Chapter 16 Financial System Design. 16-2 Key Topics Analyze the stockholder-lender and manager-stockholder conflicts Understand the different financial.

Chapter 16Financial System Design

16-2

Key Topics

Analyze the stockholder-lender and manager-stockholder conflicts

Understand the different financial structures that limit these conflicts

Compare and contrast the financial system design of Germany, Japan, the United Kingdom, and the United States

16-3

Financial System

Two models of financial system in industrialized nations are: Markets-oriented

United States and United Kingdom Banking-oriented

Germany and Japan

16-4

Common Elements Payments system

Processing of checks Electronic transfers

Specialized Financial Intermediaries Organizations or activities designed to perform

Specific functions within the financial system Deposit Insurance

Protecting individual depositor Central Bank

Responsible for issuing currency and implementing monetary policy

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Differences

Primarily related to how businesses obtain financing

The private ownership of business leads to two fundamental problems:

Stockholder-lender conflict Management-stockholder conflict

These problems are handled differently by the financial sectors in the various systems

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Stockholder-Lender Conflict

Adverse selection Firm owners (stockholders) have an

incentive to understate their true riskiness to obtain borrowing on a more favorable basis

Moral hazard Firms have an incentive to become riskier

after their loans are funded Magnitude of asymmetric information

Less for large companies Large amounts of publicly available

information

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Manager-Stockholder Conflict Greater with large companies Owners (stockholders) delegate the

management to professional managers (CEO)

Owners want manager to operate the firm in their best interest maximize value of the stock

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Manager-Stockholder Conflict Unfortunately, the manager may have

other objectives Minimize their own effort Maximize their salaries and perks Maximize the firm’s size to increase their

importance May give up value-maximizing projects

Want to preserve their jobs Choose excessively safe strategies rather than strategies that may involve more risk

16-9

Manager-Stockholder Conflict

Problems Difficult and costly to monitor performances Difficult to know if poor outcome is due to

poor performance or bad luck Difficult to judge and prove whether an

activity is in the best interest of the stockholders

Since there are often a large number of stockholders, there is no incentive for any owner to monitor the performance

16-10

Manager-Stockholder Conflict Less problem with Small, closely held

firms Owner is often the manager, which eliminates the

stockholder-manager conflict A significant amount of stock is held by one

investor Potential gains of monitoring the performance is much

greater than the costs Major stockholder has a great incentive to monitor the

manager’s performance The owner in a closely held firm often has the

power to control the firm’s board of directors and fire managers

16-11

Two conflicts are associated with external financing

almost all firms raise funds from outsiders in the form of debt or equity

These two conflicts are dealt with differently in a banking-oriented financial system as compared to a markets-oriented financial system

16-12

Information and System Design (Cont.)

• Conflict Resolution and Financial System Design (Cont.)

• Banking-oriented—banks actually own companies they monitor, and the stock and bond markets are relatively underdeveloped

• Markets-oriented—banks do not own companies and public bond and stock markets are prominent institutions

• Figure 16.2 summarizes how banking-oriented systems (a) and markets-oriented systems (b) solve the stockholder-lender and manager-stockholder conflicts

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FIGURE 16.2 Financial system design: conflict resolution.

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• Small Firms: Stockholder-Lender Conflict– Both systems treat small firms similarly– Small firms borrow from banks and other

monitoring-intensive financial intermediaries– Banks are specialists in information--ideally suited

to assess borrower risk before making the loan– Design loan contracts to minimize the incentive to

become riskier after the loan is made

• Small firms: Manager-Stockholder Conflict– Not a problem in either financial system

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• Large firms: Stockholder-Lender Conflict– The two financial systems treat large firms

significantly differently– Markets-Oriented System

• Large firms tend to borrow short term in commercial paper market and borrow long term in the bond market

• Production of information about business risk is delegated to bond rating agencies

• Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky

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• Large firms: Stockholder-Lender Conflict (Cont.)– Banking-Oriented Systems

• When lender and stockholders are the same (the bank), as is often the situation, this problem does not exists

• No incentive for stockholder to exploit themselves• However, it is generally not the case that banks own all

of the firm’s equity• Nevertheless, consolidation of ownership is often large

enough that the bank owns a controlling interest

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• Large Firms: Manager-Stockholder Conflict– Banking-Oriented Systems

