Chapter 8Chapter 8

An Economic Analysis of An Economic Analysis of Financial StructureFinancial Structure

Dr. Mohammed AlwosabiDr. Mohammed Alwosabi

One of the main requirements for a healthy One of the main requirements for a healthy economy is an efficient financial system that economy is an efficient financial system that channel funds from savers to investors.channel funds from savers to investors.

This chapter provides an economic analysis of This chapter provides an economic analysis of how financial structure is designed to promote how financial structure is designed to promote economic efficiency.economic efficiency.

BASIC FACTS ABOUT FINANCIAL STRUCTURE:BASIC FACTS ABOUT FINANCIAL STRUCTURE:

1.1. Stocks are not the most important source of Stocks are not the most important source of external financing for businesses.external financing for businesses.

2.2. Issuing marketable debt and equity securities Issuing marketable debt and equity securities is not the primary way in which businesses is not the primary way in which businesses finance their operations.finance their operations.

3.3. Indirect finance, which involves the activities of Indirect finance, which involves the activities of financial intermediaries, is many times more financial intermediaries, is many times more important than direct finance, in which important than direct finance, in which businesses raise funds directly from lenders in businesses raise funds directly from lenders in financial markets.financial markets.

4.4. Financial intermediaries, particularly banks, are Financial intermediaries, particularly banks, are the most important source of external funds the most important source of external funds used to finance businesses.used to finance businesses.

5.5. The financial system is among the most The financial system is among the most heavily regulated sectors of the economy.heavily regulated sectors of the economy.

6.6. Only large, well-established corporations have Only large, well-established corporations have easy access to securities market to finance easy access to securities market to finance their activities.their activities.

7.7. Collateral is a prevalent feature of debt Collateral is a prevalent feature of debt contracts for both households and contracts for both households and businesses.businesses.

8.8. Debt contracts typically are extremely Debt contracts typically are extremely complicated legal documents that place complicated legal documents that place substantial restrictions on the behavior of the substantial restrictions on the behavior of the borrower.borrower.

TRANSACTION COSTSTRANSACTION COSTS Transaction costsTransaction costs are a major problem in are a major problem in

financial markets. financial markets. Transaction costs are too high for ordinary Transaction costs are too high for ordinary

people.people. Financial intermediaries help in reducing Financial intermediaries help in reducing

transaction costs and allow small savers and transaction costs and allow small savers and borrowers to benefit from the existence of borrowers to benefit from the existence of financial markets.financial markets.

One solution to the problem of high transaction One solution to the problem of high transaction costs is to package the funds of many investors costs is to package the funds of many investors together so that they can take advantage of together so that they can take advantage of economies of scale.economies of scale.

Economies of scaleEconomies of scale refer to the reduction in refer to the reduction in transaction costs per unit of the amount transaction costs per unit of the amount invested as the size (scale) of transaction invested as the size (scale) of transaction increases. increases.

The presence of economies of scale in financial The presence of economies of scale in financial markets helps explain why financial markets helps explain why financial intermediaries developed and have become intermediaries developed and have become such an important part of financial structure.such an important part of financial structure.

An additional benefit of the presence of An additional benefit of the presence of economies of scale in an investment means that economies of scale in an investment means that the investment is large enough to purchase a the investment is large enough to purchase a widely diversified portfolio of securities. widely diversified portfolio of securities.

The increased The increased diversificationdiversification for individual for individual investors reduces their risk, making them better investors reduces their risk, making them better off.off.

Financial intermediaries are also better able to Financial intermediaries are also better able to develop develop expertiseexpertise to lower transaction costs. to lower transaction costs.

Another important outcome of a financial Another important outcome of a financial intermediary’s low transaction costs is the intermediary’s low transaction costs is the ability to provide its customers with ability to provide its customers with liquidity liquidity servicesservices that make it easier to conduct that make it easier to conduct transactions.transactions.

