72 econ 350 us financial systems markets and

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 We have shown that there are many different ways that financial intermediaries help to reduce the transactions costs of lending. They also do the same for borrowers, as we will see next. Borrowers Let’s now turn to your friend who is starting a business. Without financial intermediaries, she will have to ask many friends and relatives to help her with external funding. But it may difficult for her to prove that she has a good business plan, and you may be wary to make the loan lest you lose your money or ruin a friendship. The search costs of such a loan for her may be prohibitively high, even with an excellent business plan. Her friends may not be able to judge a business plan, or may not be willing to put all of their savings eggs into one business basket. A profitable business venture may never materialize. With banks and other financial intermediaries such as mutual funds, your friend and other businesses have much lower search costs for funds. Borrowers can go directly to banks for loans, which have already pooled the funds of small investors, rather than having to contact each of these small investors directly. Businesses can go to banks for loans, or can rely on the investments of mutual funds or pension plans to help finance their debt and equity sales. In this way, borrowers rely heavily on the instruments of indirect finance to raise the funds necessary for business opportunities. In sum, the concept of transactions costs helps to explain our first four puzzles. Stocks and bonds are not a primary means of external financing because transactions costs tend to be high, especially for small firms. Indirect finance, and especially bank loans, tend to dominate the financial landscape because the transactions costs of borrowing and lending are reduced. The next four puzzles can be explained by the idea of information asymmetries, mainly the concepts of adverse selection and moral hazard. Information Asymmetries In Class 3, we offered the following definitions: “Information asymmetries occur when one party to a transaction has more information than the other. There are two main types: adverse selection, which occurs before the transaction, and moral hazard, which occurs after the transaction. Adverse selection: occurs when information asymmetries lead to a market being dominated by low-quality products. In financial markets, it occurs when high risk borrowers are the ones most likely to seek out loans. The safest borrowers do not need loans in the first place. Moral Hazard: occurs when costs of an action can be transferred to third parties. In banking, moral hazard occurs when a borrower engages in more risky activities which make it less likely that the loan will be repaid.” 73
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 Many models of microeconomics, such as perfect competition, assume that market participants have perfect information. In perfect competition, buyers know the prices and quality of the products in the market, and sellers know their demand curves and cost functions.
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