Ch. 11: The Economics of Financial Intermediation - Money and Banking

short-term economies of scale liquidity rate of return

Even the bank's ___ investments will do better than an individual depositor's could, because the bank can take advantage of ___ to lower its transactions costs. It isn't much more expensive to buy a $1 million U.S. Treasury bill than it is to buy one worth only $1,000. By collecting funds from a large number of small investors, the bank can reduce the cost of their combined investment, offering each individual investor both ___ and a better ___. Pooling large numbers of small accounts in this way is very efficient. By doing so, an intermediary offers depositors something they can't get from the financial markets on their own.

stock- and bondholders private equity firms moral hazard

Finally, the threat of a takeover helps persuade managers to act in the interest of the ___. If managers don't do a good job of watching out for shareholders' interests, another company can buy the firm and replace them. In the 1980s, some firms specialized in such tactics. Today, this approach has become the business model of ___, a few of which (like Bain Capital and Kohlberg Kravis Roberts) have become very large themselves. When the new owners put their own people in charge of the firm, they eliminate the ___ problem.

diversify risk

Financial institutions enable us to ___ our investments and reduce ___. For example, a bank might collect $1,000 from each of one million depositors and then use the resulting $1 billion to make 10,000 loans of $100,000 each. So each depositor has a 1/1,000,000 share in each of the 10,000 loans.

savers and borrowers financial instruments financial markets

Financial institutions intermediate between ___, and so their assets and liabilities are primarily ___. Various sorts of banks, brokerage firms, investment companies, insurance companies, and pension funds all fall into this category. These are the institutions that pool funds from people and firms who save and lend them to people and firms who need to borrow, transforming assets and providing access to ___. They funnel savers' surplus resources into home mortgages, business loans, and investments.

Financial Intermediation

Financial institutions' purpose.

direct finance and indirect finance indirect finance increase reduce

Financial intermediaries are involved in both ___. Intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities. As providers of ___, banks want to make loans only to the highest-quality borrowers. When they do their job correctly, financial intermediaries ___ investment and economic growth at the same time that they ___ investment risk and economic volatility.

bonds and equity raise funds branding

Financial intermediaries' superior ability to screen and certify borrowers extends beyond loan making to the issuance of ___. Underwriters - large financial institutions, like Goldman Sachs, JPMorgan Chase, and Morgan Stanley - screen and certify firms seeking to raise funds directly in the financial markets. Without certification by one of these firms, companies would find it difficult to ___. Large intermediaries go to great lengths to market their expertise as underwriters; they want people to recognize their names the world over, just as everyone recognizes Coca-Cola. A can of Coke, the best-selling soft drink in the world, is instantly recognizable, whether the fine print is in English, Chinese, Arabic, or Swedish. Financial institutions have applied this concept, which marketing people call ___, to their certification of financial products. If JPMorgan Chase, a well-known bank and securities firm, is willing to sell a bond or stock, the brand name suggests that it is a high-quality investment.

value grow cheaply

From a social perspective, the fact that managers might avoid issuing stock or bonds because they know the market will not ___ their company correctly is not good. It means that the company will pass up some good investments. And because some of the best investments will not be undertaken, the economy won't ___ as rapidly as it could. Thus, it is extremely important to find ways for investors and lenders to distinguish well-run firms from poorly run firms. Well-run firms need to highlight their quality so they can obtain financing more ___. Investors need to distinguish between high- and low-risk investments so they can seek compensation corresponding to the level of risk they are taking on.

Collecting and Processing Information Services

Generating large amounts of standardized financial information.

lower scale of loans

In many emerging markets, the ratio is somewhat ___ because in recent decades their stock markets have expanded notably. However, domestic private debt securities play only a small role in most emerging market economies, which underscores the costs and challenges of developing this alternative to loan and stock finance. The biggest difference among the emerging economies is in the ___, which range from less than 15 percent of GDP in Argentina to more than 100 percent in China.

venture capital firm ventures moral hazard

In the case of some new companies, a financial intermediary called a ___ does the monitoring. Venture capital firms (like Kleiner Perkins or Draper Fisher) specialize in investing in risky new ___ in return for a stake in the ownership and a share of the profits. To guard against ___ and ensure that the new company has the best possible chance of success, the venture capitalists keeps a close watch on the managers' actions.