ASYMMETRIC INFORMATION: ADVERSE ASYMMETRIC INFORMATION: ADVERSE SELECTION AND MORAL HAZARDSELECTION AND MORAL HAZARD

Asymmetric informationAsymmetric information is a situation that is a situation that arises when one party’s insufficient knowledge arises when one party’s insufficient knowledge about the other party involved in a transaction about the other party involved in a transaction makes it impossible to make accurate decision makes it impossible to make accurate decision when conducting the transaction.when conducting the transaction.

The analysis of how asymmetric information The analysis of how asymmetric information problems affect economic behavior is called problems affect economic behavior is called

agency theoryagency theory.. The presence of asymmetric information leads The presence of asymmetric information leads

to to adverse selectionadverse selection and and moral hazardmoral hazard problemsproblems..

How Adverse Selection Influences Financial How Adverse Selection Influences Financial StructureStructure

Because of asymmetric information problem of Because of asymmetric information problem of adverse selectionadverse selection the potential buyer of stocks the potential buyer of stocks or bonds can’t distinguish between good firms or bonds can’t distinguish between good firms with high expected profits and low risk and with high expected profits and low risk and bad firms with low expected profits and high bad firms with low expected profits and high risk. risk.

In this situation, in In this situation, in equity marketequity market,, The potential buyer will be willing to pay only a The potential buyer will be willing to pay only a

price that reflects the average quality of firms price that reflects the average quality of firms issuing securities– a price that lies between issuing securities– a price that lies between the value of securities from bad firms and the the value of securities from bad firms and the value of those from good firms.value of those from good firms.

If the owners or managers of a good firm have If the owners or managers of a good firm have better information that they are sure they have better information that they are sure they have a good firm they will not accept the a good firm they will not accept the undervalued price that is offered by the undervalued price that is offered by the potential buyer.potential buyer.

The only firms willing to sell at the price The only firms willing to sell at the price offered will be bad firms because the price offered will be bad firms because the price offered is higher than the securities are worth.offered is higher than the securities are worth.

But the potential buyer is not sure of the But the potential buyer is not sure of the securities and, hence, he will decide not to securities and, hence, he will decide not to spend that much money on securities.spend that much money on securities.

Therefore, this securities market will not work Therefore, this securities market will not work very well because few firms will sell securities very well because few firms will sell securities in it to raise capital. in it to raise capital.

The analysis is similar if the potential buyer The analysis is similar if the potential buyer considers purchasing a corporate debt considers purchasing a corporate debt instrument in the instrument in the bond marketbond market..

The potential buyer will purchase a bond only if The potential buyer will purchase a bond only if its interest rate is high enough to compensate its interest rate is high enough to compensate him for the average default risk of the good and him for the average default risk of the good and bad firms willing to sell the debt.bad firms willing to sell the debt.

The owners of the good firm have more The owners of the good firm have more information than the potential buyer that their information than the potential buyer that their firm is going to pay higher interest rate than firm is going to pay higher interest rate than the buyer is expecting and hence they are the buyer is expecting and hence they are unlikely willing to borrow in this market.unlikely willing to borrow in this market.

3.3. Only the bad firms will be ready to borrow but Only the bad firms will be ready to borrow but the potential buyer is not willing to buy bonds the potential buyer is not willing to buy bonds issued by them.issued by them.

4.4. Again, few bonds are likely to be sold in this Again, few bonds are likely to be sold in this market, so it will not be a good source of market, so it will not be a good source of financing.financing.

The analysis discussed above explains why The analysis discussed above explains why marketable securities are not the primary source marketable securities are not the primary source of financing (fact 2). It also partly explains why of financing (fact 2). It also partly explains why stocks are not the most important source of stocks are not the most important source of financing (fact 1). financing (fact 1).

