Financial System Design: Conflict Resolution and Information in Different Systems

1. Chapter 16 Financial System Design

2. 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

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

4. 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

5. 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.

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

7. 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

8. 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

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

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

11. 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 markets-oriented financial system

12. 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

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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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.

33. 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