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2 marketable debt and equity securities are not the

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2. Marketable debt and equity securities are not the primary means in which U.S. businesses finance their operations. ** Again, the transactions costs are too high. 3. Indirect finance is many times more important than direct finance. **Only a small percentage of external financing comes directly from households. Firms rely primarily on financial intermediaries, even in bond and equity markets. 4. Banks are the most important source of external funds for U.S. businesses. **Banks reduce the transactions costs of lending and borrowing, and help to 76
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U.S. Financial Systems, Markets and Institutions Class 8 prevent adverse selection and moral hazard problems. 5. The financial system is among the most heavily regulated in the economy. **Regulations such as disclosure laws provide consumers with information, and thus help to lower transaction costs. Regulations over banks and securities markets help to reduce adverse selection and moral hazard problems. 6. Only large, well-established corporations have access to securities markets to finance their activities. **Only those firms with a significant amount of resources can afford the transactions costs of securities markets, and only large firms have the reputation to reduce adverse selection problems. These firms are often rated by one of the major rating agencies, so investors have more information about the quality of the company’s stocks and bonds. 7. Collateral is a prevalent feature of debt contracts. **Collateral requirements in debt contracts help to reduce moral hazard problems. If a borrower fails to repay the debt, then the lender can repossess the collateral, as in a house in a mortgage or an automobile in a car loan. 8. Debt contracts typically are extremely complicated legal documents with substantial restrictions on the behavior of the borrower. **The complexity of debt contracts is meant to avoid the problems of moral hazard. Significant restrictions on borrower behavior, known as restrictive covenants, are often included in debt contracts. These include prohibitions on borrower behavior that would reduce the likelihood of the loan being repaid, such as requiring that funds be restricted to certain uses; encouraging desirable behaviors, such as keeping the firm’s net worth high or holding compensating balances; collateral restrictions such as requiring insurance (fire or collision) on the collateral being held; and information disclosure provisions such as requiring monthly financial reports from the borrower. All of these are tools that are meant to reduce the problems of moral hazard in financial markets. Financial Crises The interplay between economic circumstances, adverse selection, and moral hazard has often helped to contribute to financial crises throughout the world. Examples include the Mexican Peso Crisis in 1994, the Asian Financial Crisis in 1997, and the Savings and Loans Crisis in the United States in the 1980s, and the financial crisis of 2008. We will examine the Savings and Loan Crisis, and the latest crisis, in more detail when we explore the history of banking regulation. 77
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