The presence of adverse selection problem The presence of adverse selection problem keeps securities markets from being effective in keeps securities markets from being effective in challenging funds from savers to borrowerschallenging funds from savers to borrowers

Tools to help Reduce Adverse Selection ProblemsTools to help Reduce Adverse Selection Problems In the absence of asymmetric information, the In the absence of asymmetric information, the

adverse selection problem goes away. If the adverse selection problem goes away. If the buyers know as much information as the sellers, buyers know as much information as the sellers, so that they can distinguish good firms from so that they can distinguish good firms from bad firms, buyers will be willing to pay full value bad firms, buyers will be willing to pay full value for securities issued by good firms, and good for securities issued by good firms, and good firms will sell their securities in the market. The firms will sell their securities in the market. The securities market will then be able to move securities market will then be able to move funds to the good firms that have the most funds to the good firms that have the most productive opportunities.productive opportunities.

((1) Production and Sale of Information1) Production and Sale of Information The solution to adverse selection problem in The solution to adverse selection problem in

financial markets is to eliminate asymmetric financial markets is to eliminate asymmetric information by furnishing the people supplying information by furnishing the people supplying funds with full details about the individuals or funds with full details about the individuals or firms seeking to finance their investment firms seeking to finance their investment activities.activities.

One way to provide information to savers-One way to provide information to savers-lenders is through lenders is through establishing private establishing private companies specialized in collecting and companies specialized in collecting and producing informationproducing information that distinguishes good that distinguishes good from bad firms and then sell this information to from bad firms and then sell this information to those who are interested in acquiring them. those who are interested in acquiring them. These firms such as Standard and Poor’s gather These firms such as Standard and Poor’s gather information of firms’ balance sheet positions information of firms’ balance sheet positions and investment activities and then sell them to and investment activities and then sell them to subscribers.subscribers.

However, the system of private production and However, the system of private production and sale of information does not completely solve sale of information does not completely solve the adverse selection problem in securities the adverse selection problem in securities market because of the free-rider problem.market because of the free-rider problem.

The The free-rider problemfree-rider problem occurs when people who occurs when people who do not pay for information take advantage of the do not pay for information take advantage of the information that other people have paid for.information that other people have paid for.

Free-riders watch the investors who have Free-riders watch the investors who have bought the information to make better decision bought the information to make better decision in purchasing the securities of good firms that in purchasing the securities of good firms that are undervalued, and then he buys the same are undervalued, and then he buys the same securities that investors who paid for securities that investors who paid for information bought. information bought.

If many free-riders act in the same way, the If many free-riders act in the same way, the increased demand for the undervalued good increased demand for the undervalued good securities will lead to an increase in the prices securities will lead to an increase in the prices of these good firms’ securities.of these good firms’ securities.

Because of free-riders, investors who paid for Because of free-riders, investors who paid for information will not have any advantage from information will not have any advantage from purchasing the information and they wish they purchasing the information and they wish they should never paid for this information in the first should never paid for this information in the first place.place.

If many investors face the same problem and If many investors face the same problem and react in the same way, firms selling information react in the same way, firms selling information will realize that this information producing will realize that this information producing business is not that profitable. This means less business is not that profitable. This means less information will be produced and adverse information will be produced and adverse selection problem will prevail resulting in selection problem will prevail resulting in inefficient functioning of securities market.inefficient functioning of securities market.

Thus, the free-rider problem prevents the private Thus, the free-rider problem prevents the private market from producing enough information to market from producing enough information to eliminate all the asymmetric information that eliminate all the asymmetric information that leads to the adverse selection problem.leads to the adverse selection problem.

(2) Government Regulation to Increase (2) Government Regulation to Increase InformationInformation

To compensate the shortage of information To compensate the shortage of information production in the private market government production in the private market government intervention is necessary. intervention is necessary.

Government regulates securities markets in a Government regulates securities markets in a way that forces firm to reveal honest way that forces firm to reveal honest information about themselves so that investors information about themselves so that investors can determine how good or bad the firms are.can determine how good or bad the firms are.

Special government agencies require firms Special government agencies require firms selling their securities to have independent selling their securities to have independent audits to certify that the firm is adhering to audits to certify that the firm is adhering to standard accounting principles and disclosing standard accounting principles and disclosing accurate information about sales, assets, and accurate information about sales, assets, and earnings. earnings.

