Financial structure

Eight financial facts:
(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 (The existence of information asymmetry)
(3) indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raises funds directly from lenders in financial markets
(4) 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 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 typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower

Financial intermediaries have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the existence of financial markets.

The presence of economies of scales in financial markets helps explain why financial intermediaries developed and are such an important part of our financial structure. (Mutual fund)

Financial intermediaries arise also because they have comparative advantage in developing expertise to lower transaction costs.

The system of private production and sale of information doesn't completely solve the adverse selection problem because of the free-rider problem. People mimic your behavior, which drives up the price of the undervalued stocks and you realize that you have wasted your money buying information.

Two important tools used to help solve adverse selection and the moral hazard problems in credit markets are collateral and restrictive covenants.

4 factors that trigger a financial crisis:
(1) increase in interest rates: good credit risks are less willing to borrow while bad credit risks still want to borrow. Adverse selection
(2) increase in uncertainty: uncertainty makes it hard to distinguish between good and bad borrowers. Adverse selection
(3) asset market effects on balance sheets: equity functions like a cushion. A decline in stock price writes down capital of firms and panics investors. A sharp drop in price level raises liability of the firms, decreasing the ownership equity. An increase in interest rates and therefore in households' and firms' interest payment decreases the firms' cash flow, which causes a deterioration in the balance sheet because it decreases the liquidity of the household or firm and thus makes it harder for lenders to know whether the firm or household or household will be able to pay its bills.  
(4) Bank panics: bankruptcy of banks will reduce financial transactions. The amount of loanable funds decreases and interest rate increases, and thus adverse selection and moral hazard kicks in.

A financial intermediary such as a bank becomes an expert in the production of information about firms so that it can sort out good credit risks from bad ones. The bank's role as an intermediary that holds mostly nontraded loans is the key to its success in reducing asymmetric information in financial markets. Banks' role in financial market will decline when information about firms become easier to acquire.

Collateral reduces the consequences of adverse selection because it reduces the lenders' losses in the event of a default.

Net worth (equity capital), the difference between a firm's assets and its liabilities, can perform a similar role as collateral.

Financial intermediaries have the ability to avoid the free-rider problem in the face of moral hazard. Verification of earnings and profits is important in eliminating moral hazard, and thus venture firm can reduce the risk for investors.