporations to adhere to standard accounting principles and that impose penalties for managerial fraud (e.g., embezzlement of profits).
This helps to explain puzzle 5 -- why the financial sector is among the most heavily regulated sectors of the economy.
A financial intermediary permitted by law to hold equity securities can protect itself against principal-agent problems by holding large blocks of common stock shares from individual corporations. This gives the financial intermediary both the incentive and the power to monitor managerial activities very closely, thus overcoming the free-rider problems that arise when corporate stockholding is widely dispersed.
For example, Mishkin discusses the special case of a "venture capital firm." A venture capital firm is a special type of financial intermediary that uses the pooled resources of its venture partners to provide start-up capitalization to new businesses in exchange for equity shares in these businesses. To reduce moral hazard problems, a venture capital firm usually participates in the management of these new businesses, so that their management activities can be closely monitored. Moreover, the new businesses are prevented from marketing their equity to anyone except the venture capital firm. This ensures that no other investors can free-ride on the monitoring efforts of the venture capital firm.
More generally, banks and other financial intermediaries specializing in private loans can avoid free-rider problems in the face of moral hazard. With private loans, a bank is assured that no one else can free-ride on its monitoring and enforcement efforts. Consequently, the bank has an incentive to include in its loan contracts various restrictive covenants -- i.e., provisions aimed at reducing moral hazard -- and to spend time and resources on monitoring to ensure their enforcement. The restrictive covenants generally take the following forms: (a) prohibitions against undesirable behavior by borrowers (e.g., excessive risk-taking); (b) encouragement of desirable behavior by borrowers (e.g., insurance coverage, maintenance of a minimum level of net worth, etc.); (c) collateral requirements; and (d) provision of pertinent information in the form of periodic accounting and income reports.
This analysis of how financial intermediaries effectively deal with moral hazard helps to explain puzzles 1 through 4 -- why financial intermediaries play a more important role than securities markets in channeling funds from lenders to borrowers.
It also helps to explain puzzle 7 -- the common inclusion of collateral provisions in debt contracts with financial intermediaries.
Finally, it helps to explain puzzle 8 -- why debt contracts entered into with financial intermediaries tend to be complicated legal documents containing numerous restrictive covenants.
Conflicts of InterestThis topic is addressed by Mishkin in Chapter 8 on pages 189-192, at the end of the online ppt slides for Mishkin Chapter 8, and in a separate set of online ppt slides titled The Enron Scandal and Moral Hazard.
Basic Concepts and Key Issues for Mishkin Chapter 8