Financial StructureECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Fall 2018

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Readings

I Text:I Mishkin Ch. 8

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Financial Structure

I Firms all have balance sheets – they finance assets with somemix of equity and debt (liabilities)

I Non-financial firms: these assets are real assets (capital)I Financial firms: these assets are financial assets (contractual

claims)

I How do non-financial firms finance their assets? Does itmatter? Why does it matter?

I A couple of useful distinctions:I External vs. internal: raise funds externally or use retained

earningsI Equity vs. debt: promised share of cash flows from assets

(equity) or promised fixed payments (debt)I Direct vs. indirect: raise funds directly from lender/equity

investor or indirectly through financial intermediary

I Modigliani-Miller: firm financial structure is irrelevant, butassumptions underlying this don’t seem particularly realistic

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How Do Businesses Finance Their Activities?

I A significant fraction of business investment comes fromexternal funds

I Two sources of external funds:

1. Direct: get funds directly from a lender or equity investor2. Indirect: get funds indirectly from a financial intermediary (e.g.

a bank)

I Indirect finance is mostly comprised of debt contracts,whereas direct finance could either be debt (e.g. issuecorporate bonds) or equity (e.g. issue new stock)

I Fact: indirect finance is more important than direct finance,particularly for all but the very largest firms, and bank loans(use of financial intermediary) are really important

I This is why financial structure is relevant for monetary policy– so much depends on banking

I Financial intermediation is process by which funds get routedfrom savers to non-financial firms

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Sources of External Funding

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Why is Financial Intermediation so Important?

I Chiefly for two reasons:

1. Transactions costs2. Informational asymmetries

I Transaction costs: cheaper to finance projects on a largescale, which means it is efficient to pool lots of smallresources and have an intermediary invest it rather than eachsmall saver doing the investment directly

I We will focus mostly on informational asymmetries

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Asymmetric Information

I Asymmetric information generally refers to a situation inwhich different parties to a transaction are not equallyinformed about characteristics or actions of the other partiesto the transaction

I Two main kinds of asymmetric information:

1. Adverse Selection: information asymmetry which occurs beforea transaction takes place

2. Moral Hazard: information asymmetry which occurs after atransaction takes place

I Both types of asymmetric information can help us understandthe kind of financial structure we observe in the real world –in particular, why indirect finance is so important (and hencewhy financial intermediation is important)

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Adverse Selection

I The buyer of a product (e.g. a car, a stock) doesn’t know thetrue “type” of the seller of the product (e.g. good or bad,risky or safe)

I Only knows the average type of the seller

I Hence, buyer will only be willing to pay the average valuation,which is more than the bad type but less than the good type

I This tends to drive sellers who are a good type away andattract sellers who are a bad type

I But then buyer knows this, and entire market can fall apart

I Easy to understand through an example – “lemons” in themarket for used cars

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Lemons Example

I After Ackerlof (1970)

I Suppose there are two types of used cars: lemons (bad) andpeaches (good)

I Sellers know whether they have a lemon or a peach, butbuyers only know the fraction of lemons and peaches out there

I Suppose each type has the following valuations:

Valuation Peach Lemon

Buyer $20,000 $15,000Seller $18,000 $13,000

I Without informational asymmetry, both kinds of cars wouldbe sold – buyers value each type more than sellers

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Asymmetric Information

I Suppose buyer doesn’t know whether she is meeting a seller ofa peach or a lemon

I She only knows there is a 50 percent chance it’s a peach, and50 percent chance it’s a lemon

I The average valuation for the buyer is $17,500, which is themaximum she will pay for a car

I But since this is less than a peach owner’s valuation, peacheswill not be sold

I But then the buyer will know only lemons are on the market

I Only lemons will sell for a price between $13,000 and $15,000

I The “good” cars get driven out of the market by the presenceof bad cars – inefficient!

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Alternative Example

I Suppose valuations are now:

Valuation Peach Lemon

Buyer $20,000 $12,000Seller $18,000 $13,000

I Buyer values lemons less than seller. With symmetricinformation, only peaches would be sold

I Suppose probabilities of peaches and lemons are same asabove. Average valuation from buyer’s perspective is now is$16,000

I Since this is less than seller’s valuation, peaches will not besold

I But then buyer knows she can only buy a lemon, but doesn’twant a lemon

I End result: market breaks down and no cars are sold

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Dealing with the Lemons Problem in the Used Car Market

I Most used car deals are through dealerships, notperson-to-person transactions

I Sort of easy to understand why

I The dealership serves as an intermediary and helps solve theinformational problem

I The dealership gets good at determining lemons vs. peaches,and can offer warranties to buyers to ensure that the buyerisn’t dealing with a lemon

I Hence, intermediaries who specialize in resolving informationalasymmetry problem naturally arise in the car market

I Similarly in financial markets

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Lemons Problem and Indirect Finance

