economics_of_money_banking__financial_markets

C H A P T E R 8 An Economic Analysis of Financial Structure 185

and is more likely to invest in the ice-cream store, which is more of a sure thing. Hence when Steve has more of his own money (net worth) in the business, you are more likely to make him the loan.

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it makes the debt contract incentive-compatible; that is, it aligns the incentives of the borrower with those of the lender. The greater the borrowerÕs net worth, the greater the borrowerÕs incentive to behave in the way that the lender expects and desires, the smaller the moral hazard problem in the debt contract is, and the easier it is for the firm to borrow. Conversely, when the borrowerÕs net worth is lower, the moral hazard problem is greater, and it is harder for the firm to borrow.

Monitoring and Enforcement of Restrictive Covenants. As the example of Steve and his ice-cream store shows, if you could make sure that Steve doesnÕt invest in anything riskier than the ice-cream store, it would be worth your while to make him the loan. You can ensure that Steve uses your money for the purpose you want it to be used for by writing provisions (restrictive covenants) into the debt contract that restrict his firmÕs activities. By monitoring SteveÕs activities to see whether he is complying with the restrictive covenants and enforcing the covenants if he is not, you can make sure that he will not take on risks at your expense. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. There are four types of restrictive covenants that achieve this objective:

1.Covenants to discourage undesirable behavior. Covenants can be designed to lower moral hazard by keeping the borrower from engaging in the undesirable behavior of undertaking risky investment projects. Some such covenants mandate that a loan can be used only to finance specific activities, such as the purchase of particular equipment or inventories. Others restrict the borrowing firm from engaging in certain risky business activities, such as purchasing other businesses.

2.Covenants to encourage desirable behavior. Restrictive covenants can encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. One restrictive covenant of this type requires the breadwinner in a household to carry life insurance that pays off the mortgage upon that personÕs death. Restrictive covenants of this type for businesses focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive covenants typically specify that the firm must maintain minimum holdings of certain assets relative to the firmÕs size.

3.Covenants to keep collateral valuable. Because collateral is an important protection for the lender, restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower. This is the type of covenant ordinary people encounter most often. Automobile loan contracts, for example, require the car owner to maintain a minimum amount of collision and theft insurance and prevent the sale of the car unless the loan is paid off. Similarly, the recipient of a home mortgage must have adequate insurance on the home and must pay off the mortgage when the property is sold.

4.Covenants to provide information. Restrictive covenants also require a borrowing firm to provide information about its activities periodically in the form of quarterly accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. This type of covenant may also stipulate that the lender has the right to audit and inspect the firmÕs books at any time.

effective use of these two tools. In these countries, bankruptcy procedures are often extremely slow and cumbersome. For example, in many countries, creditors (holders of debt) must first sue the defaulting debtor for payment, which can take several years, and then, once a favorable judgment has been obtained, the creditor has to sue again to obtain title to the collateral. The process can take in excess of five years, and by the time the lender acquires the collateral, it well may have been neglected and thus have little value. In addition, governments often block lenders from foreclosing on borrowers in politically powerful sectors such as agriculture. Where the market is unable to use collateral effectively, the adverse selection problem will be worse, because the lender will need even more information about the quality of the borrower in order to screen out a good loan from a bad one. The result is that it will be harder for lenders to channel funds to borrowers with the most productive investment opportunities, thereby leading to less productive investment, and hence a slower-growing economy. Similarly, a poorly developed legal system may make it extremely difficult for borrowers to enforce restrictive covenants. Thus they may have a much more limited ability to reduce moral hazard on the part of borrowers and so will be less willing to lend. Again the outcome will be less productive investment and a lower growth rate for the economy.

Governments in developing and transition countries have also often decided to use their financial systems to direct credit to themselves or to favored sectors of the economy by setting interest rates at artificially low levels for certain types of loans, by creating so-called development finance institutions to make specific types of loans, or by directing existing institutions to lend to certain entities. As we have seen, private institutions have an incentive to solve adverse selection and moral hazard problems and lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so because they are not driven by the profit motive and so their directed credit programs may not channel funds to sectors that will produce high growth for the economy. The outcome is again likely to result in less efficient investment and slower growth.

In addition, banks in many developing and transition countries have been nationalized by their governments. Again, because of the absence of the profit motive, these nationalized banks have little incentive to allocate their capital to the most productive uses. Indeed, the primary loan customer of these nationalized banks is often the government, which does not always use the funds wisely.

We have seen that government regulation can increase the amount of information in financial markets to make them work more efficiently. Many developing and transition countries have an underdeveloped regulatory apparatus that retards the provision of adequate information to the marketplace. For example, these countries often have weak accounting standards, making it very hard to ascertain the quality of a borrowerÕs balance sheet. As a result, asymmetric information problems are more severe, and the financial system is severely hampered in channeling funds to the most productive uses.

