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Financial markets
Financial markets promote economic efficiency by temporarily transferring wealth from lenders - those with assets for which they have little productive use - to borrowers - those with productive uses for funds.
Main Puzzle
Why, in general, does this temporary transfer of funds not occur directly between lenders and borrowers? An alternative way of stating this is: why do we need financial intermediation?
Main Puzzle
Simply put, the market for financial services should be an exchange between those who have funds to lend and those who wish to borrow. What is so complex about that?
Main Puzzle
The complexities that arise are due to: (1) the cost of coordinating borrowers and lenders (transaction costs), and (2) the difficulty of getting certain information about the product: loan contract, the repayment, and the fee
source of external financing for business? 2 Why issuing marketable debt and equity securities is not the primary way in which businesses finance their operations? 3 Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?
1. Stocks are not most important source of external finance for businesses
The principal-agent problem (a kind of moral hazard problem) naturally arises in equity (stock) financing. The managers might do things that majority shareholders would not want -- e.g., embezzling, slacking off, buying herself expensive company cars and office fixtures etc. But the principal-agent problem is less of a concern with debt contracts, because a typical bond or loan calls for the borrower to pay back fixed dollar amounts at regular intervals. For that reason, the volume of debt financing in the Mauritius is larger than the volume of equity financing, because more savers would be willing to purchase a debt instrument than an equity instrument.
1. Stocks are not most important source of external finance for businesses
Since corporate borrowers must pay off their creditors (bondholders, banks that loaned them money) before their equityholders, corporate debt is a much less risky asset than corporate stock Corporate debt is also less risky because debt securities give you a claim to a fixed stream of income from the corporation, instead of a share of uncertain profits and assets.
1. Stocks are not most important source of external finance for businesses
The adverse selection problem exists here too (this problem is less in bond market and least in Bank loans) The transactions costs of readying a stock (also a bond) offering and marketing it to the public are prohibitively high for most small and medium-sized companies.
2.Issuing marketable securities is not the primary funding source for businesses
Same reason as puzzle 1
3.Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?
Adverse selection: Screening out bad risks can be difficult, and banks are in a much better position than ordinary savers to screen out bad risks and lend savers' money to good credit risks.
3.Why indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets?
Moral hazard: Monitoring somebody after you've loaned him money can be difficult. But banks develop expertise in monitoring borrowers. They also avoid the free-rider problem inherent in, say, a bond issue: If a company finances its operations by selling bonds, then every bondholder wants the company to be monitored somehow, but none of them wants to pay for that monitoring herself. By contrast, a financial intermediary like a bank bears the whole cost of monitoring its borrowers, but it also captures the whole return from that monitoring.
5 Why the financial system is among the most heavily regulated sectors of the economy?
The financial sector is one of the most heavily regulated sectors of the economy. government regulation (e.g., forcing firms to follow standardized accounting principles, imposing stiff penalties for defrauding stockholders and creditors) is one way to deal with the principal-agent problem. By strictly regulating the banks and other financial institutions, the government can act on behalf of individual depositors, stockholders, and creditors (the principals), who otherwise would lack the ability or the incentive to keep track of what the managers (the agents) are up to.
8. Debt contracts are typically extremely complicated legal documents with restrictive covenants Restrictive covenants, restricting what the borrower can and cannot do during the lifetime of the loan, help to overcome the moral hazard problem.
The existence of financial intermediation suggests to us that there are features of direct finance that ensures that the market in direct finance doesn't work. The first of these features is transactions costs.
Information Asymmetry
On their own transaction costs are sufficient to ensure that the market for direct finance doesn't work; however there are costs associated with gathering and monitoring information of investments that compound these problems and which can explain the structure of financial intermediation.
Information Asymmetry
The information problems are caused by the fact that the borrower has more knowledge than the lender regarding the use(s) that the funds being transferred are going to be put to. If there was no risk of default (in terms of returning the funds to the lender at some specified date, or paying the fee for the funds), this asymmetry of information would cause no problem (hence the issues of collateral and complex legal documents in the puzzles: i.e. Puzzles 5, 6, 7 and 8).
These facts further explain why intermediation is necessary: In addition to the high transaction costs, private production of information is necessary to solve the problem of asymmetric information.
Puzzle 6
The better known a corporation is, the more information about its activities is available. This information lessens the need for private production for information - as it reduces the asymmetry of information.
Transaction costs and asymmetric information lead to inefficient outcomes in the market for direct finance and thus form the rationale for financial intermediation. The existence of the free-rider problem for traded securities indicates that financial intermediation, particularly by banks, should play a greater role than the securities markets in financing the activities of businesses.
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