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Moral hazard in debt markets moral hazard in debt

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Moral hazard in debt markets Moral hazard in debt markets occurs after the loan is made. It is when the borrower engages in risky activities that are undesirable to the lender because they reduce the likelihood of the loan being repaid. For instance, the borrower of a car loan may have the incentive to drive the car recklessly as long as the bank still owns most of it, since the bank will bear any costs of the damage to the vehicle if the loan fails to be repaid. Or a borrower of a business loan may have the incentive to use the funds for personal use rather than putting the loan into making the business more profitable. Rather than buying a barbershop, a business borrower may have the incentive to take a trip around the world. Moral hazard in equity markets Moral hazard in equity markets occurs when the managers of a firm may have different interests than the owners (or stockholders) of the firm. This is also known as the principal/agent problem or agency theory. For example, stockholders have an interest in maximizing the long-term profitability of the firm. Management may have other goals, such as maximizing the size of their staff, their own prerequisites, or the short-term value of their stock options. Such conflicts have come to a head lately in the corporate accounting scandals that we studied last week. Solving the Puzzles We now can sum up the argument by returning to the list of eight puzzles of the financial system with which we started. The ideas of transactions costs, adverse selection and moral hazard help to explain these puzzles. 1. Stocks are not the most important source of external financing for U.S. firms. ** The transactions costs of equity financing for most firms are just too high. 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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Econ 350 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.
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