short-term liquid long-term short-term

In the same way that insurance company knows that not all its policyholders will have automobile accidents on the same day, a bank knows that not all its depositors will experience an emergency and need to withdraw funds at the same time. The bank can structure its assets accordingly, keeping enough funds in ___, ___ financial instruments to satisfy the few people who will need them and lending out the rest. And because ___ loans usually have higher interest rate than ___ money-market instruments - for instance, commercial paper and U.S. Treasury bills - the bank can offer depositors a higher interest rate than they would get otherwise.

directly free-rider problem reduce

These reports are not cheap. For example, Value Line charges nearly $600 a year for its weekly publication. To be credible, the companies examining can't pay ___ for the research themselves, so investors have to. And while some individuals might be willing to pay, in the end they don't have to and so they won't. Private information services face what is called a ___. Even though these publications are expensive, public libraries subscribe to some of them. Reporters for The Wall Street Journal and other periodicals read them and write stories publicizing crucial information. And individual investors can simply follow the lead of people they know who subscribe to the publications. Of course, all these practices ___ the ability of the producers of private information to actually profit from their hard work.

activities monitor

Many financial intermediaries (other than banks) hold significant numbers of shares in individual firms. When they do, they find ways to monitor the companies' ___. Before buying a company's stock, managers do a significant amount of research on the firm; once they have purchased the shares, they ___ the firm's activities very closely. In some cases, they place a representative on the company's board of directors to monitor and protect investment firsthand.

financial markets

Markets are remarkably effective at coordinating the behavior of millions of firms and households in an economy. And ___ are among the most important markets of all; they price economic resources and allocate them to their most productive uses.

transactions costs information costs reduce

Most people take for granted the ability of the financial system to shift resources from savers to investors, but when you look closely at the details, you're such by how complicated the task is. It's amazing the enterprise works at all. Lending and borrowing involve both ___, like the cost of writing a loan contract, and ___, like the cost of figuring out whether a borrower is trustworthy. Financial institutions exist to ___ these costs.

liquidity

One function that is related to access to the payments system is the provision of ___.

information 1. government-required disclosure 2. private collection and production of information (like CARFAX for used cars)

One obvious way to solve the hidden attributes problem is to generate more ___. This can be done in one of two ways: ___. In most advanced economies, public companies - those that issue stocks and bonds that are bought and sold in public financial markets - are required to disclose voluminous amounts of information. Corporations are also required to disclose, on an ongoing basis, information that could have a bearing on the value of their firms.

borrowing money collateral net worth

The importance of net worth in reducing adverse selection is the reason owners of new businesses have so much difficulty ___. If you want to start a bakery, for example, you will need financing to buy equipment and cover the rent and payroll for the first few months. Such seed money is very hard to get. Most small business owners must put up their homes and other property as ___ for their business loans. Only after they have managed to establish a successful business and have built up some ___ in it, can they borrow without pledging their personal property.

small savers large loans

The most straightforward economic function of a financial intermediary is to pool the resources of many ___. By accepting many small deposits, banks empower themselves to make ___.

Payments System

The network that transfers funds from the account of one person or business to the account of another.

financial institutions information costs screen borrowers

The problems of adverse selection and moral hazard make securities finance expensive and difficult to get. These drawbacks lead us immediately to loans and the role of ___. Much of the information that financial intermediaries collect is used to reduce ___ and minimize the effects of adverse selection and moral hazard. To reduce potential costs of adverse selection, intermediaries ___ loan applicants. To minimize moral hazard, they monitor ___. And when borrowers fail to live up to their contracts with lenders, financial intermediaries penalize them by enforcing the contracts.

adverse selection moral hazard

The two problems eBay faced arise in financial markets, too. In fact, information problems are the key to understanding the structure of our financial system and the central role of financial intermediaries. Asymmetric information poses two important obstacles to the smooth flow of funds from savers to investors. The first, called ___, arises before the transaction occurs. Just as buyers on eBay need to know the relative trustworthiness of sellers, lenders need to know how to distinguish good credit risks from bad. The second problem, called ___, occurs after the transaction. In the same way that buyers on eBay need reassurance that sellers will deliver their purchases after receiving payment, lenders need to find a way to tell whether borrowers will use the proceeds of a loan as they claim they will.

