7 collateral is a prevalent feature of debt contracts

Info icon This preview shows pages 10–12. Sign up to view the full content.

View Full Document Right Arrow Icon
7. Collateral is a prevalent feature of debt contracts. **Collateral requirements in debt contracts help to reduce moral hazard problems. If a borrower fails to repay the debt, then the lender can repossess the collateral, as in a house in a mortgage or an automobile in a car loan. 8. Debt contracts typically are extremely complicated legal documents with substantial restrictions on the behavior of the borrower. **The complexity of debt contracts is meant to avoid the problems of moral hazard. Significant restrictions on borrower behavior, known as restrictive covenants, are often included in debt contracts. These include prohibitions on borrower behavior that would reduce the likelihood of the loan being repaid, such as requiring that funds be restricted to certain uses; encouraging desirable behaviors, such as keeping the firm’s net worth high or holding compensating balances; collateral restrictions such as requiring insurance (fire or collision) on the collateral being held; and information disclosure provisions such as requiring monthly financial reports from the borrower. All of these are tools that are meant to reduce the problems of moral hazard in financial markets. Financial Crises The interplay between economic circumstances, adverse selection, and moral hazard has often helped to contribute to financial crises throughout the world. Examples include the Mexican Peso Crisis in 1994, the Asian Financial Crisis in 1997, and the Savings and Loans Crisis in the United States in the 1980s, and the financial crisis of 2008. We will examine the Savings and Loan Crisis, and the latest crisis, in more detail when we explore the history of banking regulation. 77
Image of page 10

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 The Structure of U.S. Commercial Banking Before we end for the day, let’s briefly look at the structure of commercial banking in the United States. Earlier we discussed the existence of economies of scale in the banking system. This can be seen from the following graphs. Figure 8-3 Number of FDIC - insured banks in US, 1990-2009 0 2000 4000 6000 8000 10000 12000 14000 16000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 year number commercial banks savings institutions Source: www.ffiec.gov Figure 8-3 shows that the number of commercial banks and savings institutions has been declining in recent years. What is going on here? Has there been an explosion of bank closings in recent years? Figure 8-4 shows that bank closings cannot explain the decline in the number of banks before 2008. While there were a significant number of bank failures in the 1930s due to the Great Depression and in the early 1990s due to the savings and loan crisis, the number of declines from 1993 – 2007 has been relatively small. There must be another explanation for the decline in the number of banks in this period. From 2008 – 2009, the number of bank closings increased dramatically. Up until December 16, 2009, there had been 140 bank failures for the year (FDIC).
Image of page 11
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern