Chapter 16 Financial System Design Financial System Two

Chapter 16 Financial System Design

Financial System § Two models of financial system can be found in industrialized nations. Those are: § Markets-oriented § United States and United Kingdom § Banking-oriented § Germany and Japan

Common Elements § Payments system § Processing of checks § Electronic transfers § Specialized Financial Intermediaries § Organizations or activities designed to perform specific functions within the financial system

Common Elements § Deposit Insurance § Protecting individual depositor § Central Bank § Responsible for issuing currency and interest rates § Maintaining stability of the system § Implementing monetary policy § Macroeconomic objectives: § Inflation control § Unemployment reduction

Differences § Financing § Primarily difference is related to how businesses obtain financing § Conflict Resolution § The private ownership of business leads to two fundamental conflicts: § Stockholder-lender conflict § Management-stockholder conflict § These problems are handled differently.

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

Manager-Stockholder Conflict § Arises primarily with large companies where 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 § Principal-agent problems however produce this conflict

Principal-Agent Problem § Manager often have objectives different from the owners. § 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 than strategies that may involve more risk, proportionately larger gains

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

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

Conflict Resolution in Different Financial Systems § Two Conflicts § Stockholder – Lender Conflict § Manager –stockholder Conflict § Two Systems § Banking oriented system § Market oriented system § These two conflicts are dealt with differently in a banking-oriented financial system as compared to a marketsoriented financial system

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

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

Information and System Design § Small Firms: § Manager-Stockholder Conflict § Not a problem in either financial system § Manager is often the owner of the firm

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

Information and System Design § Large firms: Stockholder-Lender Conflict § Widespread availability of public information, plus credit ratings, enables large firms to develop reputation for not becoming too risky

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

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

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

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

Large Firms: Manager-Stockholder Conflict § Markets-Oriented Systems § To minimize the conflict, management’s compensation packages are structured to link compensation to performance desired by stockholders

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

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

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

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

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

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

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

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

Financial System Design: Summary of Four Countries § 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 longterm credit banks, specialized small business and industrial institutions

Financial System Design: Summary of Four Countries § United Kingdom § Financial system is very much marketsoriented, 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

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.

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