Chapter 16 Financial System Design. 16-2 Key Topics Stockholder-lender and Manager- stockholder conflicts Different financial structures that limit.

Chapter 16

Financial System Design

16-2

Key Topics

Stockholder-lender and Manager-stockholder conflicts

Different financial structures that limit these conflicts

Compare and contrast the financial system design of Germany, Japan, the UK, and the US

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

16-5

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

16-6

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

16-7

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

16-8

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

Conflict Resolution and Financial System Design

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

16-13

Information and System Design

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

16-14

Information and System Design

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

16-15

Information and System Design

Large firms: Stockholder-Lender Conflict 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

16-16

Information and System Design

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

16-17

Information and System Design

Large Firms: Manager-Stockholder Conflict 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

16-18

Information and System Design

Large Firms: Manager-Stockholder Conflict Markets-Oriented Systems

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

16-19

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

16-20

Financial System Design: Summary of Four Countries

Hausbank 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

16-21

Financial System Design: Summary of Four Countries

Germany 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

16-22

Financial System Design: Summary of Four Countries

Germany Organization of the banking system

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

16-23

Financial System Design: Summary of Four Countries

Germany 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

16-24

Financial System Design: Summary of Four Countries

Germany 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

16-25

Financial System Design: Summary of Four Countries

Germany 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

16-26

Financial System Design: Summary of Four Countries

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

16-27

Financial System Design: Summary of Four Countries

Japan 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

16-28

Financial System Design: Summary of Four Countries

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

16-29

Financial System Design: Summary of Four Countries

United Kingdom 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.

16-30

Financial System Design: Summary of Four Countries

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