Economic Analysis of Financial Structure - How moral hazard affects the choose between debt and equity contracts
3 important questions on Economic Analysis of Financial Structure - How moral hazard affects the choose between debt and equity contracts
What are tools to overcome the principal-agent problem?
- Production of information, auditing and checkin. (costly state verification makes the equity contract less desirable, and explains why equity is not a more important element in financial structure.
- Government regulation to increase information.
- Financial intermediation (example of venture capitalists)
- Debt contracts
What are tools to help solve moral hazard in debt contracts
- Net worth and collateral (makes the debt contract incentive compatible; aligns the incentives of borrowers with those of the lender.
- Monitoring and enforcement of restrictive covenants (four types of restrictive covenants ( Covenants to 1. discourage undesirable behaviour 2. encourage desirable behaviour. 3. keep collateral valuable(in good condition) 4. provide information
- Financial intermediation
What is the consequence of the fact that financial systems are underdeveloped in ex-communist countries like russia (transition countries)?
Their financial systems face difficulties form operating efficiently because of several reasons.
- Inadequate government regulation and a poorly functioning legal system (property rights functions poorly), which makes it difficult to use collateral and restorative covenants to overcome adverse selection and moral hazard problems. The result is that it is harder for lenders to channel funds to borrowers with the most productive investment opportunities
- Governments in developing countries often use financial systems to direct credit to themselves (absence of profit motive). Sometimes even state ownership
- Weak accounting standards making it hard to see the difference between good an bad firms.
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