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NotesonMishkinChapter8
("EconomicAnalysisofFinancialStructure")
Econ353:Money,Banking,andFinancialInstitutions

LastUpdated:28March2015
LatestCourseOffering:Spring2011
CourseInstructor:
ProfessorLeighTesfatsion
tesfatsiATiastate.edu
Econ353HomePage:
http://www2.econ.iastate.edu/classes/econ353/tesfatsion/

I.EightPuzzlesConcerningFinancialStructure
II.TransactionsCostsinRelationtoPuzzle3
III.AsymmetricInformationProblemsRevisited
A.AdverseSelectioninFinancialMarkets
B.MoralHazardinFinancialMarkets
IV.AdverseSelectioninRelationtoPuzzles17
V.MoralHazardinRelationtoPuzzles15and78
VI.ConflictsofInterest
VII.BasicConceptsandKeyIssuesforMishkinChapter8

EightPuzzlesConcerningFinancialStructure
ThissectionsummarizeseightpuzzlesregardingrealworldfinancialstructurestressedbyMishkin.The
remainingfoursectionsdiscusspossibleresolutionsforthesepuzzlesbasedonanunderstandingofhow
transactioncostsandinformationcostsaffectfinancialstructure.
Thefinancialstructureofabusinessreferstothemannerinwhichthebusinessfinancesitsactivitiesusing
externalfunds,i.e.,fundsobtainedfromoutsidethebusiness.Therearetwoimportantaspectstothis
financialstructure:
themixofexternalfundsbetweenequityanddebt
thesourceofexternalfunds,eitherfinancialintermediariesorsecuritiesmarkets.
Mishkinprovidesafigure(Figure1)thatshowsthemixandsourceofexternalfundsfornonfinancial
businessesintheUnitedStatesandothercountriesduringtheperiod19702000.
Regardingmix,notethatvariousformsofdebtinstruments(loansandbonds)accountedforabout89percent
oftheexternalfundswhereasequityinstruments(stocks)onlyaccountedforabout11percentofthese
externalfunds.
Regardingsource,notethatloansprovidedbyfinancialintermediariesaccountedforabout57percentof
theseexternalfundswhilesalesofsecurities(bondsandstocks)accountedforabout43percentofthese
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externalfunds.
Mishkinusesthedatainthisfigureasevidenceinsupportofeight"puzzles"regardingfinancialstructuresall
overtheworld,asfollows.
1.Stocksarenotthemostimportantsourceofexternalfinancingforbusinesses.
AsseeninFigure1,thestockmarketaccountedforarelativelysmallfractionofexternalfinancingby
U.S.corporationsinthedepictedperiod.
Puzzle:WhyisthestockmarketlessimportantthanothersourcesoffinancingintheUnited
Statesandothercountries?
2.Issuingmarketablesecurities(whetherdebtorequity)isnottheprimarywayinwhich
businessesfinancetheiroperations.
AsseeninFigure1,bondswereafarmoreimportantsourceoffinancingthanstocksintheUnited
Statesduringthedepictedperiod19702000Nevertheless,bondsandstockstogethersuppliedless
thanathirdofthetotalexternalfundsacquiredbyU.S.corporationstofinancetheiractivitiesduring
thisperiod.AsseeninFigure1,thisistrueelsewhereintheworldaswell.
Puzzle:Whydon'tbusinessesmakemoreextensiveuseofdebtandequitysecurityissuesto
financetheiractivities?
3.Indirectfinance,whichinvolvestheactivitiesoffinancialintermediaries,ismoreimportant
thandirectfinance,inwhichbusinessesraisefundsdirectlyfromlendersinsecuritiesmarkets.
Puzzle:Whyarefinancialintermediariesandindirectfinancesoimportantinfinancialmarkets?
4.Financialintermediaries,particularlybanks,arethemostimportantsourceofexternalfunds
usedtofinancebusiness.
AsMishkinnotes,inanaverageyearintheUnitedStates,morethanfourtimesmorefundsareraised
withloansthanwithstocks,andloansareevenmoreimportantinothercountriesoftheworldin
GermanyandJapan,forexample.
Puzzle:Whatmakesbankssoimportanttotheworkingsofthefinancialsystem?