I Lemons problem helps us understand why direct finance is notthat important for external funds

I The firms who most want funds are probably those who arethe worst type

I But savers know this

I And hence will not buy stock or debt directly from firms

I Financial intermediaries (e.g. banks) can step in

I These financial intermediaries can become experts in learningabout firms and can therefore alleviate the informationalasymmetry problems

I Because these financial intermediaries make private loans theycan avoid the free rider problem that arises when third partyfirms try to produce information about firms

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Example: Risky and Safe Firms

I There are two types of firms who need 1 unit to undertake aproject

I Project succeeds or fails with a given probability

I Firm types and payoffs are:

Safe Firm Risky Firm

Payoff in “good” state 4 8Payoff in “bad” state 0 0

Prob. of “good” state 12

14

I Expected return the same for both firms, but lender wouldprefer to loan to safe firm since it is less risky

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One Kind of Debt Contract

I Suppose there is only one kind of debt contract: bank lendsfirm one unit, firm promises to repay R (gross) units if projectsucceeds, 0 otherwise (it can’t pay back in event low stateoccurs)

I Borrower only has to pay back in event good statematerializes. Borrower expected payoffs are:

Safe =1

2(4 − R)

Risky =1

4(8 − R)

I Borrower will only take a loan if his/her expected payout isnon-negative

I Hence, if R > 4, safe firms won’t take loan

I If R > 8, neither firm will take loan

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Expected Payoffs for Borrower

Borrower Expected Profit

𝑅𝑅

2

4 8

Safe firm

Risky firm 1

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Lender Problem

I Lender’s opportunity cost of funds is 1 – if it doesn’t earn atleast 1 in expectation, it won’t make a loan

I If lender charges R > 8, it will make no loan and hence“earns” 1 (i.e. keeps its money)

I If it charges R ≤ 4, both types of firms will take the loan

I If it charges R > 4, only the risky type firm will take the loan

I Suppose fraction q of firms are risky, and 1 − q are safe.Lender expected payout:

R ≤ 4 E (payout) = (1 − q)1

2R︸︷︷︸

Safe

+q1

4R︸︷︷︸

Risky

4 < R ≤ 8 E (payout) =1

4R

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Pooling vs. Separating Equilibrium

I A pooling equilibrium is a value of R (i.e. a debt contract) inwhich both types of firms take a loan

I A separating equilibrium is a value of R in which only onetype of firm gets a loan, and the other type of firm chooses tosit out

I Let’s first look for a pooling equilibrium to see if one exists(i.e. focus on R ≤ 4). Can write lender’s expected payout as:

E (payout) =

(1

2− 1

4q

)R

I Suppose q = 0.9, so most firms are risky. Expected payoutmust be at least 1. Solve for the “break-even” R:

R ≥ 3.6364

I So 3.6364 ≤ R ≤ 4 would be a pooling equilibrium, whereas4 < R ≤ 8 would be a separating equilibrium.

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Lender Expected Payoffs

Lender Expected Profit

𝑅𝑅 4 8

1.1

1.0

3.64

0.2750 × 𝑅𝑅

0.25 × 𝑅𝑅

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Equilibrium

I A pooling equilibrium exists for 3.64 ≤ R ≤ 4

I A separating equilibrium exists for 4 < R ≤ 8

I Don’t know which equilibria we’ll end up at

I But if it’s separating equilibrium, safe firm doesn’t get a loan,which is a bad outcome relative to symmetric information case

I If it’s pooling equilibrium, interest rate charged to safe firmmay be “too high” relative to symmetric information case andinterest rate charged to risky firm is “too low”

I This will tend to over-attract risky firms and deter safe firmsfrom getting loans

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Adverse Selection and Collateral

I Collateral is an important feature of many debt contracts

I A firm receiving funds pledges some collateral that can beseized in the event that the firm defaults

I Banks can offer different kinds of contracts – some requireposting more collateral and some require less collateral butcharge higher interest rates

I This offering different kinds of contracts can get firms tovoluntarily reveal their type

I We see exactly same thing in mortgage finance – the moreyou put down (more collateral), the better the terms on theloan typically

I So collateral can be a useful way for financial contracts todeal with information asymmetry. When collateral loses value(“bubble bursting”) this can exacerbate informationasymmetry problems

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Loan Contracts with Collateral

I Suppose the lender requires borrower to post collateral, C ,which borrower has to pay in event project fails

I Then borrower expected payouts are:

Safe =1

2(4 − R)− 1

2C

Risky =1

4(8 − R)− 3

4C

I Observe that R “hurts” the safe firm more, and C “hurts” therisky firm more

I Suppose that the lender posts two contracts, one with(R,C = 0) and the other (RC ,C > 0). The idea is to get thesafe firm to post collateral and thereby reveal itself

