ECON 354 Money and Banking Professor Yamin Ahmad Lecture 15 Puzzles of Financial Structure Adverse Selection and <a href="/keyword/moral-hazard/" >moral hazard</a> in Financial Markets Financial Crises Big Concepts Asymmetric Information in Financial Markets: Adverse Selection <a href="/keyword/moral-hazard/" >moral hazard</a> &quot;Market For Lemons ...&quot; Importance of Financial Development for Economic Growth Importance of Financial Crises Note: These lecture notes are incomplete without having attended lectures Sources of External Finance in U.S Note: These lecture notes are incomplete without having attended lectures Sources of Foreign External Finance Note: These lecture notes are incomplete without having attended lectures &quot;Puzzles&quot; of Financial Structure 1. Stocks are not most important source of external finance for businesses 1. Issuing marketable securities not primary funding source for businesses 1. Indirect finance (financial intermediation) is far more important than direct finance 1. Banks are most important source of external finance Note: These lecture notes are incomplete without having attended lectures &quot;Puzzles&quot; of Financial Structure 1. Financial system is among most heavily regulated sectors of economy 1. Only large, well established firms have access to securities markets 1. Collateral is prevalent feature of debt contracts 1. Debt contracts are typically extremely complicated legal documents with restrictive covenants Note: These lecture notes are incomplete without having attended lectures Transaction Costs and Financial Structure Transaction costs hinder flow of funds to people with productive investment opportunities Note: These lecture notes are incomplete without having attended lectures Role of Financial Intermediaries Financial intermediaries make profits by reducing transaction costs: 1. Take advantage of economies of scale Example: Mutual Funds 1. Develop expertise to lower transaction costs Explains Puzzle 3 Note: These lecture notes are incomplete without having attended lectures Adverse Selection and <a href="/keyword/moral-hazard/" >moral hazard</a> : Definitions Definition: Adverse Selection 1. Before transaction occurs 1. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected Note: These lecture notes are incomplete without having attended lectures Adverse Selection and <a href="/keyword/moral-hazard/" >moral hazard</a> : Definitions Definition: <a href="/keyword/moral-hazard/" >moral hazard</a> 1. After transaction occurs 1. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back Note: These lecture notes are incomplete without having attended lectures Adverse Selection and Financial Structure Lemons Problem in Securities Markets 1. If can't distinguish between good and bad securities, willing to pay only average of good and bad securities' values. 1. Result: Good securities undervalued and firms won't issue them; bad securities overvalued, so too many issued. 1. Investors won't want to buy bad securities, so market won't function well. Note: These lecture notes are incomplete without having attended lectures Explains Puzzle 2 and Puzzle 1. Also explains Puzzle 6: Less asymmetric information for well known firms, so smaller lemons problem Note: These lecture notes are incomplete without having attended lectures Tools to Help Solve Adverse Selection (Lemons) Problem 1. Private Production and Sale of Information Free-rider problem interferes with this solution 1. Government Regulation to Increase Information Explains Puzzle 5 Note: These lecture notes are incomplete without having attended lectures Tools to Help Solve Adverse Selection (Lemons) Problem 1. Financial Intermediation Analogy to solution to lemons problem provided by used-car dealers Avoid free-rider problem by making private loans Explains Puzzles 3 and 4 1. Collateral and Net Worth Explains Puzzle 7 Note: These lecture notes are incomplete without having attended lectures <a href="/keyword/moral-hazard/" >moral hazard</a> : Debt versus Equity <a href="/keyword/moral-hazard/" >moral hazard</a> in Equity: Principal-Agent Problem 1. Result of separation of ownership by stockholders (principals) from control by managers (agents) 1. Managers act in own rather than stockholders' interest Note: These lecture notes are incomplete without having attended lectures Tools to Help Solve the Principal-Agent Problem 1. Monitoring: production of information 1. Government regulation to increase information 1. Financial intermediation 1. Debt contracts Explains Puzzle 1: Why debt used more than equity Note: These lecture notes are incomplete without having attended lectures <a href="/keyword/moral-hazard/" >moral hazard</a> and Debt Markets <a href="/keyword/moral-hazard/" >moral hazard</a> : borrower wants to take on too much risk Tools to Help Solve <a href="/keyword/moral-hazard/" >moral hazard&...