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8 debt contracts typically are extremely complicated

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8. Debt contracts typically are extremely complicated legal documents with substantial restrictions on the behavior of the borrower. We will spend class today exploring these puzzles, and show how economic concepts such as transactions costs and information asymmetries can shed light on these puzzles. Figure 8-1 (source: Mishkin, 8 th edition) Figure 8-1 provides an illustration of the first four puzzles. Note that bank loans are the largest source of external financing, at 40%. The total amount of loans, both bank and non-bank, makes up the majority of the sources of external financing at 55% (40 + 15). Bonds comprise 36%, while stocks make up 9% of external funding for U.S. businesses. The table is misleading in several ways. First, although stocks and bonds make up about 45% of financing in total, the vast bulk of this (about 90%) comes from financial institutions such as mutual funds and pension plans. Only about 10% (or 4.5% of the total) comes from households in the form of direct financing. So indirect financing is much more important as a source of funds, either from banks or other types of financial institutions. 69 Sources of External Financing for U.S. Non-financial Firms 1970 - 1996 Bank Loans 40% Bonds 36% Stock 9% Nonbank Loans 15%
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 Second, the importance of stocks is somewhat underestimated in the table as a source of ongoing funds. A stock sale provides funds permanently, while a bond sale only provides funds until the bond matures. Bond financing over time requires a continual re-issuance of the bonds, while stocks only have to be sold once to provide funds for the same period of time. So for any given year, the amount of stock issued that year will be less than the total amount of financing provided by stock sales over time that can be utilized that year. The last four puzzles are concerned with the complexity of the financial system. The financial system is heavily regulated, as we have seen, and only a relatively few well- known firms have access to securities markets. Debt contracts are very complicated legal documents, with lots of restrictive covenants and collateral features. We now turn our attention to the major explanations for these characteristics of the banking system. First, as we discussed earlier in Class 2, financial intermediaries help to reduce transactions costs, so businesses tend to rely primarily on bank loans because the transactions costs are less than direct finance. Second, most of the complexity of the banking system is meant to address issues of information asymmetries, when one party to a transaction has more information than another. In particular, we will examine the cases of moral hazard and adverse selection. Transactions costs: The costs of originating, organizing, arranging, and implementing an exchange. Information Asymmetries:
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8 Debt contracts typically are extremely complicated legal...

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