1. Collateral 2. Net Worth

There are two mechanisms for ensuring that a borrower is likely to repay a lender:

hidden actions

Thus, a lender's or investor's information problems do not end with adverse selection. A second information asymmetry arises because the borrower knows more than the lender about the way borrowed funds will be used and the effort that will go into a project. Where adverse selection is about hidden attributes, moral hazard is about ___. Moral hazard plagues both equity and bond financing, making it difficult for all but the biggest, best-known companies to issues either stocks or bonds successfully.

credit score

To get a loan, whether from a bank, a mortgage company, or a finance company, you must fill out an application. As part of the process, you will be asked to supply your Social Security number. The lender uses the number to identify you to a company that collects and analyzes credit information, summarizing it for potential lenders in a ___.

moral hazard restrictive covenants net worth

To some degree, a good legal contract can solve the ___ problem that is inherent in debt finance. Bonds and loans often carry ___ that limit the amount of risk a borrower can assume. For example, a covenant may restrict the nature of the goods or services the borrower can purchase. It may require the firm to maintain a certain level of ___, a minimum balance in a bank account, or a minimum credit rating. Home mortgages often come with restrictive covenants requiring the homeowners to purchase fire insurance or to make monthly deposits toward payment of their property taxes. (Failure to pay property taxes can lead the government to seize the borrower's house, complicating the mortgage company's attempt to recover its principal.)

GDP bigger larger 100

Two things need to be noted for the importance of different channels of finance. First, to make comparisons across countries of vastly different size, we measure everything relative to ___. Second, there is no reason that the value of a country's stock market, bonds outstanding, or bank loans cannot be ___ than its GDP. In fact, we would expect it to be much ___, because the value of a company to its owners is often several time the level of one year's sales. This means that when you add up all the types of financing, direct and indirect, as a percentage of GDP, the numbers will generally sum to more than ___ in an advanced economy.

adverse selection

What about the private collection and sale information? You might think that this would provide investors with what they need to solve the ___ problem, but unfortunately it doesn't work. While it is in everyone's interest to produce credible proof of the quality of a company's activities, such information doesn't really exist. In a limited sense there is private information collected and sold to investors.

financial market

When it comes to information costs, financial markets are not that different from the used-car market. In the same way that the seller of a used car knows more about the car than the buyer, potential borrowers know more about the projects they wish to finance than prospective lenders. And in the same way that information asymmetries can drive good cars out of the used-car market, they can drive good stocks and bonds out of the ___.

Deflation

When prices are declining on average.

disappears

When the managers of a company are the owners, the problem of moral hazard in equity financing ___. This suggests that investors should prefer debt financing to equity financing. But debt financing has its problems, too. Imagine that instead of buying a 90 percent share in your cousin Ina's software venture, you lender her $9,000 at an 11 percent annual interest rate. The debt contract specifies that she will repay you $9,990 in one year's time. This arrangement dramatically changes Ina's incentives. Now, if she works hard, she gets $90,010, but if she goes surfing, she still has to repay the $9,990, leaving her nothing at the end of the year. Surely this solves your problem.

Moral Hazard

When we cannot observe people's actions and so cannot judge whether a poor outcome was intentional or just a result of bad luck.

safekeeping payments system cheaply financial transactions

When we think of banks, ___ is only one of several services that immediately come to mind. The others are Internet and mobile access, automated teller machines, credit and debit cards, checkbooks, and monthly bank statements. In providing depositors with these physical and electronic services, a bank gives them access to the ___. The bank provides depositors a way to get cash into their wallets and to finalize payments using credit cards, debit cards, and checks. And because banks specialize in handling payments transactions, they can offer all these services relatively ___. Financial intermediaries reduce the costs of ___.

asymmetric information works

The 2001 Nobel Prize in Economics was awarded to George A. Akerlof, A. Michael Spence, and Joseph E, Stiglitz "for their analyses of markets with ___." Professor Akerlof's contribution came first, in a paper published in 1970 titled "The Market for 'Lemons.'" Akerlof's papers explained why the market for used cars - some of which may be "lemons" - doesn't function very well. So long as there exists a technology that lets buyer determine, at a reasonable cost, the hidden attributes of used cars for sale, the market ___.

liquidity services

The ___ financial intermediaries provide go.

information asymmetry

The fact that sellers have much more information about the items they are selling and their own reliability creates an ___.