However, disclosure requirements do not However, disclosure requirements do not always work well. For example, the collapse of always work well. For example, the collapse of Enron, WorldCom and other firms illustrates that Enron, WorldCom and other firms illustrates that government regulation can lessen asymmetric government regulation can lessen asymmetric information problems of adverse selection and information problems of adverse selection and moral hazard, but cannot eliminate them.moral hazard, but cannot eliminate them.

Even when firms provide information to the Even when firms provide information to the public about their sales, assets, or earnings, public about their sales, assets, or earnings, they still have more information than they still have more information than investors:investors:

1.1. There is information related to quality that There is information related to quality that cannot be provided merely by statistics. cannot be provided merely by statistics.

2.2. Furthermore, bad firms have an incentive to Furthermore, bad firms have an incentive to make themselves look like good firms making make themselves look like good firms making it hard for investors to sort out good firms it hard for investors to sort out good firms from the bad one.from the bad one.

The adverse selection in financial markets The adverse selection in financial markets helps explain why financial markets are among helps explain why financial markets are among the most heavily regulated sectors in the the most heavily regulated sectors in the economy (fact 5).economy (fact 5).

(3) Financial Intermediation(3) Financial Intermediation As discussed above, private production of As discussed above, private production of

information and government regulation to information and government regulation to encourage provision of information lessen encourage provision of information lessen but don not eliminate the adverse but don not eliminate the adverse selection problem in financial markets.selection problem in financial markets.

Financial intermediaries help solve Financial intermediaries help solve adverse selection problems in financial adverse selection problems in financial markets markets by producing information about by producing information about firmsfirms, so that it can sort out good credit , so that it can sort out good credit risks from bad ones. Then it can acquire risks from bad ones. Then it can acquire funds from depositors and lend them to funds from depositors and lend them to the good firms, which results in high the good firms, which results in high profit for the bank.profit for the bank.

An important element in the bank’s ability to An important element in the bank’s ability to profit from the information it produces is that profit from the information it produces is that it it avoids the free-rider problem by mainly making avoids the free-rider problem by mainly making private loans rather than purchasing securities private loans rather than purchasing securities that are traded in the open marketthat are traded in the open market..

The bank’s role as an intermediary that hold The bank’s role as an intermediary that hold mostly non-traded loans is the key to its mostly non-traded loans is the key to its success in reducing asymmetric information in success in reducing asymmetric information in financial markets.financial markets.

Since financial intermediaries play a greater role Since financial intermediaries play a greater role in moving funds to firms than securities markets in moving funds to firms than securities markets do, indirect finance is so much more important do, indirect finance is so much more important than direct finance and banks are the most than direct finance and banks are the most important source of external funds for financing important source of external funds for financing businesses (facts, 3 and 4).businesses (facts, 3 and 4).

Since information about private firms is harder Since information about private firms is harder to collect in developing countries than in to collect in developing countries than in industrialized countries, there is a greater role industrialized countries, there is a greater role for banks and smaller role for securities for banks and smaller role for securities markets.markets.

The larger and more established a firm is, the The larger and more established a firm is, the more likely it will be to issue securities to raise more likely it will be to issue securities to raise funds, because investors have fewer worries funds, because investors have fewer worries about adverse selection with well-known about adverse selection with well-known corporations.corporations.

(4) Collateral and Net Worth (4) Collateral and Net Worth Collateral reduces the consequences of adverse Collateral reduces the consequences of adverse

selection because it reduces the lenders losses selection because it reduces the lenders losses in the event of a default. Lenders are more in the event of a default. Lenders are more willing to make loans secured by collateral, and willing to make loans secured by collateral, and borrowers are willing to supply collateral in borrowers are willing to supply collateral in order to get the loan and at better rate (fact 7). order to get the loan and at better rate (fact 7).

