THE ECONOMICS OF THE PRIVATE MARKET
Private Placements, the Theory of Financial Intermediation, and the Structure of Capital Markets
As previously discussed, contract terms and borrower and lender characteristics differ systematically across major debt markets (see table 8). Privately and publicly issued bonds tend to have long terms and fixed rates, whereas bank loans tend to have short terms and floating rates. Public issues and issuers are the largest on average, and bank loans and bank borrowers are the smallest. On average, public issues are the least risky, private placements are riskier, and bank loans are riskier still. Public issuers tend to be well known; private placement issuers tend to be less well known; and bank borrowers tend to be companies for which relatively little information is available publicly. 74 Public issues rarely include collateral and have few restrictive covenants. In traditional private placements, collateral is not uncommon, and covenants often impose significant restrictions on borrowers. Bank loans, in contrast, tend both to be secured and to have tight covenants. The terms of public issues are rarely renegotiated, whereas those of most private placements are renegotiated at least once, and those of bank loans are frequently renegotiated. Public issues are typically liquid, whereas most private placements and bank loans are illiquid. Investors in public securities carry out relatively little due diligence and monitoring of borrowers. Investors in bank loans and private placements perform significant amounts of due diligence and loan monitoring. Most private placement lending is done by a single type of financial intermediary, life insurance companies.
This section offers an integrated explanation for these patterns, elements of which have been mentioned in previous sections. The explanation is centered on hypotheses that borrowers pose a spectrum of information problems for lenders and that lenders address such problems through due diligence at loan origination and loan monitoring thereafter. Firms that are not information problematic can borrow in any market but generally find costs to be lowest in the public bond (and commercial paper) markets. Information-problematic firms find it optimal to negotiate debt contracts that include certain kinds of covenants and collateral and to deal with lenders having a capacity for due diligence and loan monitoring. Such lenders also can flexibly renegotiate the contracts, which is efficient since covenants are frequently violated.
Such contracts are not well suited to the public markets that exist today; instead they are issued in the bank loan and private placement markets. 75 Lenders in these markets are almost always financial intermediaries, and they tend to focus their investments in assets that match the rate and maturity structure of their liabilities. Correlations among several factors-the degree of information problems posed by borrowers, the borrowers' size, their risk, and the size of the loan-account for borrowers being smaller and riskier on average and loans smaller on average in such informationintensive markets than those in the public markets.
The differences between the average borrower from banks and the average issuer of private placements arise mainly because monitoring and risk control mechanisms involving covenants and collateral are less reliable the longer the average life of a loan is. Such mechanisms are most important in loans to very information-problematic borrowers; these borrowers can obtain long-term loans only at high rates, if at all. Thus, they tend to borrow in the shorter-term market, causing the average severity of information problems posed by borrowers to be highest there.
This explanation accounts for more of the features of the U.S. financial system than do traditional explanations that focus mainly on regulation and considerations of asset-liability matching as causal factors. It raises many new questions, however. Why must lenders to information-problematic borrowers be intermediaries? How do due diligence and loan monitoring mitigate risks associated with information problems? What is the role of covenants and collateral? Why are these risk-control mechanisms less effective for long-term loans? Why would a borrower agree to a contract with tighter rather than looser covenants? Why are covenants frequently violated and renegotiated, and why is a lender's reputation for flexibility in renegotiation important? Why is information-intensive debt illiquid? Why is the public market ill-suited to information-intensive lending (what is to prevent public market lenders from acquiring capacity in due diligence and loan monitoring)? What complex of characteristics is required to make a lender competitive in an information-intensive debt market?
Most of these questions have been addressed at least to some extent by existing financial theory. In the rest of this section, we review and extend relevant areas of financial theory to answer these questions and to provide a sense of the foundations of this study. We find existing individual theories of covenants and financial intermediation to be inadequate as a basis for a theory of financial structure. We propose a merging and an extension of the two bodies of theory in the form of a ''covenant-monitoring-renegotiation'' (CMR) paradigm in order to answer to the questions posed earlier. We evaluate the consistency of the paradigm with some recent research in empirical finance and graphically relate borrowers and capital markets on an information continuum.