An Analysis of Financial Structure and Transaction Cost Finance Essay

In an economy, the financial structure is designed promote economic efficiency. One of the main requirements for a healthy economy is an efficient financial system that channel funds from savers to investors." The financial structure of a country includes a complex structure of financial system including many different financial institutions: banks, insurance companies, mutual funds, stock and bonds markets, etc. which channel the money from the people who save to people with investment opportunities." (Mishkin 169)

Basic Facts about Financial Structure

According to Mishkin," There are eight basic puzzles that we need to solve in order to understand how the financial system works."(Mishkin 169-172) Stocks are not the most important source of external financing for businesses. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Indirect finance, which involves the activities of financial intermediaries, is any times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. The financial system is among the most heavily regulated sectors of the economy. Only large, well-established corporations have easy access to securities market to finance their activities. Collateral is a prevalent feature of debt contracts for both households and businesses. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. Financial structure depends on two factors: transactions costs, and information costs.

Transaction Cost

Transactions costs influence financial structure. They are major problems in financial markets and are too high for ordinary people. Financial intermediaries-help in reducing transaction costs and allow small savers and borrowers to benefit from the existence of financial markets. One solution to the problem of high transaction costs is to package the funds of many investors together so that they can take advantage of economies of scale. (Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only as little as the size of the transaction grows.) They also develop expertise to lower transactions costs and provide investors with liquidity services.

Source: The Financial Express. "Indian Securities Market Has Lowest Transaction Cost; Malaysian Highest." Business News, Finance News, Stock Market, World Business, Financial Markets News Online. N.p., n.d. Web. 21 July 2010. In the chart above we can see that the securities market in India has emerged as the lowest cost market among all these countries. According to a study by market regulator Securities & Exchange Board of India (Sebi), transaction cost in this market is 40 bps . The second lowest cost market is Hong Kong, which has a transaction cost of 43.03 bps, while the Malaysian market with transaction cost at 97.50 bps is the highest. Among the other markets where cost of transaction is comparatively higher with respect to Indian markets is Thailand (60 bps), USA (64.60 bps), Singapore (75.50 bps) and Australia (81 bps). These transaction cost includes various components like brokerage, regulator's fee, custody charges, clearing charges and levies like stamp duty.

Asymmetric Information: Adverse Selection and Moral Hazard

Asymmetric information is a situation that arises when one party's insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions when conducting the transaction. The presence of asymmetric information leads to adverse selection and moral hazard problems.

Adverse Selection

Adverse selection is an asymmetric information problem that occurs before the transaction. Potential bad credit risks are the ones who most actively seek out loans. Because adverse selection increases the chances that a loan might be made to a bad credit risk, lenders might decide not to make any loans, even though there are good credit risks in the marketplace.

Moral Hazard

Moral hazard arises after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lenders point of view because they make it less likely that the loan will be paid back. Because moral hazard lowers the chance that the loan will be paid back, lenders may decide that they would rather not make loans.

The Lemons Problem: How Adverse Selection Influences Financial Structure

The Lemons Problem arises when investors can't distinguish between good and bad securities, and are willing to pay only average of good and bad securities' value. The result is that good securities are undervalued and firms won't issue them; whereas bad securities overvalued so too many are issued. So, Investors won't want to buy bad securities, so market won't function well. According George Akerlof, "A Information asymmetry occurs when the seller knows more about a product than the buyer." ( Akerlof 3)

Tools to Help Solve Adverse Selection (Lemons) Problems

Furnishing the people who supply funds (lenders) with full details about the individuals or firms seeking to finance their investment activities (borrowers). Private companies who collect information from the firms' balance sheets and investment activities publish the data and sell them to subscribers. For example: S&P or Moody's

Free-rider problem interferes with this solution

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

Government Regulation to Increase Information

The government regulates the securities market in a way that encourages firms to reveal honest information about themselves so that the investors can determine how good or bad the firms are. For example, annual audits of public corporations.