If a firm has a high net worth (equity capital) it is If a firm has a high net worth (equity capital) it is less likely to default and if it defaults the lender less likely to default and if it defaults the lender can sell its net worth to recover its loan. When can sell its net worth to recover its loan. When firm seeking credit has high net worth, adverse firm seeking credit has high net worth, adverse selection problem will not be severe and lenders selection problem will not be severe and lenders are more willing to make loans.are more willing to make loans.

HOW MORAL HAZARD AFFECTS THE CHOICE HOW MORAL HAZARD AFFECTS THE CHOICE BETWEEN DEBT AND EQUITY CONTRACTSBETWEEN DEBT AND EQUITY CONTRACTS

Moral hazard is the asymmetric information Moral hazard is the asymmetric information problem that occurs after financial transaction problem that occurs after financial transaction takes place, when the seller of a security may takes place, when the seller of a security may have incentives to hide information and engage have incentives to hide information and engage in activities that are undesirable for the in activities that are undesirable for the purchaser of the security.purchaser of the security.

Moral hazard has important consequences for Moral hazard has important consequences for whether a firm finds it easier to raise funds with whether a firm finds it easier to raise funds with debt than with equity contracts.debt than with equity contracts.

Moral Hazard in Equity Contracts: The Principal-Moral Hazard in Equity Contracts: The Principal-Agent ProblemAgent Problem

Equity contracts, such as common stock, are Equity contracts, such as common stock, are claims to a share in the profits and assets of a claims to a share in the profits and assets of a business. business.

Equity contracts are subject to a particular type Equity contracts are subject to a particular type of moral hazard called the of moral hazard called the principal-agent principal-agent problem.problem.

The stockholders who own most of the firm's The stockholders who own most of the firm's equity (the principals) are not the same people equity (the principals) are not the same people as the managers of the firm who may own only a as the managers of the firm who may own only a small fraction of the firm they work for (the small fraction of the firm they work for (the agents of the owners).agents of the owners).

This separation of ownership and management This separation of ownership and management involves moral hazard.involves moral hazard.

The managers in control (the agents) may act in The managers in control (the agents) may act in their own interest rather than in the interest of their own interest rather than in the interest of the owners (principals) because the managers the owners (principals) because the managers have less incentive to maximize profits than have less incentive to maximize profits than stockholders-owners do.stockholders-owners do.

Agents (managers in control) mayAgents (managers in control) may1.1. have different goals than the ownershave different goals than the owners2.2. have less incentives to maximize firm’s have less incentives to maximize firm’s

profitprofit3.3. not provide a quick and friendly service to not provide a quick and friendly service to

the firm’s customersthe firm’s customers4.4. spend money unnecessarily on decoration spend money unnecessarily on decoration

and artificial issuesand artificial issues5.5. waste time in their own personal leisure waste time in their own personal leisure 6.6. not be honest with the firm’s ownernot be honest with the firm’s owner7.7. diverting funds for their own personal use,diverting funds for their own personal use,8.8. pursue corporate strategies that enhance pursue corporate strategies that enhance

their own personal power but do not their own personal power but do not increase the firm’s profitability.increase the firm’s profitability.

The principal-agent problem, which is an The principal-agent problem, which is an example of moral hazard, would not arise if the example of moral hazard, would not arise if the owners of the firm had complete information owners of the firm had complete information about what the managers were up to and could about what the managers were up to and could prevent wasteful expenditures and fraud.prevent wasteful expenditures and fraud.

The principal-agent problem arises only The principal-agent problem arises only because a manager has more information about because a manager has more information about his activities than the stockholder does-that is, his activities than the stockholder does-that is, there is asymmetric information.there is asymmetric information.

The principal-agent problem would not arise if The principal-agent problem would not arise if there were no separation of ownership and there were no separation of ownership and control- that is the owner is the manager.control- that is the owner is the manager.

Tools to Help Solve the Principal-Agent ProblemTools to Help Solve the Principal-Agent Problem

1. Production of Information: Monitoring1. Production of Information: Monitoring One way for stockholder to reduce this moral One way for stockholder to reduce this moral

hazard problem is to monitor the firm’s activities hazard problem is to monitor the firm’s activities through different monitoring process such as through different monitoring process such as auditing and checking what the management is auditing and checking what the management is doing.doing.