5.Thefinancialsystemisoneofthemostheavilyregulatedsectorsoftheeconomy.
AsstudiedinChapter2,governmentsregulatefinancialmarketsprimarilytopromotetheprovisionof
informationandtoensurethesoundnessofthefinancialsystem.Thisregulationisextensiveinthe
UnitedStatesandinallotherhighlyindustrializedeconomies.
Puzzle:Whyarefinancialmarketssoextensivelyregulatedthroughouttheworld?
6.Onlylarge,wellestablishedcorporationshaveaccesstosecuritiesmarketstofinancetheir
activities.
AsMishkinnotes,individualsandsmallerbusinessesthatarenotwellestablishedrelyheavilyon
banksforexternalfundsonlyrarelydotheyattempttoobtainexternalfundsthroughbondandstock
issue.
Puzzle:Whydoonlylarge,wellknowncorporationshavetheabilitytoraisefundsinsecurities
markets?
7.Collateralisaprevalentfeatureofdebtcontractsforbothhouseholdsandbusinesses.
Collateralisanassetownedbyaborrowerthatispledgedtothelenderintheeventtheborrower
defaultsontheloan,i.e.,intheeventtheborrowerisunabletomeethisdebtpaymentobligationsto
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thelender.Forexample,whenaborrowerreceivesarealestateloanfromabanktofinance
constructionofahouse,thecollateralisusuallythehouseitself.Ownershipofthehouserevertstothe
bankiftheborrowerdefaultsontheloan.
Debtcontractsbetweenaborrowerandlenderthatinvolvetheuseofsomekindofcollateralto
guaranteetheloanarereferredtoascollateralizeddebt(orsecureddebt).Debtthatisnotsecuredby
collateralforexample,creditcarddebtisreferredtoasunsecureddebt.AsMishkinnotes,the
majorityofhouseholddebtintheUnitedStatesconsistsofcollateralizedloansandborrowingby
nonfinancialbusinessesfrequentlyinvolvessomeformofcollateralaswell.
Puzzle:Whyiscollateralsuchanimportantfeatureofdebtcontracts?
8.Debtcontractsaretypicallyextremelycomplicatedlegaldocumentsthatplacesubstantial
restrictionsonthebehavioroftheborrower.
Throughouttheworld,debtcontractstypicallytaketheformoflengthylegaldocumentswithextensive
restrictivecovenants,i.e.,provisionsrestrictingthebehavioroftheborrower.Forexample,aborrower
receivingarealestateloanmayberequiredtocarryliabilityinsurancecoveringaccidentsathis
constructionsite.
Puzzle:Whyaredebtcontractssocomplexandrestrictive?
AsMishkinnotes,theexplanationsfortheseeightpuzzlesregardingrealworldfinancialstructuringcanin
largepartbetracedtotransactionandinformationcostsinherentinfinancialmarketactivity.
Theconceptof"transactioncosts"isactuallyquitetrickytodefineinamannerthatisbothclearanduseful.
Roughlyspeaking,transactioncostsarethecostsassociatedwiththeorganizationofproductiveactivities,
suchasthecostsarisingfromtheneedtosearchforcustomersandtopreparecontractsforlongerterm
customersupplierrelationships.Incontrast,productioncostsarethecostsarisingfromtheneedtopayfor
directinputstoproduction,suchassalaries(thepriceoflaborservices)andrentalpayments(thepriceof
capitalservicesgeneratedbyrentedcapitalequipment).
Theconceptof"informationcosts"ismorestraightforward.Informationcostsarethecostsincurredwhen
attemptsaremadetoreducemoralhazardandadverseselectionproblemsarisingfromconditionsof
asymmetricinformation.
Forexample,adebtcontractisintendedtobeaproductiveactivityinthesensethatacontractually
determinedamountofloanedfunds(input)isusedbyaborrowertoproduceastreamofreturns(output)that
isexpectedtocoverdebtpaymentobligations(inputcosts)whileleavingsomepositivenetreturn(profit)for
theborrower.