The institutional environment of a poor legal system, weak accounting standards, inadequate government regulation, and government intervention through directed credit programs and nationalization of banks all help explain why many countries stay poor while others grow richer.

problems in financial markets and provoke a financial crisis. A decline in the stock market means that the net worth of corporations has fallen, because share prices are the valuation of a corporationÕs net worth. The decline in net worth as a result of a stock market decline makes lenders less willing to lend because, as we have seen, the net worth of a firm plays a role similar to that of collateral. When the value of collateral declines, it provides less protection to lenders, meaning that losses on loans are likely to be more severe. Because lenders are now less protected against the consequences of adverse selection, they decrease their lending, which in turn causes investment and aggregate output to decline. In addition, the decline in corporate net worth as a result of a stock market decline increases moral hazard by providing incentives for borrowing firms to make risky investments, as they now have less to lose if their investments go sour. The resulting increase in moral hazard makes lending less attractiveÑ another reason why a stock market decline and resultant decline in net worth leads to decreased lending and economic activity.

In economies in which inflation has been moderate, which characterizes most industrialized countries, many debt contracts are typically of fairly long maturity with fixed interest rates. In this institutional environment, unanticipated declines in the aggregate price level also decrease the net worth of firms. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of firmsÕ liabilities in real terms (increases the burden of the debt) but does not raise the real value of firmsÕ assets. The result is that net worth in real terms (the difference between assets and liabilities in real terms) declines. A sharp drop in the price level therefore causes a substantial decline in real net worth and an increase in adverse selection and moral hazard problems facing lenders. An unanticipated decline in the aggregate price level thus leads to a drop in lending and economic activity.

Because of uncertainty about the future value of the domestic currency in developing countries (and in some industrialized countries), many nonfinancial firms, banks, and governments in these countries find it easier to issue debt denominated in foreign currencies. This can lead to a financial crisis in a similar fashion to an unanticipated decline in the price level. With debt contracts denominated in foreign currency, when there is an unanticipated decline in the value of the domestic currency, the debt burden of domestic firms increases. Since assets are typically denominated in domestic currency, there is a resulting deterioration in firmsÕ balance sheets and a decline in net worth, which then increases adverse selection and moral hazard problems along the lines just described. The increase in asymmetric information problems leads to a decline in investment and economic activity.

Although we have seen that increases in interest rates have a direct effect on increasing adverse selection problems, increases in interest rates also play a role in promoting a financial crisis through their effect on both firmsÕ and householdsÕ balance sheets. A rise in interest rates and therefore in householdsÕ and firmsÕ interest payments decreases firmsÕ cash flow, the difference between cash receipts and cash expenditures. The decline in cash flow causes a deterioration in the balance sheet because it decreases the liquidity of the household or firm and thus makes it harder for lenders to know whether the firm or household will be able to pay its bills. As a result, adverse selection and moral hazard problems become more severe for potential lenders to these firms and households, leading to a decline in lending and economic activity. There is thus an additional reason why sharp increases in interest rates can be an important factor leading to financial crises.

C H A P T E R 8 An Economic Analysis of Financial Structure 191

Problems in the Banking Sector. Banks play a major role in financial markets because they are well positioned to engage in information-producing activities that facilitate productive investment for the economy. The state of banksÕ balance sheets has an important effect on bank lending. If banks suffer a deterioration in their balance sheets and so have a substantial contraction in their capital, they will have fewer resources to lend, and bank lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity.

If the deterioration in bank balance sheets is severe enough, banks will start to fail, and fear can spread from one bank to another, causing even healthy banks to go under. The multiple bank failures that result are known as a bank panic. The source of the contagion is again asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of deposit insurance) and not knowing the quality of banksÕ loan portfolios, withdraw their deposits to the point that the banks fail. The failure of a large number of banks in a short period of time means that there is a loss of information production in financial markets and hence a direct loss of financial intermediation by the banking sector. The decrease in bank lending during a financial crisis also decreases the supply of funds to borrowers, which leads to higher interest rates. The outcome of a bank panic is an increase in adverse selection and moral hazard problems in credit markets: These problems produce an even sharper decline in lending to facilitate productive investments that leads to an even more severe contraction in economic activity.

Government Fiscal Imbalances. In emerging market countries (Argentina, Brazil, and Turkey are recent examples), government fiscal imbalances may create fears of default on the government debt. As a result, the government may have trouble getting people to buy its bonds and so it might force banks to purchase them. If the debt then declines in priceÑwhich, as we have seen in Chapter 6, will occur if a government default is likelyÑthis can substantially weaken bank balance sheets and lead to a contraction in lending for the reasons described earlier. Fears of default on the government debt can also spark a foreign exchange crisis in which the value of the domestic currency falls sharply because investors pull their money out of the country. The decline in the domestic currencyÕs value will then lead to the destruction of the balance sheets of firms with large amounts of debt denominated in foreign currency. These balance sheet problems lead to an increase in adverse selection and moral hazard problems, a decline in lending, and a contraction of economic activity.