• Solution is driven principally by the bank’s ownership of the business

• Bank has the incentive to monitor the behavior of the firm’s management

• Bank also has control over management so it can fire an incompetent manager

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• Large Firms: Manager-Stockholder Conflict (Cont.)– Markets-Oriented Systems

• Because of diffuse ownership, little incentive for individual stockholders to monitor performance of managers

• Often the CEO will influence who is selected to serve on the board of directors, which results in ignoring the CEO’s poor performance

• Creates a distinct possibility that inefficient managers become entrenched and the firm becomes manager-controlled

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• Large Firms: Manager-Stockholder Conflict (Cont.)– Markets-Oriented Systems (Cont.)

• Often this situation is resolved through a corporate takeover and new owners replace previous managers

• Managers will actively resist such a takeover effort• Hostile takeover—attempts to takeover a company

against current management’s wishes• To minimize the conflict, management’s compensation

packages are structured to link compensation to performance desired by stockholders

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Financial System Design: Summary of Four Countries

• Germany– A strong banking-oriented financial system– Hausbank

• A single bank that is the primary source of external financing, both debt and equity

• The relationship between a business firm and their Hausbank is a very powerful one

• This relationship fosters bank participation in the strategic activities of the firm through stock ownership and control, and sitting on company supervisory boards

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Financial System Design: Summary of Four Countries (Cont.)

• Germany (Cont.)– Hausbank (Cont.)

• Bank ownership participation is both direct and indirect

– Direct—bank owns a large share of the stock– Indirect—individuals and institutions deposit stock

holdings in a trust account with a bank and voting rights are conveyed to the bank

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• Germany (Cont.)– Organization of the banking system

•Commercial banks– Comprised of three major banks and a number of

regional and private banks– Active participants in the international markets

•Savings banks– Typically owned by regional or town government

which operate locally– Initially organized as mortgage lenders but now

offer full commercial banking services

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• Germany (Cont.)– Organization of the banking system

(Cont.)•Cooperative banks

– First established to collect savings and extend credit to individuals

•Specialized banks– Mortgage, consumer lending, small business loan

guarantees, export financing, and industry-specific financing

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• Germany (Cont.)– Dominance of banks in Germany comes at

the expense of the securities markets• Stock, bond, and commercial paper markets are

not very important• Eight regional stock exchanges, dominated by

the Frankfurt exchange• Less than a quarter of the largest German

companies are listed, and a large proportion are not actively traded

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• Germany (Cont.)• Corporate bond and commercial paper market

is very small, largely due to taxes and regulations prior to 1992 making it very expensive to issue these securities

•Therefore, most German companies are highly dependent on their banks for credit

16-26


• Germany (Cont.)– Dominance of banking system is aided by

regulations that permits universal banking• Can engage in a variety of financial service activities• Permitted to own nonfinancial companies and underwrite

corporate securities and insurance• Those who advocate giving U.S. banks full underwriting

privileges cite German universal banking as model of success

• However, this success might be a result of a poorly developed stock and bond market which is not the case in the United States

16-27


• Japan– Keiretsu form of industrial organization

• A group of companies that are controlled through interlocking ownership—companies own stock in each other

• Encourages strong loyalty among the companies, including favoritism in customer-supplier relationships

• Each keiretsu has a main bank that typically owns stock in other members of the keiretsu

16-28


• Japan (Cont.)– Japanese banks may own equity in nonfinancial

companies, although this is now limited to 5 percent in any single firm

– Organization of the banking system• City banks—represent a disproportionately large

fraction of the world’s biggest banks • Regional banks• Special-purpose financial institutions—include long-

term credit banks, specialized small business and industrial institutions

16-29


• Japan (Cont.)– Historically corporate debt markets have been

suppressed, further enhancing power of banks – The result is a vast majority of debt financing

that comes from the banking system– Unlike Germany, stock market is quite large,

however extensive cross ownership masks high degree of concentration of ownership

– Adopted laws that separate commercial banking from investment banking, however, this separation has been eroded

16-30


• United Kingdom– Financial system is very much markets-oriented,

although banks play a very important role– London serves as both a domestic financial

center as well as the center of the Eurobond market

– Regulatory environment encourages foreign participation and competition in financial markets

16-31


• United Kingdom (Cont.)– Organization of the banking system

• Clearing banks—universal banks, securities activities through subsidiaries, extensive branch networks

• Merchant banks—provide wholesale banking services to large corporations

• “other” British banks—consisting of institutions similar to merchant banks and specialized banks

• “other” deposit-taking institutions—mostly building societies which are similar to savings and loan associations in U.S.

