An Economic Analysis of
Financial Structure
Why do Financial Institutions Exist?
(Why is Indirect Finance so Important?)

Chapter 8

Chapter Preview
W e take a closer look at why financial institutions exist and how they promote economic efficiency.
Topics include:
• A Few Basic Facts About Financial Structure
• Transaction Costs
• Asymmetric Information: Adverse Selection and
Moral Hazard

Chapter Preview (cont.)
• The Lemons Problem: How Adverse Selection
Influences Financial Structure
• How Moral Hazard Affects the Choice Between
Debt and Equity Contracts
• How Moral Hazard Influences Financial
Structure in Debt Markets

1

Basic Facts About Financial Structure
Throughout the World
• The chart on the next …show more content…

• Healthy drop out and go without insurance. • Adverse selection: Bad quality pushes good quality from the market because of an information gap.

8

How about charging less say $555.56 to everyone? How about charging less say $555.56 to everyone? • Break even on the healthy type, but lose on sickly type.
• Only way for insurance company in this case to break even is to charge $5,000


Healthy will go without insurance.

Adverse Selection and Financial Structure
Lemons Problem in Securities Markets
• Suppose investors cannot distinguish between good and bad securities, willing to pay only the average of the good and bad securities’ values. • Result: Good securities undervalued and firms won’t issue them; bad securities overvalued, so too many issued.

9

Lemons Problem in Securities Markets
• Investors won’t want to buy bad securities, so m arket won’t function well.


Explains Facts 1 and 2



Also explains Fact 6: only large well established firms have access to securities m arkets

• Bad quality pushes good quality from the m arket because of an information gap.

Tools to Help Solve Adverse Selection
Problems
• Private Production and Sale of
Information


Free-rider problem interferes with this solution • Government Regulation to Increase
Information (explains Fact # 5)

Tools to Help Solve Adverse Selection
Problems
• Financial Intermediation


Analogy to