Adebtcontractentailstwodistincttypesoftransactioncosts:(a)theorganizationalcostsassociatedwith
findingandbringingtogethertheborrowerandlenderand(b)theorganizationalcostsassociatedwiththe
actualwritingupandsigningofthedebtcontract.Inaddition,adebtcontracttypicallyinvolvesinformation
costsinthatthebehavioroftheborrowermustbemonitoredinanattempttoensurethattheborrowermeets
thetermsofthedebtcontractasspecifiedinitspaymentscheduleandrestrictivecovenants.
Thenexttwosectionsdiscussmorecarefullyhowtransactioncostsandinformationcostsaffectthefinancial
structureofbusinessesinwaysthathelptoexplaintheaboveeightlistedpuzzles.Inparticular,Mishkin
arguesthataconsiderationoftransactioncostsisparticularlyhelpfulforunderstandingpuzzle3,whereasa
considerationofinformationcostshelpstoexplainalleightpuzzles.

TransactionCostsinRelationtoPuzzle3
Recallpuzzle3:"Whyarefinancialintermediariesandindirectfinancesoimportantinfinancialmarkets?"
Aspreviouslyseen(puzzle1),businessesintheUnitedStatesandothercountriesrelymuchmoreheavilyon
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debtfinancingthanonequityfinancing.Puzzle3concernswhyfinancialintermediaries(primarycommercial
banks)playsuchalargeroleinthisdebtfinancing.Whydon'tbusinessessimplyselldebtissueinsecurities
marketsratherthangoingthroughthehassleofsecuringloansfromfinancialintermediaries?
AsMishkinnotes,partoftheexplanationforpuzzle3isthatobtainingdebtfinancingthroughafinancial
intermediaryratherthanthroughasecuritiesmarketcansignificantlyreducetransactioncosts.Thisreduction
occursfortwomainreasons.
First,financialintermediarieshelptomatchborrowersandlenders,cuttingdownontheirsearchcosts.For
borrowerswithspecialneedsandcircumstances,thesesearchcostscanbeveryhigh.[Indeed,aswillbe
clarifiedbelow,aborrowerwhoseneedsandcircumstancesaretoospecialmaybeunabletosecureany
lendingatallthroughsecuritiesmarketsbecauseofhighinformationcosts.]
Second,financialintermediariesengageinassettransformation,whichallowsthemtoreducetransaction
costsbytakingadvantageofvarious"economiesofscale."
Moreprecisely,financialintermediariespooltogetherfundsfrommanydifferentlendersundercontractual
termsthattheselendersfindattractivee.g.,withdrawalupondemand(liquidity).Theythenusethese
pooledfundstocreatenewtypesofloaninstrumentsspecificallytailoredtothespecialneedsand
circumstancesofthosewhoborrowfromthem.Thisassettransformationcantakeawidevarietyofforms.
Forexample,itmaytaketheformofmutualfundtransactionsinwhichmanysmalllendersbuysharesof
largediversifiedstockorbondportfolios.Oritmaytaketheformofsavingsandloantransactionsinwhich
thefundsfrommanysmalldepositaccountsarepooledtogethertofinancemortgages.
Thispoolinggenerallypermitsfinancialintermediariestosignificantlyreducetransactioncostsbytaking
advantageofeconomiesofscale,areductionincostsperdollarloanedasthesize(scale)oftheloan
principalincreases.
Forexample,onewayinwhichpoolingcanleadtoareductionintransactioncoststhrougheconomiesof
scaleisifthecostsincurredinwritingupaloancontract(lawyers'fees,titlesearches,etc.)arefairly
insensitivetothesizeoftheloanprincipal.Toillustrate,supposethecostofwritingupaloancontractfor
$100,000isthesameasthecostofwritingupaloancontractfor$10,000:namely,$100.Suppose,also,that
allsuchcostsarebornebytheborrower.Comparethecostspaidbytheborrowerinthefollowingtwocases:
(a)Theresourcesoftendifferentlendersarepooledtogetherbyafinancialintermediarytoconstructa
singleloancontractwithaborrowerMr.Jonesforaloanprincipalof$100,000,witheachlender
contributing$10,000.
(b)TendifferentlendersindividuallywriteuptendifferentloancontractswithMr.Jones,eachfora
loanprincipalof$10,000.