16-32


• United Kingdom (Cont.)– Banks in the United Kingdom generally do not

own nonfinancial corporations• While not explicitly prohibited, this practice is

discourage by The Bank of England to promote a safer banking system

– The Bank of England supervises banks on an informal basis, relying on the English tradition—“Old boy network” and applying moral suasion to influence the banking system

16-33


• United States– Financial system in the United States has been

extensively examined in Chapters 11-15– Very large stock, bond, and commercial paper

markets--model of the markets-oriented system– Securitization of residential mortgages and other

financial assets has further strengthened the traded securities markets

– Banks play a key role in external financing for small and midsize companies, not for large firms

16-34

Financial System Design and Conflict Resolution

• Measure differences between banking-oriented and markets-oriented systems– Figure 16.3 shows the size of the banking market

and stock market in each of the four countries– Banking dominates in Germany and Japan, while

financial markets dominate in the U.K. and U.S.– Large degree of ownership by banks in banking-

oriented system, much less in markets-oriented– Quantitative evidence strongly supports labeling

Germany and Japan as banking-oriented and the U.S. and U.K. as markets-oriented

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FIGURE 16.3 Size of banking and stock markets (percentage of GDP), 2007.

16-36

Financial System Design and Conflict Resolution (Cont.)

• Conflict Resolution in the Big Four– How is financial distress managed within the

two major orientations of the financial system– When a company is in financial distress it cannot

meet its financial obligations• For markets-oriented system, during these periods,

stockholder-bondholder (lender) conflict is extreme since owners have very little stake left in their firm and cannot agree on a strategy short of bankruptcy

• In banking-oriented systems it is easier for company to deal with conflict under protective wing of its main bank.

16-37


• Conflict Resolution in the Big Four (Cont.)– Dealing with manager-stockholder conflict varies

between the two systems• Concentration of ownership in the banking-oriented system

gives banks a major incentive to monitor corporate management

• Due to diffusion of concentration in the markets-oriented system, little incentive for the individual stockholder to monitor performance

• Predictably, there is a much larger volume of mergers and acquisitions under the markets-oriented system

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• And the Winner is. . .– Each system has advantages and disadvantages– A few conclusions:

• Banks with substantial ownership are better at solving the stockholder-lender or management-stockholder conflict than rating agencies or individual stockholders

• This requires intensive monitoring which is expensive• Stocks and bonds issued by firms in banking-oriented

systems are much less liquid because of poorly developed markets

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A few conclusions: This raises the cost of raising capital in Germany

and Japan Therefore, there is a trade-off between the

two systems

Financial innovations and developments in all four countries suggest that there might be a good compromise between extremes of the two systems

16-40

Financial System Design for Eastern Europe and other Emerging Economics

• An initial development in these countries was to develop privatization programs which transforms government-owned companies into privately owned firms

• Typically involve distribution of shares to major stockholders (employees, managers, and creditors)

• Privatization initially focused on small and midsize companies

16-41

Financial System Design for Eastern Europe and other Emerging Economics

• Privatization must occur with developments of new securities markets—primarily equity markets

• However, it is likely a banking-oriented system may make more sense for these formerly planned economies that are accustomed to strict governmental control

16-42

Eastern Europe and other Emerging Economics

• At present, Eastern Europe can be regarded as an information-poor environment, with little public information about large firms– Rating agencies do not exist– Reputation building is extremely difficult– Lack of managerial talent and experience

suggests that monitoring will be especially critical• All these factors indicate that a

banking-oriented system may be more suitable

Chapter 16 Financial System Design. 16-2 Key Topics Analyze the stockholder-lender and manager-stockholder conflicts Understand the different financial.

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