Financial Intermediation

A financial intermediary becomes an expert in producing information about firms, so that it can sort out good credit risk form bad ones. Banks can also avoid free-rider problem. It is making private loans Banks are more important in the financial systems of developing countries When the quality of information is better, asymmetric information problems will be less severe. Also the larger and more established a corporation is, the more likely it will be to issue securities to raise funds.

Collateral and Net Worth

Collateral reduces the consequences of adverse selection because it reduces the lenders losses in the event of a default. Lenders are more willing to make loans secured by collateral, and borrowers are willing to supply collateral in order to get the loan and at better rate. Net worth (equity capital), the difference between a firm's assets and its liabilities, can perform a similar role to collateral.

How Moral Hazard Affects the Choice between Debt & Equity Contracts

Moral hazard is the asymmetric information problem that occurs after financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. It has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts.

Moral Hazard in Equity Contracts: The Principal-Agent Problem

The Principal-Agent Problem is the result of separation of ownership by stockholders (principals) from control by managers (agents). Managers act in own rather than stockholders' interest because the managers have less incentive to maximize profits than stockholders-owners do. "The agent is hired to act on behalf of (and in the best interests of) the principal "(Silver). C:UsersChrish_naDesktopPrincipal_agent.png Source: ("WGA update: the not-so-basic economics of industrial action") In the figure above it can be seen how the Principal-agent Problem treats the difficulties that arise under conditions of incomplete andA asymmetric informationA when aA principalA hires anA agent, such as the problem of potentialA moral hazardA andA conflict of interest, in as much as the principal is most probably hiring the agent to pursue its, the principal's, interests. Various mechanisms may be used to try to align the interests of the agent in cohesion with those of the principal, such as piece rates/commissions,A profit sharing,A efficiency wages,A performance measurementA (includingA financial statements), the agent posting a bond, or fear of firing. The principal-agent problem is found in most employer/employee relationships, for example, whenA stakeholdersA hire top executives ofA corporations.

Tools to Help Solve the Principal-Agent Problem

One way for stockholder to reduce this moral hazard problem is to monitor the firm's activities through different monitoring process such as auditing and checking what the management is doing.

Government Regulation to increase information

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

Financial Intermediation

Financial intermediation has the ability to avoid the free-rider problem in the face of moral hazard, and this is another reason why indirect finance is so important.

Debt Contracts

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

How Moral Hazard Influences Financial Structure in Debt Markets

Even with the advantages over equity contact, debt contracts are still subject to moral hazard. Because a debt contract requires the borrower to pay out a fixed amount and lets him keep any profits above this amount, the borrower has an incentive to take on investment projects that are riskier than the lenders would like. Because of the potential moral hazard, lenders may not make the loan to the borrower.

Tools to Help Solve Moral Hazard in Debt Contracts

When borrowers have more at stake because their net worth is high or collateral they have pledged to the lender is valuable, the risk of moral hazard will be reduced .

Monitoring and Enforcement of Restrictive Covenants

Restrictive covenants are directed to reduce moral hazard either by ruling out undesirable behaviour or by encouraging desirable behaviour.

Financial Intermediation:

Banks and other intermediaries have special advantages in monitoring. Financial intermediaries-particularly banks- have the ability to avoid the free-rider problem as the make primarily private loans. Private loans are not traded, so no free-rider problem exists.

Conclusion

A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities. A proper financial system makes sure that the hard-earned savings of people get channeled to productive investors. There are powerful economic concepts that enable us to explain features of the financial system, such as why financial contracts are written as they are and that the financial intermediaries are more important than securities markets for getting funds to borrowers. The economic analysis of the financial structure also explains about how financial intermediaries are important for small investors to invest their money and help in reducing the transaction costs, these financial intermediaries also enable small investors to diversify their portfolio and minimize losses. It also explains about the risks involved when borrowers borrow money from various markets such as the Debt and Equity markets and also teaches us the tools and techniques to minimize losses due to these risks.

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