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    Chapter 7 Why Do Financial Institutions Exist

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    Jay Ann Dome
    Financial institutions exist primarily to reduce transaction costs associated with direct financing between businesses and lenders. They do this through economies of scale and expertise. Indirect financing through financial intermediaries like banks is much more important than direct financing through stock and bond markets. However, asymmetric information problems like adverse selection and moral hazard make lending risky and must be addressed.

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    Chapter 7 Why Do Financial Institutions Exist

    Uploaded by

    Jay Ann Dome
    169 views10 pages
    Financial institutions exist primarily to reduce transaction costs associated with direct financing between businesses and lenders. They do this through economies of scale and expertise. Indirect financing through financial intermediaries like banks is much more important than direct financing through stock and bond markets. However, asymmetric information problems like adverse selection and moral hazard make lending risky and must be addressed.

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    Financial institutions exist primarily to reduce transaction costs associated with direct financing between businesses and lenders. They do this through economies of scale and expertise. Indirect financing through financial intermediaries like banks is much more important than direct financing through stock and bond markets. However, asymmetric information problems like adverse selection and moral hazard make lending risky and must be addressed.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    169 views10 pages

    Chapter 7 Why Do Financial Institutions Exist

    Uploaded by

    Jay Ann Dome
    Financial institutions exist primarily to reduce transaction costs associated with direct financing between businesses and lenders. They do this through economies of scale and expertise. Indirect financing through financial intermediaries like banks is much more important than direct financing through stock and bond markets. However, asymmetric information problems like adverse selection and moral hazard make lending risky and must be addressed.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 10

    CHAPTER 7:

    WHY DO FINANCIAL
    INSTITUTIONS EXIST?
    8 BASIC FACTS ABOUT FINANCIAL STRUCTURE
    THROUGHOUT THE WORLD
    1. Stocks are not the most important source 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, 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.
    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 typically are extremely complicated
    legal documents that place substantial restrictions on the
    behavior of the borrower.
    TRANSACTION COSTS
    1. How Transaction Costs Influence Financial Structure
    - Purchase is so small that the brokerage commission
    for buying the stock you picked will be a large
    percentage of the purchase price of the shares.
    - Only a restricted number of investments can be made
    because a large number of small transactions would
    result in very high transaction costs.
    • 2. How Financial Intermediaries Reduce Transaction
    Costs
    Economies of Scale- the reduction in
    transaction costs per dollar of investment as the size
    (scale) of transactions increases.
    • A mutual fund is a financial intermediary that sells shares to
    individuals and then invests the proceeds in bonds or stocks.
    3. Expertise- ability to provide its customers with liquidity
    services, services that make it easier for customers to
    conduct transactions.
    ASYMMETRIC INFORMATION:
    ADVERSE SELECTION AND MORAL HAZARD

    • Asymmetric information—a situation that arises


    when one party’s insufficient knowledge about the
    other party involved in a transaction makes it
    impossible to make accurate decisions when
    conducting the transaction
    ADVERSE SELECTION

    • Occurs before the transaction: Potential bad credit risks


    are the ones who most actively seek out loans.
    Because adverse selection increases the chances that a
    loan might be made to a bad credit risk, lenders might
    decide not to make any loans, even though good credit
    risks can be found in the marketplace.
    MORAL HAZARD
    • Arises after the transaction occurs: The lender runs the
    risk that the borrower will engage in activities that are
    undesirable from the lender’s point of view because they
    make it less likely that the loan will be paid back.
    Because moral hazard lowers the probability that the
    loan will be repaid, lenders may decide that they would
    rather not make a loan.

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