Ineachcase(a)and(b),Mr.Jonesreceivesthesametotalloanprincipalof$100,000.However,transaction
costsaresubstantiallydifferent.Incase(a),totaltransactioncostsareonly$100onlyoneloancontractis
writtensoMr.Jonesonlyhastopay$100.Incase(b),totaltransactioncostsare$100*10=$1000since
tendifferentloancontractsarewritten,henceMr.Joneshastopay$1000.
Anotherwayinwhichpoolingcanleadtoareductionintransactioncoststhrougheconomiesofscaleisby
permittingthespreadofequipmentandothercapitalcostsoverlargenumbersofborrowers.Forexample,the
costofinstallingasophisticatedcomputersystemtokeeptrackoffinancialtransactions(e.g.,interest
payments)withjustoneborrower,suchasMr.Jones,mightbeprohibitiveforalenderwithnoother
borrowers.However,alender(e.g.,afinancialintermediary)simultaneouslytransactingwithalargepoolof
borrowerscouldhandletheseequipmentcostsbychargingeachoftheborrowersinhisborrowingpoola
smallfractionofthesecosts.

AsymmetricInformationProblemsRevisited
Asymmetricinformationissaidtoexistbetweenabuyerandsellerofanassetifeitheragenthasinformation
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relevantfortheexchangethatisnotavailabletotheotheragent.AsdiscussedinMishkin(Chapter2),
asymmetricinformationcanleadtoproblemsofadverseselectionandmoralhazard.
Thissectionstartswithabriefreviewofthetypesofadverseselectionandmoralhazardproblemsendemic
tofinancialmarkets.TheimportanceoftheseproblemsaskeyexplanatoryfactorsunderlyingMishkin'seight
financialstructurepuzzlesisthenexamined.

A.AdverseSelectioninFinancialMarkets
RecallfromChapter2thatadverseselectionisaproblemthatarisesforbuyersofassetswhentheyhave
difficultyassessingthequalityoftheseassetsinadvanceofpurchase.Consequently,itisaproblemthat
arisesbecauseofasymmetricinformationbetweenbuyersandsellersofassetsbeforeanypurchase
agreementtakesplace.
Specifically,theadverseselectionproblemisthatthestepstakenbybuyerstoprotectthemselvesagainst
purchasesofpoorqualityassetsmayhavetheperverseeffectofloweringtheaveragequalityofthepoolof
assetsthatsellersbringtothemarket.Inshort,adverseselectionisanadversepooleffect.
Adverseselectionisaseriousprobleminfinancialmarkets,becausefinancialtransactionsareintrinsically
characterizedbyasymmetricinformation.Borrowers(sellersoffinancialassets)generallyhaveprivate
informationthatismoreaccuratethantheinformationpossessedbylenders(buyersoffinancialassets)
regardingtheattributesandprospectsofborrowers.Consequently,alendermaystillbeuncertainaboutthe
defaultriskofaloancontractevenaftercheckingintothestandard"fiveC"riskfactorsforaborrower
capacity(torepay),capital,character,collateral,andconditions(oftheeconomy).
Iflenderstrytoprotectthemselvesagainstdefaultriskbysettingtheircontractualtermsinamanner
appropriatefortheexpected(i.e.,average)qualityoftheirloanapplicants,thenasexplainedatsome
lengthinChapter2theyruntheriskthathighriskborrowerswillbeencouragedtoselfselectintotheir
loanapplicantpoolwhileatthesametimelowriskborrowerswillbeencouragedtoselfselectoutofthis
pool.Theresultingadverseeffectsonthequalityoftheirloanapplicantpoolconstitutesanexampleof
adverseselection.

B.MoralHazardinFinancialMarkets
AsdetailedinChapter2,Moralhazardissaidtoexistinthecontextofafinancialmarketif,afterapurchase
agreementhasbeenconcludedbetweenabuyerandsellerofafinancialasset:
thesellerchangeshisorherbehaviorinsuchawaythattheprobabilites(riskcalculations)usedbythe
buyertoassessthequalityofthefinancialassetarenolongeraccurate
thebuyerofthefinancialassetisonlyimperfectlyabletomonitor(observe)thischangeintheseller's
behavior.
