Summary 3 Financial Institutions

A snapshot of the summary - 3 Financial Institutions

• 8 An Economic Analysis of Financial Structure

• 8.1 Basic Facts about Financial Structure throughout the World

• Why is the Financial system complex in structure and function throughout the
  world?

  Because there are many different types of institutions that are regulated by the government:
  • Banks, Insurance companies, Mutual funds
  • Stock and bond markets, …
  And because it channels trillions of dollars per year from savers to people with investment opportunities
• Which corporations have easy access to securities markets to finance their activities?

  Only large, well-established corporations
• What are debt contracts?

  Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers. (covenants are restrictions that indicate which activities are allowed)

• 8.2 Transaction Costs

• How can financial intermediaries reduce transaction costs?

  1. Economies of scale: bundle the funds
  2. Expertise: ex. Computer technology

• 8.3 Asymmetric Information: Adverse Selection and Moral Hazard

• What is adverse selection?

  Asymmetric information problem that occurs before a transaction occurs. (ex. Potential bad credit risks are the ones that most actively seek for a loan)

• 8.4 The Lemons Problem: How Adverse Selection Influences Financial Structure

• What is a lemon?

  A bad car in the used-car market (antonym= peach)
• How does adverse selection happen?

  A lemon owner will be happy if he sells his car at average price, a peach owners won't be happy. Fewer good cars will thus come to the market
• How to apply the lemon-peach theory in finance?

  Owners or managers of a good firm know they have a good firm: securities are undervalued and are not willing to sell
  Only bad firms will be willing to sell securities, because the price will be above the value of the securities
  
  This problem explains fact 2 (Issuing marketable debt and equity securities is not
  the primary way in which businesses finance their operations) and partially explains fact 1 (Stocks are not the most important sources of external financing for businesses)  
• How do we solve the adverse selection problem? free-rider problem

  Private production and sale of information: Private companies that collect and produce information that distinguishes good firms from bad firms (e.g. Standard and Poor’s, Moody’s)
• How do we solve the adverse selection problem? No free-rider problem

  Government regulation to increase information: Releasing negative information may be politically difficult