Chapter 8

Question 1

Basic facts about financial structure

Answer 1

1) Stocks are not the most important sources of external financing for businesses.
2) Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.
3) Indirect finance is many times more important than direct finance
4) Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses.
5) The financial system is among the most heavily regulated sectors of the economy.
6) Only large, well-established corporations have easy access to securities markets to finance their activities.
7) Collateral is a prevalent feature of debt contracts for both households and businesses.
8) Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers.

Question 2

Transaction costs

Answer 2

Financial intermediaries have evolved to reduce transaction costs.

• Economies of scale
• Expertise

Question 3

Tools to help solve adverse selection problems

Answer 3

1) Private production and sale of information
- Free-rider problem
2) Government regulation to increase information
- Not always works to solve the adverse selection problem, explains Fact 5
3) Financial intermediation
- Explains facts 3, 4, & 6
4) Collateral and net worth
- Explains fact 7

Question 4

Principal-Agent problem (w/ debt and equity contracts)

Answer 4

-Principal: less information (stockholder)
-Agent: more information (manager)
-Separation of ownership and control of the firm
+Managers pursue personal benefits and power rather than the profitability of the firm

Question 5

Tools to help solve the principle-agent problem

Answer 5

1) Monitoring (Costly State Verification)
- Free-rider problem (Fact 1)
2) Government regulation to increase information
- Fact 5
3) Financial Intermediation
- Fact 3
4) Debt Contracts
- Fact 1

Question 6

Moral hazard influences in debt markets

Answer 6

• Borrowers have incentives to take on projects that are riskier than the lenders would like.
• This prevents the borrower from paying back the loan

Question 7

Tools to help solve moral hazard in debt contracts

Answer 7

1) Net worth and collateral
- Incentive compatible
2) Monitoring and enforcement of restrictive covenants
- Discourage undesirable behavior, encourage desirable behavior, keep collateral valuable, provide information
3) Financial intermediation
- Facts 3 & 4

Question 8

Financial repression

Answer 8

Characterized by:

• Poor system of property rights (unable to use collateral efficiently)
• Poor legal system (difficult for lenders to enforce restrictive covenants)
• Weak accounting standards (less access to good information)
• Government intervention through directed credit programs and state owned banks (less incentive to proper channel funds to its most productive use)