The problem is that monitoring process can be The problem is that monitoring process can be costly in terms of time and money. This is called costly in terms of time and money. This is called costly state verificationcostly state verification, which makes equity , which makes equity contract less desirable. It explains, in part, why contract less desirable. It explains, in part, why equity is not the most important element in our equity is not the most important element in our financial structure.financial structure.

Because it is expensive to monitor, the Because it is expensive to monitor, the free rider free rider problemproblem occurs which decreases the possibility occurs which decreases the possibility to monitor the firm properly. If you know that to monitor the firm properly. If you know that other stockholders are paying to monitor the other stockholders are paying to monitor the activities of the firm you hold shares in, you can activities of the firm you hold shares in, you can take a free ride on their activities and save take a free ride on their activities and save yourself some expenses. The problem occurs yourself some expenses. The problem occurs when every stockholder think the same. The when every stockholder think the same. The result is no one will spend any resources to result is no one will spend any resources to monitor the firm.monitor the firm.

2. Government Regulation to increase information2. Government Regulation to increase information Governments have laws to force firms to adhere Governments have laws to force firms to adhere

to standard accounting principles that make to standard accounting principles that make profit verification easier. They also impose stiff profit verification easier. They also impose stiff criminal penalties on people who commit the criminal penalties on people who commit the fraud of hiding and stealing profits. However, fraud of hiding and stealing profits. However, these laws and regulations are not fully these laws and regulations are not fully effective. It is not easy to catch the fraudulent effective. It is not easy to catch the fraudulent managers because they have incentives to make managers because they have incentives to make very hard for government agencies to find or very hard for government agencies to find or prove fraud.prove fraud.

33. Financial Intermediation. Financial Intermediation Financial intermediation has the ability to avoid Financial intermediation has the ability to avoid

the free-rider problem in the face of moral the free-rider problem in the face of moral hazard, and this is another reason why indirect hazard, and this is another reason why indirect finance is so important.finance is so important.

One financial intermediary that helps reduce the One financial intermediary that helps reduce the moral hazard arising from the principal-agent moral hazard arising from the principal-agent problem is the venture capital firm.problem is the venture capital firm.

Venture capital firmVenture capital firm pools the resources of their pools the resources of their partners and uses the funds to help new partners and uses the funds to help new entrepreneurs to establish a new business firm entrepreneurs to establish a new business firm with the condition that the venture capital firm with the condition that the venture capital firm receives an equity share in the new business receives an equity share in the new business and puts some of its own people in the and puts some of its own people in the management team of the new firm so that they management team of the new firm so that they can keep close watch on the firm’s activities. can keep close watch on the firm’s activities.

The equity of the new business firm splits only The equity of the new business firm splits only between the entrepreneurs and the venture between the entrepreneurs and the venture capital firm and no other investors are allowed. capital firm and no other investors are allowed. Thus, the free-rider problem in monitoring the Thus, the free-rider problem in monitoring the firm does not exist.firm does not exist.

44. Debt Contracts. Debt Contracts Debt contract is an agreement whereby the Debt contract is an agreement whereby the

borrower pays the lender a fixed amount at borrower pays the lender a fixed amount at periodic intervals. As long as the lender periodic intervals. As long as the lender receives the agreed amount, he does not care receives the agreed amount, he does not care whether the firm is making profit or suffering a whether the firm is making profit or suffering a loss. loss.

The less frequent need to monitor the firm, and The less frequent need to monitor the firm, and thus the lower cost of state verification, helps thus the lower cost of state verification, helps explain why debt contracts are used more explain why debt contracts are used more frequently than equity contracts to raise capital.frequently than equity contracts to raise capital.

