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Capital Market Frictions and Bank Lending in the EU

In: Frontiers of Banks in a Global Economy

Author

Listed:
  • Yener Altunbaş

    (Bangor University)

  • David Marques

    (European Central Bank)

  • Balzhan Zhussupova

    (Bangor University)

Abstract

Modigliani and Miller (1958, 1963) suggest that in perfectly efficient markets a firm’s capital structure does not affect market value, and the type of source of finance is irrelevant for investment decisions. The firm can raise enough capital to finance all its projects offering positive net present values. However, the violation of the perfect market assumption ascribes a role for financial factors in the company’s value and investment decisions. Asymmetric information and costly enforcement of contracts can disrupt the functioning of capital markets, leading to a wedge between the cost of external finance and the opportunity cost of internal funds for the firm. This wedge, called the external premium, represents the deadweight costs associated with the agency problem that normally exists between lenders and borrowers. The costs include the lenders’ costs of information acquisition, evaluation, and monitoring of the borrowers’ projects. The wedge reflects the ‘lemon’ premium that is charged because the borrowers have more information about the investment projects than the lenders do. There are also costs associated with the risk that the borrowers can change behaviour due to moral hazard problems or the contracts’ restrictions to contain moral hazard. Thus, the external finance premium is the difference in cost between the funds raised externally by issuing equity or debt and the funds generated internally by retaining earnings (Bernanke and Gertler, 1995).

Suggested Citation

  • Yener Altunbaş & David Marques & Balzhan Zhussupova, 2008. "Capital Market Frictions and Bank Lending in the EU," Palgrave Macmillan Studies in Banking and Financial Institutions, in: Philip Molyneux & Eleuterio Vallelado (ed.), Frontiers of Banks in a Global Economy, chapter 5, pages 103-130, Palgrave Macmillan.
    • Handle: RePEc:pal:pmschp:978-0-230-59066-3_5
    DOI: 10.1057/9780230590663_5
    as

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