Forexample,amoralhazardproblemarisesif,afteralenderhaspurchasedadebtsecurityfromaborrower,
theborrowerincreasestherisksoriginallyassociatedwiththedebtsecuritybyinvestinghisborrowedfunds
inmoreriskyprojectsthanheoriginallyreportedtothelender.

AdverseSelectioninRelationtoPuzzles17
Considerthemostobviouspossiblesolutiontoadverseselectioninfinancialmarkets:eliminationofthe
asymmetryininformationthatexistsbetweenbuyersandsellersoffinancialassetspriortopurchase
agreements.
Itwillnowbeshownwhyfinancialintermediaries(inparticularbanks)arebetterablethansecuritiesmarkets
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toaccomplishtheeliminationofthistypeofasymmetricinformation,whichhelpstoexplainpuzzles1
through4.Moreover,inthecourseofthisdiscussion,itwillbeseenwhypuzzles5through7canalsobe
explainedinpartastheresultofattemptstoeliminatethistypeofasymmetricinformation.
Lowriskborrowersarewillingtopaytocommunicateinformationabouttheirattributesandprospects,and
lendersarewillingtopayforinformationaboutborrowerattributesandprospects.Thisprovidesaprofit
opportunitytothosewhoarewillingandabletospecializeingatheringthistypeofinformation.
Participantsinsecuritiesmarketsrelyontheprovisionofinformationbyprivateinvestmentadvisoryfirms
suchasMoody'sandStandardandPoor's,whoseratingsaredesignedtomeasuredefaultrisk.Private
productionandsaleofinformationdoesnotcompletelyresolveadverseselectionproblemsinsecurities
markets,however,becauseof"freerider"problems.
Afreeriderproblemoccurswhenpeoplewhodonotpayforinformationtakeadvantageoftheinformation
thatotherpeoplehavepaidforbyobservingandmimickingtheirbehavior.Thisreducesoreveneliminates
theabilityofpeopletoprofitfromthepurchaseofinformationandhencediscouragesthemfrompurchasing
informationinthefirstplace.This,inturn,weakenstheabilityofprivatefirmstoprofitbyselling
information.
Asaconsequenceoffreeriderproblems,privateprovisionofinformationinsecuritiesmarketstendstobe
underprovided,inthesensethatitisinsufficienttoeliminateadverseselectionproblems.Asaresult,many
smallnewlyestablishedfirmshaveadifficulttimeobtainingexternalfundsinsecuritiesmarketsbecause
lenderslacktheinformationneededtoverifytheirquality(financialsoundness).Incontrast,largewell
establishedfirmshaveaneasiertimeobtainingexternalfundsinsecuritiesmarketsbecauselendersaremore
confidentabouttheirquality.
Thisadverseselectionanalysishelpstoexplainpuzzles1,2,and6whydebtandequityissuein
securitiesmarketsisnotthemajorsourceofexternalfundsformostborrowers,especiallyforindividuals
andsmallbusinesses.
Anotherpossibilityisforgovernmenttoregulatesecuritiesmarketsinsuchawaythatthesecurityissuers,
themselves,areencouragedorrequiredtorevealaccurateinformationabouttheirattributesandprospects.
ThisistheapproachfollowedintheUnitedStatesandinmostcountriesthroughouttheworld.IntheUnited
States,thegovernmentagencyinchargeofensuringinformationdisclosureinsecuritiesmarketsisthe
SecuritiesandExchangeCommission(SEC).
Thishelpstoexplainpuzzle5thefactthatthefinancialsectorisoneofthemostheavilyregulated
sectorsoftheeconomy.
Althoughgovernmentregulationsencouragingandrequiringinformationdisclosurelessenadverseselection
problems,theydonoteliminatethem.Securityissuersstillhavemoreinformationabouttheirfinancial
conditionthanpurchasers,inspiteofdisclosureregulations,becausethesedisclosureregulationsare
necessarilywritteninbroadgeneralterms.Moreover,itcanbedifficult,evenfortheSEC,toensurethat
disclosedinformationisaccurate.
Financialintermediariessuchasbankshaveaneasiertimeensuringaccurateandcompleteinformation
disclosureandhencethereductionoreliminationofadverseselectionproblems.
Mostimportantly,bankscanprofitablyspecializeininformationgatheringaboutparticulartypesofloans,
e.g.,homemortgageloans,orloanstobusinessesinaparticulartypeofindustry.Freeriderproblemsare
avoidedbybanksbecausemostoftheirloansareprivate,i.e.,theyarenottradedonanopenmarket.
Consequently,othertraderscannotusetheinformationgatheredbyabanktomakecompetingbidsforits
loans,biddingupprices(i.e.,biddingdowninterestrates)toapointwherethebankmakesnoprofits.
Also,banksmaybeabletoforceborrowerstorevealtheirtruetype(highorlowrisk)throughspecialloan
contractprovisions.
Forexample,borrowersmayberequiredtopledgesomeoftheirownassetsascollateral,whichthebankcan
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claimiftheborrowerdefaults.Since,ingeneral,onlylowrisktypesarewillingtooffersubstantialcollateral,
theamountofcollateralpledgedinaloancontractactsasasignaltothebankregardingthequalityofthe
borrower.
Inaddition,collateralprovisionsreducetheconsequencesofadverseselectionforbanksbecausetheyreduce
thelossesincurredbythebanksincaseofdefault.Thenetworth(orequitycapital)ofaborrowerdefined
asthedifferencebetweenwhatheowns(hisassets)andwhatheowes(hisliabilities)canplayasimilar
roletocollateralinreducingthedefaultriskforabanktotheextentthatthebankispermittedbylawtotake
titletotheborrower'sassetsincaseofdefault.Sincebankruptcyregulationstypicallypermitborrowersto
protectatleastsomeoftheirassetsfromseizurebycreditors,however,collateralprovisionsprovidemore
securitytobanksthanborrowernetworthperse.
Thisadverseselectionanalysishelpstoexplainpuzzle7whycollateralisaprevalentfeatureofdebt
contractsforbothhouseholdsandbusinesses.
Inaddition,thisadverseselectionanalysissuggestswhyfinancialintermediariesingeneral,andbanksin
particular,playagreaterroleintheprovisionofexternalfundsforbusinessesthandodebtandequity
securitiesmarkets.Consequently,ithelpstoexplainpuzzles3and4.

MoralHazardinRelationtoPuzzles15and78
Asreviewedabove,moralhazardarisesinafinancialmarketafterafinancialtransactionhastakenplace,
whenthesellerofafinancialassethasanincentivetoconcealinformationandtoactinawaythatmaynot
reflecttheinterestsofthebuyerofthefinancialasset.Aswillnowbeseen,moralhazardhasimportant
consequencesforfinancialstructurethathelptoexplainpuzzles15and78.
Puzzle1concernswhybusinessesdonotmakemoreextensiveuseofequity(stock)issuetoraiseexternal
funds.Onereasoninhibitingthisuseisaparticulartypeofmoralhazardassociatedwiththeownershipof
commonstock.
Whenabusinessisorganizedincorporateform,itsownersareitscommonstockholders.Ingeneral,the
managersofacorporationownonlyasmallfractionoftheoutstandingcommonstocksharesofthe
corporation.Consequently,thereisaseparationofownershipfromcontrol.Thatis,theownersofthe
corporation(calledtheprincipals)arenotthesamepeopleasthemanagersofthecorporation(calledthe
agentsoftheowners).
Exceptintimesofextremeduress,thecommonstockholders(principals)ofacorporationusuallydonot
activelymanagethedaytodayoperationsofthecorporation.Consequently,theequitystakeofcommon
stockholdersmakesthemmorecomparabletolendersthantoactiveowners,andthemanagers(agents)are
essentiallyborrowersofthestockholders'equitycapital.
Thisseparationofownershipfromcontrolconstitutesaspecialformofmoralhazard,referredtoin
economicsasaprincipalagentproblem.Theobjectivesofthemanagers(e.g.,increasesalariesnow)may
differfromtheobjectivesofthecommonstockholders(e.g.,increaseinvestmentnowtoensurehigherprofits
later)totheextentthatthemanagersarecompensatedthroughsalariesratherthanthroughbonusestiedto
profitperformance.Inthiscase,themanagershaveanincentivetobehaveinwaysthatarenotinthebest
interestsofthecommonstockholders.
