Chapter 8 Mishkin Notes

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An Economic Analysis of
Financial Structure
Why do Financial Institutions Exist?
(Why is Indirect Finance so Important?)

Chapter 8

Chapter Preview
W e take a closer look at why financial institutions
exist and how they promote economic efficiency.
Topics include:
• A Few Basic Facts About Financial Structure
• Transaction Costs
• Asymmetric Information: Adverse Selection and
Moral Hazard

Chapter Preview (cont.)
• The Lemons Problem: How Adverse Selection
Influences Financial Structure
• How Moral Hazard Affects the Choice Between
Debt and Equity Contracts
• How Moral Hazard Influences Financial
Structure in Debt Markets

1

Basic Facts About Financial Structure
Throughout the World
• The chart on the next slide shows how
non-financial business get external
funding in the U.S., Germany, Japan, and
Canada.
• Notice that, although many aspects of
these countries are quite different, the
sources of financing are somewhat
consistent, with the U.S. being different in
its focus on debt.

Sources of External Finance

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8-5

Eight Basic Facts of Financial Structure
1. Stocks are not the most important
source of external financing for
businesses [Direct Finance]
2. Issuing marketable debt and equity
securities is not the primary way in
which businesses finance their
operations [Direct Finance]

2

Eight Basic Facts of Financial Structure
3. Indirect finance, which involves the
activities of financial intermediaries, is
m any times more important than direct
finance, in which businesses raise funds
directly from lenders in financial markets.
4. Financial intermediaries, particularly banks,
are the most important source of external
funds used to finance businesses.

Eight Basic Facts of Financial Structure
5. The financial system is among the most
heavily regulated sectors of economy.
6. Only large, well -established corporations
have easy access to securities markets to
finance their activities.

Eight Basic Facts of Financial Structure

7. Collateral is a prevalent feature of debt
contracts for both households and
businesses.
8. Debt contracts are typically extremely
complicated legal documents that place
substantial restrictions on the behavior of
the borrowers.

3

W hy is Indirect Finance so Important?
• Transactions Cost
• Information Cost

Transaction Costs
• Financial intermediaries to reduce
transaction costs (and make profits)
through –
• Economies of scale
• Expertise

• Read the municipal bond article.

Transaction Costs
• Transactions costs





E.g., a $5,000 investment only allows you
to purchase 100 shares @ $50 / share
(equity)
No diversification
Bonds even worse—most have a $1,000
size

4

Transaction Costs
• Financial intermediaries make profits by
reducing transactions costs


Take advantage of economies of scale
(example: mutual funds)



Develop expertise to lower transactions
costs



provide investors with liquidity and
diversification

Information Costs - Asymmetric Information
• symmetric information—the case where all
parties to a transaction or contract have the
same information.
• In many situations, this is not the case. We
refer to this as asymmetric information.

Asymmetric Information:
Adverse Selection and Moral Hazard
• We will focus on two specific forms of
asymmetric information:


Adverse selection



Moral hazard

5

Asymmetric Information: Adverse
Selection and Moral Hazard
• Adverse Selection
1.

Occurs when one party in a transaction has
better information than the other party

2.

Before transaction occurs

3.

Potential borrowers most likely to produce
adverse outcome are ones most likely to
seek loan

The Lemons Problem: How Adverse Selection
Influences Financial Structure
• If quality cannot be assessed, the buyer is willing to pay at m ost a...
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