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Requirements

I Suppose that, if lender seizes collateral, a fraction d goes bad,so lender only recovers (1 − d)C . Think of this as a“bankruptcy cost”

I For this to work, we must have the following hold:

1. Risky firm prefers no collateral contract2. Safe firm prefers posting collateral3. Lender breaks even (or better) on both contracts

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Risky Firm Prefers No Collateral

I This requires that:

1

4(8 − RC )−

3

4C ≤ 1

4(8 − R)

I This requires:R − RC ≤ 3C

I We can see:

1. R > RC (you get a lower interest rate if you post collateral)2. Collateral must be sufficiently big to induce risky firm to take

a higher interest rate

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Safe Firm Prefers Posting Collateral

I This requires that:

1

2(4 − R) ≤ 1

2(4 − RC )−

1

2C

I Which works out to:

R − RC ≥ C

I We can see:

1. R > RC again2. Collateral can’t be too big, otherwise safe firm won’t post it

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Lender Must at Least Break Even on Both Contracts

I This requires:

1

4R ≥ 1

1

2RC +

1

2(1 − d)C ≥ 1

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All Conditions

I All together, we have:

R − RC ≤ 3C

R − RC ≥ C

R ≥ 4

RC + (1 − d)C ≥ 2

I Will be multiple solutions. One possibility: lender just breakseven on both contracts and risky firm is indifferent betweencontracts (weakly prefers the no-collateral contract)

I Suppose d = 14

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Lender Just Breaks Even

I Would mean: R = 4 and RC + 34C = 2 which means:

3C = 8 − 4RC

I Risky firm just breaks even:

4 − RC = 3C

= 8 − 4RC

I Implies RC = 43 and C = 8

9

I The firms voluntarily separate

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Collateral, Adverse Selection, and Business Cycles:Financial Accelerator

I Posting of collateral allows safe firms to reveal their type.Allows them to get loans (depending on market structure) andresults in more efficient allocation

I Since collateral consists of assets, asset price fluctuations canaffect ability of firms to get loans

I Financial accelerator:1. Decline in economic activity (e.g. a recession) causes assets to

lose value2. Declining asset values makes it harder for firms to post

collateral3. Inability to post collateral exacerbates adverse selection

problem, resulting in less investment and/or a worse allocationof investment between safe and risky firms

4. Less investment causes more declines in economic activity, andfurther falls in collateral values

5. An adverse feedback loop!

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Moral Hazard

I Moral hazard: information asymmetry which occurs after atransaction takes place

I For example, someone lends you money, but then can’tperfectly monitor what you do with the money

I Because of limited liability, you have an incentive to “gamble”with someone else’s money

I In other words, moral hazard can encourage excessive risktaking once a loan has been made

I Can be applied to insurance markets too – once you haveinsurance, you have less incentive to behave safely

I But insurer will know that, and may not sell you insurance infirst place

I Just like adverse selection, markets can break down

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Moral Hazard and Financial Structure

I Moral hazard can also help us understand why indirect financeis more important than direct finance

I Intermediaries (e.g. banks) become experts in monitoring thebehavior of borrowers in a way that wouldn’t be possible withdirect finance: leads to less “gambling” and explains why loancontracts often include covenants restricting behavior

I Also helps make sense of preference of debt over equity

I With equity, lender needs to monitor profits all the time (sinceequity owner is due his/her share of profits)

I With debt, since payments are fixed, only need to monitorbehavior of firm in event of default

I So lower monitoring costs (what is called “costly stateverification”) with debt over equity

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Moral Hazard and Collateral

I Collateral also plays a role in mitigating moral hazard

I Requiring firms to post collateral gives them some “skin in thegame” and encourages good behavior

I Without collateral, lenders may be reluctant to lend becausethey can’t perfectly control what borrowers do

I Similarly to adverse selection, this importance of collateral cangive rise to a financial accelerator mechanism

I If assets decline in value, harder to post collateral, harder forfirms to get loans

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Economic Development and Financial Structure

I Developing countries often have poorly developed legalsystems and ill-defined property rights

I This makes it difficult for collateral to serve the role it does indeveloped economies like the US

I It is also more difficult for lenders to monitor the behavior ofborrowers

I As a result, the financial system is underdeveloped

I This makes it difficult to funnel savings to investments(particularly the most profitable investments), which results inweak economic growth

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Relevance for Monetary Policy

I Financial intermediation (indirect finance) is much moreimportant than direct finance for external funding for firms

I Asymmetric information (adverse selection and moral hazard)can help explain this phenomenon

I Asymmetric information also affords an important role tocollateral in indirect finance

I Possibility of financial accelerator mechanismI Relevance for Monetary Policy:

1. Banking system (over which central banks have some control)really important for functioning of economy

2. Fluctuating asset prices (e.g. bubbles) can impact ability ofbanking system to funnel savings into productive investments

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