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Chapter 5 An Economic Analysis of Financial Structure

Chapter 5 An Economic Analysis of Financial Structure. ⅠWhy Financial Intermediaries Exist. 1. Reduce Transaction Costs 2. Asymmetric Information: Adverse Selection And Moral Hazard. Reduce Transaction Costs (1)Economics of scale (2)Expertise.

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Chapter 5 An Economic Analysis of Financial Structure

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  1. Chapter 5 An Economic Analysis of Financial Structure

  2. ⅠWhy Financial Intermediaries Exist • 1. Reduce Transaction Costs • 2. Asymmetric Information: Adverse Selection And Moral Hazard

  3. Reduce Transaction Costs (1)Economics of scale (2)Expertise

  4. 2. Asymmetric Information: Adverse Selection and Moral Hazard • (1)How adverse selection influences financial structure • (2) How moral hazard affects the choice between debt and equity contracts.

  5. (1)how adverse selection influences financial structure • A.Introduction • adverse selection problem was put forward by George Akerlof in his famous article The Market for “Lemons” : Quality, Uncertainty And The Market Mechanism”. George A. Akerlof（1940- ）

  6. B. Lemon problem in the used car market • C. Lemon problem in the stock and bond market • Outcome: security market (bonds and stock market) will not work very well.

  7. D. How to overcome adverse selection problem • First, Private production and sale of information. • Second, government regulation. • Third, financial intermediation. • Fourth, collateral and net worth.

  8. (2)How moral hazard affects the choice between debt and equity contracts. • A. moral hazard in equity market----principal-agent problem • B. tools to help solve the principal-agent problem • First，production of information: monitoring. • Second, government regulation to increase information. • Third, financial intermediation • Fourth, debt contract

  9. C. moral hazard in debt market • D.tools to help solve moral hazard in debt contracts • first, net worth. • Second, monitoring and enforcement of restrictive covenants • Third, financial intermediation

  10. restrictive covenants • covenant of keeping the borrower from engage in the undesirable behavior of taking risky investment. • covenant of encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off • covenant of encourage the borrower to keep collateral in good condition and make sure that it stays in the possession of the borrower. • covenant of requiring a borrowing firm to provide information about its activities periodically in the form of quarterly accounting and report, making it easier for lender to monitor the firm and reduce moral hazard.

  11. Ⅱ Financial Crises and Aggregate Economic Activity • 1.financial crises • Major disruption in financial market that characterized by sharp declines in asset prices and the failures of many financial and non financial firms

  12. 2.factors causing financial crises • (1)increase in interest rates • (2)Increase in uncertainty • (3)Asset market effects on balance sheet • (4)Problem in the banking sector • (5)Government Fiscal Imbalances.

  13. Discussion • Please analyze the reason of US. Sub-prime crisis in 2008.

  14. Summary • 1. Because financial intermediaries can reduce transaction cost and lessen the problem of asymmetric of information, financial intermediaries are still the main channel of business finance funds.

  15. 2. Information asymmetry in debt and stock market lead to adverse selection and moral hazard, which influence the function of financial market. tools to help reduce the adverse selection pro belms include private production and sales of information, government regulation, financial intermediation, and collateral and net worth.

  16. 3. Moral hazard in equity contract is expressed as principal-agent problem. Tools to reduce principal-agent problem are monitoring, government regulation to increase information, and financial intermediation.

  17. 4.In debt market, moral hazard is that borrowers take on investment project riskier than lender’s willing, tools reduce moral hazard in debt market include net worth, monitoring and enforcement of restrictive covenant, and financial intermediaries.

  18. 5. Financial crises are major disruption in financial market. Financial crises occurs when there is a disruption in financial system that causes such sharp increase in adverse selection and moral hazard problems in financial markets that make markets unable to channel funds from saver to productive investor. There are four reasons cause financial crises: increase in interest rates, increase in uncertainty, asset market effects on balance sheets, and problems in the banking sector.

  19. Questions and key terms • 1.why financial market can not take the place of financial intermediation . • 2.what is adverse selection in financial market, and how to overcome it. • 3.what is moral hazard in debt and equity market, and which tools can help solve the problem.

  20. 4.which factors can induce financial crisis. • 5.key words • Asymmetric information • Moral hazard • Adverse selection • Financial crisis

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