HOW MORAL HAZARD INFLUENCES FINANCIAL HOW MORAL HAZARD INFLUENCES FINANCIAL STRUCTURE IN DEBT MARKETSSTRUCTURE IN DEBT MARKETS

Even with the advantages over equity contact, Even with the advantages over equity contact, debt contracts are still subject to moral hazard. debt contracts are still subject to moral hazard.

Because a debt contract requires the borrower Because a debt contract requires the borrower to pay out a fixed amount and lets him keep any to pay out a fixed amount and lets him keep any profits above this amount, the borrower has an profits above this amount, the borrower has an incentive to take on investment projects that are incentive to take on investment projects that are riskier than the lenders would like. Because of riskier than the lenders would like. Because of the potential moral hazard, lenders my not make the potential moral hazard, lenders my not make the loan to the borrower.the loan to the borrower.

Tools to Help Solve Moral Hazard in Debt ContractTools to Help Solve Moral Hazard in Debt Contract

1. Net Worth and Collateral1. Net Worth and Collateral When the net worth is high or the collateral is When the net worth is high or the collateral is

valuable, the risk of moral hazard will be highly valuable, the risk of moral hazard will be highly reduces because the borrower himself have a lot reduces because the borrower himself have a lot to lose.to lose.

Net wroth and collateral make the debt contract Net wroth and collateral make the debt contract incentive-compatibleincentive-compatible. It makes the incentives of . It makes the incentives of both borrowers and lenders are the alike. The both borrowers and lenders are the alike. The greater the borrower’s net worth and collateral, greater the borrower’s net worth and collateral, the greater the borrower’s incentive to behave in the greater the borrower’s incentive to behave in the way that the lender expects and desires, the the way that the lender expects and desires, the smaller the moral hazard problem in the debt smaller the moral hazard problem in the debt contract, and easier for the borrower to get the contract, and easier for the borrower to get the loan.loan.

22. Monitoring and Enforcement of Restrictive . Monitoring and Enforcement of Restrictive CovenantsCovenants

Lenders can ensure that the borrower uses the Lenders can ensure that the borrower uses the fund for the purpose it has been agreed upon by fund for the purpose it has been agreed upon by writing writing provisions (restrictive covenants)provisions (restrictive covenants) into into the debt contract that restrict the borrower’s the debt contract that restrict the borrower’s activities in order to reduce moral hazard. Then activities in order to reduce moral hazard. Then the lenders can monitor the borrower’s activities the lenders can monitor the borrower’s activities to see whether he is complying with the to see whether he is complying with the restrictive covenants or not.restrictive covenants or not.

There are four types of restrictive covenantsThere are four types of restrictive covenants1.1. Covenants to discourage undesirable Covenants to discourage undesirable

behavior,behavior,2.2. covenants to encourage desirable behavior,covenants to encourage desirable behavior,3.3. covenants to keep collateral valuable,covenants to keep collateral valuable,4.4. covenants to provide informationcovenants to provide information

3. Finance intermediation3. Finance intermediation Although restrictive covenants help reduce the Although restrictive covenants help reduce the

moral hazard problem, they do not eliminate it moral hazard problem, they do not eliminate it completely. It is almost impossible to write completely. It is almost impossible to write covenants that rule out every risky activity.covenants that rule out every risky activity.

Furthermore, borrower may be clever enough to Furthermore, borrower may be clever enough to find loopholes in restrictive covenants that find loopholes in restrictive covenants that make them ineffective.make them ineffective.

Restrictive covenants must be monitored and Restrictive covenants must be monitored and enforced. Monitoring and enforcement is costly. enforced. Monitoring and enforcement is costly. Thus, the free-rider problem arises in debt Thus, the free-rider problem arises in debt market, and moral hazard continues to be high.market, and moral hazard continues to be high.

Financial intermediaries-particularly banks- Financial intermediaries-particularly banks- have the ability to avoid the free-rider problem have the ability to avoid the free-rider problem as the make primarily private loans.as the make primarily private loans.

Private loans are not traded, so no free-rider Private loans are not traded, so no free-rider problem exists.problem exists.