Chapter Overview: The Puzzle of Financial Structure
The goal of this chapter is to explain why our financial system is structured the way it is. It uses
Agency Theory (the analysis of asymmetric information) to solve eight "puzzles" that
characterize financial markets worldwide.
I. The Eight Puzzles of Financial Structure
Data from major economies reveal eight facts that seem counterintuitive:
1. Stocks are not the primary source of external finance: They provide a small fraction
of business funding (e.g., ~9% in the U.S.).
2. Marketable securities are not the main way to finance: Bonds and stocks combined
provide less than half of external corporate funds.
3. Indirect finance is more important than direct finance: Borrowing through
intermediaries is far more common than selling securities directly to households.
4. Banks are the most important source of external funds: They provide significantly
more capital than stock markets.
5. Heavily Regulated: The financial system is among the most regulated sectors of the
economy.
6. Limited Access: Only large, well-established corporations have easy access to securities
markets.
7. Prevalence of Collateral: Most debt contracts for households and businesses require
property pledges.
8. Complicated Contracts: Debt contracts are complex legal documents with many
behavioral restrictions.
II. Topic 1: Transaction Costs
Transaction costs (time and money spent on transactions) can prevent small savers from
investing directly.
The Problem: Small investors lack the funds to diversify or pay high brokerage fees and
legal costs for individual loan contracts.
The Solution (Financial Intermediaries):
o Economies of Scale: By bundling funds, intermediaries reduce costs per dollar
(e.g., mutual funds).
o Expertise: They develop specialized skills (e.g., in computer technology or legal
drafting) to provide low-cost liquidity services like checking accounts.
III. Topic 2: Asymmetric Information (The Core Framework)
Asymmetric information occurs when one party has less info than the other. This leads to two
major problems:
1. Adverse Selection (The "Lemons Problem")
Timing: Occurs before the transaction.
Mechanism: Potential bad credit risks seek loans most actively. If lenders can't
distinguish "good" from "bad" firms, they only pay an "average" price. Good firms then
exit the market because their securities are undervalued, leaving only "lemons".
Solutions and Explanations:
o Private Production of Info: Companies like Moody's sell info, but the Free-
Rider Problem (people using info without paying) limits its effectiveness.
o Government Regulation: The SEC requires disclosure of information to reduce
the problem.
o Intermediation: Banks make private, non-traded loans to avoid the free-rider
problem, explaining why indirect finance dominates.
o Collateral and Net Worth: High net worth reduces the consequences of a bad
choice for the lender.
2. Moral Hazard
Timing: Occurs after the transaction.
Equity Markets (Principal-Agent Problem): Managers (agents) may act in their own
interest instead of the owners' (principals), such as by spending on "empire building"
rather than profits.
Debt Markets: Borrowers have incentives to take on riskier projects than agreed upon
because they keep all profits above the fixed debt payment.
Solutions:
o Monitoring (Costly State Verification): Auditing firms, but this is expensive.
o Venture Capital: Firms provide funds in exchange for a board seat to monitor
closely.
o Debt Contracts: Since debt only requires fixed payments, lenders don't need to
monitor as much as equity holders, unless there is a default. This explains why
debt is used more than equity.
o Restrictive Covenants: Legal provisions that mandate or forbid specific actions
(e.g., requiring insurance or forbidding risky acquisitions).
IV. Financial Development and Economic Growth
Poorly developed financial systems (financial repression) often lead to low growth rates in
developing countries.
Legal Systems: Poor bankruptcy procedures make it hard to use collateral or enforce
covenants, worsening adverse selection and moral hazard.
Government Intervention: Nationalizing banks or directing credit to favored sectors
(rather than productive ones) reduces economic efficiency.
V. Financial Crises: Factors and Sequence
A financial crisis is a major disruption characterized by sharp asset price declines and firm
failures.
Trigger Factors:
1. Increased Interest Rates: Attracts riskier borrowers (adverse selection).
2. Increased Uncertainty: Harder for lenders to screen borrowers after major firm failures
or market crashes.
3. Asset Market Declines: Lower corporate net worth reduces collateral value and
increases moral hazard.
4. Banking Sector Problems: Deteriorating bank balance sheets lead to a contraction in
lending and potential bank panics.
5. Government Fiscal Imbalances: In emerging markets, fears of default can spark foreign
exchange crises.