Thedaytodayuseoffundsbymanagerstendstobehiddenfrompublicview.Iftheprofitperformanceof
thecorporationweredirectlyrelatedtomanagerialeffort,therewouldbenoinformationproblembecause
managerialeffortcouldbediscernedfromprofitoutcomes.Ingeneral,however,corporationsaresubjectto
positiveandnegativeshocksfromexternalsourcesthatmakeitdifficulttoattributeprofitperformancesolely
tomanagerialeffort.
Consequently,commonstockholdershaveanincentivetomonitortheactivitiesofmanagerstoprotect
themselvesagainstprincipalagentproblems.However,thismonitoringiscostlyintermsofbothtimeand
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resources.Indeed,asMishkinnotesinChapter8,economistsrefertomonitoringactivitiesascostlystate
verification.
Moreover,whenownershipofthecorporationiswidelydispersed,freeriderproblemsmakeitparticularly
difficulttocarryouteffectivemonitoring.Althoughownersofcommonstockareentitledtovoteat
stockholdermeetingsonmattersofcorporatemanagement,mostcommonstockholdersofwidelyheld
corporationsdonotbothertoattendstockholdermeetingsinperson,oreventoreadtheannualreportsofthe
corporation.Instead,theycountonbeingabletofreerideontheeffortsofotherstockholderswhodoattend
thesemeetingsandwhodoreadthesereports.Thus,theamountofinformationgeneratedthroughmonitoring
ofmanagerstendstobeinsufficienttoeliminateprincipalagentproblems.
Forthesereasons,commonstockholdingislessdesirablethanitwouldbeintheabsenceofprincipalagent
problems,makingitharderforbusinessestoraiseexternalfundsthroughequityissue.Incontrast,debt
securitiesarestructuredtopaytheholderafixedamountatperiodicintervalsregardlessofprofit
performance(exceptintheextremecaseofbankrupcty).Consequently,holdersofcorporatedebtareless
vulnerabletoprincipalagentproblemsandhavelessfrequentneedtomonitortheactivitiesofmanagersthan
docommonstockholders.
Thismoralhazardanalysishelpstoexplainpuzzle1withregardtocommonstocksi.e.,whycommon
stocksarenotthemostimportantsourceofexternalfinancingforbusinesses.
TechnicalNote:
Holdersof"preferred"stockissuedbyacorporationarepromisedastreamoffixedpersharedividend
payments,typicallyexpressedasapercentageofthefacevalueofashare.Hence,likedebtholders,
theyarelessvulnerablethancommonstockholderstoprincipalagentproblems.However,businesses
canmissdividendpaymentstopreferredstockholderswithnoimmediatepenalty(unlikethecasefor
debtpayments)andpreferredstockpaymentsaresubordinatetodebtpaymentsincaseofbankruptcy.
Hence,preferredstockisriskierthandebtsecuritiesissuedbythesamecorporation.Moreover,
preferredstockpaymentsarepaidfromacorporation'saftertaxearnings,makingthemmorecostlyto
thecorporationthandebtpayments,whicharepaidoutofpretaxearnings.
CombiningtheseobservationswithMishkin'smoralhazardanalysisabovehelpstoexplainwhy
puzzle1holdsforanyformofequityissue,whethercommonstockorpreferredstock.
Aswithadverseselection,thepersistenceofprincipalagentproblemsduetofreeriderproblemsgives
governmentanincentivetoregulatefinancialmarkets.Forexample,mostcountrieshavelawsthatrequire
corporationstoadheretostandardaccountingprinciplesandthatimposepenaltiesformanagerialfraud(e.g.,
embezzlementofprofits).
Thishelpstoexplainpuzzle5whythefinancialsectorisamongthemostheavilyregulatedsectorsof
theeconomy.
Afinancialintermediarypermittedbylawtoholdequitysecuritiescanprotectitselfagainstprincipalagent
problemsbyholdinglargeblocksofcommonstocksharesfromindividualcorporations.Thisgivesthe
financialintermediaryboththeincentiveandthepowertomonitormanagerialactivitiesveryclosely,thus
overcomingthefreeriderproblemsthatarisewhencorporatestockholdingiswidelydispersed.
