An Economic Analysis of Financial Structure
FACTS ABOUT FINANCIAL STRUCTURE
The financial system is complex and contains institutions like: Banks, insurance companies, mutual funds, stock and bond markets. The most important role of the financial markets is to channel funds from savers to people with productive investment opportunities. For the financial structure their are eight basic facts, where the four first emphasize the importance of financial intermediaries and the relative unimportance of securities markets for financing corporations. The first four tells about how stocks and bonds are relatively unimportant in financing corporations. And how indirect financing and financial intermediaries (ex. Bank loans) are by far the most used financing. The next four says how the financial sector is among the most regulated sector (5). How only large and well established companies can benefit from the financial markets (6). I also states that collateral is a common feature in most debt contracts (7). And it says that debt contracts are extremely complicated legal documents, which place many restrictions on the behavior of the borrowers (8).
Transaction costs and the size of securities posts are major problems in the financial markets. Only every second household in the states hold securities, which often is undiversified, this because of the size of the security posts and transaction costs. One way to reduce transaction costs is by using financial intermediaries like banks. Savers can also bundle up and buy in large volumes and then achieve economics of scale, reducing costs. This is also done through mutual funds. They sell shares to investors and reinvest the proceeds in shares and bonds, then achieving reduced risk and lower costs. Financial intermediaries also achieve expertise through specializing in trades also creating benefits.
The analysis of how asymmetric information creates the root of many economical problems is called the agency theory. Asymmetric information is defined as a situation where one party in a trade is lacking information, which unable the parties to make an accurate decision in the trade. The financial market reflects this issue. This theory is trying to explain why the financial structure takes the form it does through looking at the problem of adverse selection and moral hazard. Adverse selection occurs before a transaction and refers to the fact that bad credit risks are the ones most likely to a make a loan. While moral hazard occurs after a transaction and refers to activities the borrowers does, which is undesirable to the lender, but which the lender doesn’t know about.
ADVERSE SELECTION AND FINANCIAL STRUCTURE
Adverse selection affects the market. Many can relate to it through the pecking order theory and also through a theory called the Lemons Problem. Why does adverse selection create a poorly functioning financial market? By looking at how a company thinks when they issue stock, knowing that if they think they are a good company they will never issue stock at a price anyone will buy for. And if they know they are a bad company, then they will gladly issue a stock price the buyer will pay. The buyer knows the company have more information than him and rationally keeps away. The result explains the basic fact number one and two, showing that the security market is not well functioning. Knowing the effects of adverse selection, do we know what to do about it? The main problem is an asymmetric information picture. So the focus would be to make the market more transparent. One solution would be to buy information from private company’s specializing in getting this information. This would provide the buyer with a better picture of how to pay the right price for the right company. The problem here comes with something called the free rider problem. Because the market is open, free riders will also buy where they see other people making a...
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