Week 1

• Bank loans are the main source of funding for advanced countries
• Equity is the least relevant source of funding for advanced countries because they are reluctant to use it
• Stocks are not the most important source of external financing for businesses
• issuing marketable debt and equity securities is not the primary way that businesses finance their operations
• Indirect finance and the actions of financial intermediaries is much more important than direct finance
• Financial intermediaries are the most important source of external funds to finance businesses
• The financial system is one of the most heavily regulated sectors of the economy, as a response to asymmetric information
• Only large well established corporations have easy access to securities markets to finance their activities, many smaller companies are excluded
• Collateral is a prevalent feature of debt contracts for both businesses and households
• Debt contracts are very complicated legal documents that put very restrictive covenants on borrowers to regulate their activity
• Financial intermediaries have evolved to reduce transaction costs, and increases saver/ borrower matching efficiency
• economies of scale are used by intermediaries by bundling funds together to reduce per dollar transaction costs. Bigger bundles means lower transaction costs
• Economies of scale are used by intermediaries by accumulating expertise to reduce risk
• Financial intermediaries develop expertise of information and advise to improve their ability to work out who will and won’t pay their debts, which lowers transaction costs
• Financial intermediaries develop expertise in liquidity services to ease transactions and lower transaction costs
• Asymmetric information describes the issue that in bi-lateral trading one side is more informed than the other
• Adverse selection is the issue that the borrowers most likely to produce adverse outcomes are the ones most likely to seek loans and be selected
• Moral hazard is the fact that borrowers have incentives to engage in undesirable activities that make them less likely to pay the loan back
• Adverse selection is when one party has more information about a product or service than the other party
• Adverse selection takes place before the transaction
• Adverse selection is shown through the lemons problem
• The lemons problem shows that buyers are only willing to pay the price for average quality, so people with high quality goods won’t sell (as the price is too low) so all that’s left in the market is poor quality goods, so the buyer doesn’t buy anything
• Adverse selection explains why issuing marketable debt and equity is not the primary source of business finance
• Adverse selection partially explains why stove aren’t the most important source of external finance
• Adverse selection interferes with the efficient functioning of financial markets
• Adverse selection can be solved using private production and sale of information, however it does introduce the free rider problem, where they avoid paying for information, but still enjoy the benefits
• Adverse selection can be solved using government regulation to increase information. This explains why the financial markets are so heavily regulated, and gives markets more information
• Financial intermediation helps solve adverse selection, with banks providing private loans and not operating in the open markets. they avoid free-riding problems
• Collateral helps solve adverse selection as it is promised to the lender if the borrower defaults, and is a guarantee of repayment
• Moral hazard takes place after the transaction
• Moral hazard occurs when the borrower has an incentive to increase its risk exposure because it doesn’t bear the full costs of the risk
• The Principal-Agent problem is an example of moral hazard, as managers (agents) will pursue personal benefits over profitability of the form for stakeholders (principal)
• Moral hazard can be solved through monitoring, where stakeholders pay someone to monitor managers. This is expansive and introduces the risk of free-riders
• Government regulation can help solve moral hazard by increasing information
• Financial intermediation can solve moral hazard by directly participating with the firm
• A debt contract can solve moral hazard by asking for repayment in fixed amounts instead of subject to performance. they have right restrictions
• Financial institutions are economies of scope, so provide multiple services at lower cost for maximum efficiency
• Economies of scope can generate conflicts of interest, and the risk of provision of misleading information
• Conflicts of interests can reduce quality of information in financial markets and increase asymmetric information problems. This is because funds are not channeled into productive investment opportunities
• Investment banks research companies and give information on what securities to buy. the also sell stocks, so there may be a conflict of interest where they bias opinion to a particular stock they are trying to sell