Forexample,Mishkindiscussesthespecialcaseofa"venturecapitalfirm."Aventurecapitalfirmisa
specialtypeoffinancialintermediarythatusesthepooledresourcesofitsventurepartnerstoprovidestartup
capitalizationtonewbusinessesinexchangeforequitysharesinthesebusinesses.Toreducemoralhazard
problems,aventurecapitalfirmusuallyparticipatesinthemanagementofthesenewbusinesses,sothattheir
managementactivitiescanbecloselymonitored.Moreover,thenewbusinessesarepreventedfrom
marketingtheirequitytoanyoneexcepttheventurecapitalfirm.Thisensuresthatnootherinvestorscan
freerideonthemonitoringeffortsoftheventurecapitalfirm.
Moregenerally,banksandotherfinancialintermediariesspecializinginprivateloanscanavoidfreerider
problemsinthefaceofmoralhazard.Withprivateloans,abankisassuredthatnooneelsecanfreerideon
itsmonitoringandenforcementefforts.Consequently,thebankhasanincentivetoincludeinitsloan
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contractsvariousrestrictivecovenantsi.e.,provisionsaimedatreducingmoralhazardandtospendtime
andresourcesonmonitoringtoensuretheirenforcement.Therestrictivecovenantsgenerallytakethe
followingforms:(a)prohibitionsagainstundesirablebehaviorbyborrowers(e.g.,excessiverisktaking)(b)
encouragementofdesirablebehaviorbyborrowers(e.g.,insurancecoverage,maintenanceofaminimum
levelofnetworth,etc.)(c)collateralrequirementsand(d)provisionofpertinentinformationintheformof
periodicaccountingandincomereports.
Thisanalysisofhowfinancialintermediarieseffectivelydealwithmoralhazardhelpstoexplainpuzzles1
through4whyfinancialintermediariesplayamoreimportantrolethansecuritiesmarketsin
channelingfundsfromlenderstoborrowers.
Italsohelpstoexplainpuzzle7thecommoninclusionofcollateralprovisionsindebtcontractswith
financialintermediaries.
Finally,ithelpstoexplainpuzzle8whydebtcontractsenteredintowithfinancialintermediariestendto
becomplicatedlegaldocumentscontainingnumerousrestrictivecovenants.

ConflictsofInterest
ThistopicisaddressedbyMishkininChapter8onpages189192,attheendoftheonlinepptslidesfor
MishkinChapter8,andinaseparatesetofonlinepptslidestitledTheEnronScandalandMoralHazard.

BasicConceptsandKeyIssuesforMishkinChapter8
BasicConceptsforMishkinChapter8:
financialstructure(mixandsource)
collateral
default
collateralizeddebt(orsecureddebt)
restrictivecovenants
transactioncosts
informationcosts
economiesofscale
asymmetricinformation
adverseselection
moralhazard
freeriderproblem
networth
principalagentproblem
costlystateverification
preferredstock
venturecapitalfirm
conflictsofinterest
KeyIssuesforMishkinChapter8:
EightpuzzlesregardingrealworldU.S.financialstructure
WhataretheadvantagesanddisadvantagesforU.S.corporationsofusingstockissueasasourceof
externalfinance?
WhataretheadvantagesanddisadvantagesforU.S.corporationsofusingsecuritiesasasourceof
externalfinance.?
WhataretheadvantagesanddisadvantagesforU.S.corporationsofusingindirectfinanceasasource
ofexternalfinance?
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WhataretheadvantagesanddisadvantagesforU.S.corporationsofusingloans(particularlybank
loans)asasourceofexternalfinance?
WhyisthefinancialsectorsoheavilyregulatedintheU.S.?
WhydolargerfirmstendtohaveeasieraccesstosecuritiesmarketsforexternalfinanceintheU.S.?
WhyiscollateralsuchaprevalentfeatureofdebtcontractsintheU.S.?
WhyaredebtcontractssocomplicatedandfullofrestrictivecovenantsintheU.S.?
Howdotransactioncostshelptoexplainpuzzle3?
Howdoesadverseselectionhelptoexplainpuzzles1through7?
Howdoesmoralhazardhelptoexplainpuzzles15and78?
Possibleconflictofinterestremedies(e.g.,SarbanesOxleyActandtheGlobalLegalSettlementActof
2002)
CaseStudy:TheEnronScandal

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