Asymmetric Information

The fact that the two parties to a transaction have unequal knowledge about each other. A borrower, for example, has more information about his or her abilities and prospects than a lender.

Unsecured Loans

A loan that is not guaranteed by collateral; like a credit card debt; they typically charge very high interest rates; adverse selection is the reason.

Pooling Savings

Accepting resources from a large number of small savers/lenders in order to provide large loans to borrowers.

low-cost low-cost idiosyncratic risk low

All financial intermediaries provide a ___ way for individuals to diversify their investments. Mutual fund companies offer small investors a ___ way to purchase a diversified portfolio of stocks and eliminate the ___ associated with any single investment. Many of the mutual funds based on the S&P 500 Index require a minimum investment of as little as a few thousand dollars. Because the average price of each stock in the index usually runs between $40 and $60, a small investor would need more than $20,000 to buy even a single share of stick in each of the 500 companies in the index (not to mention the fees the investor would need to pay to a broker to do it). Thus, the mutual fund company lets a small investor buy a fraction of a share in each of the 500 companies in the fund. And because mutual fund companies specialize in this activity, the cost remains ___.

Providing Liquidity

Allowing depositors to transform their financial assets into money quickly, easily, and at low cost.

profits and debt Information

And since August 2000, U.S. companies have been required to release to the public any information they provide to professional stock analysts. As we learned in 2001 and 2002, however, these requirements can go only so far in ensuring that investors are well informed. Despite government regulations designed to protect investors, Enron, WorldCom, Global Crossing, and numerous other companies managed to distort the ___ levels published in their financial statements. With the help of some unethical accountants, company executives found a broad range of ways to manipulate the statements to disguise their firms' true financial condition. While accounting practices have changed since then and financial statements may now convey more information than they once did, everyone remains on guard. ___ problems persist.

bank lending bank lending

Banks are still critical providers of financing around the world, although ___ may not be the dominant source of financing that it once was. And intermediation is not limited to ___. Intermediaries determine which firms can access the stock and bond markets. Just as banks decide the size of a loan and the interest rate to be charged, securities firms set the volume and price of new stock and bond issues when they purchase them for sale to investors. And other intermediaries, like mutual funds, help individual investors sort among the thousands of stocks and bonds that are issued to develop a diversified portfolio with the desire risk characteristics.

individual and their business customers adverse selection

Banks can collect information on a borrower that goes beyond what a loan application or credit report contains. By noting the pattern of deposits and withdrawals from your account, as well as your use of your debit card if you have one, they can learn more about you than you might like. Banks monitor both their ___ in this way. Again, the information they collect is easy to protect and use. The special information banks have puts them in an almost unique position to screen customers and reduce the costs of ___. This expertise helps explain another phenomenon, the fact that most small and medium-size business depend on banks for their financing.

small stake

Banks mitigate risk in a straightforward way: They take deposits from thousands or even millions of individuals and make thousands of loans with them. Thus, each depositor has a very ___ in each one of the loans.

legal contracts costly economies of scale

Before we continue, we should note that providing safekeeping and accounting services, as well as access to the payments system, forces financial intermediaries to write ___. Writing individualized contracts to ensure that each customer will maintain a checking account balance as required, or repay a loan as promised, would be extremely ___. But a financial intermediary can hire a lawyer to write one very high-quality contract that can be used over and over again, thus reducing the cost of each use. In fact, much of what financial intermediaries do takes advantage of what are known as ___, in which the average cost of producing a good or service falls as the quantity produced increases.

out of luck fall repaid net worth

Consider what would happen if a firm with a high net worth borrowed to undertake a project that turned out to be unsuccessful. If the firm had no net worth, the lender would be ___. Instead, the firm's owners can use their net worth to repay the lender. The same is true of a home mortgage. A mortgage is much easier and cheaper to get when a homebuyer makes a substantial down payment. For the lender, the risk is that the price of the home will ___, in which case its value will not be sufficient to fully compensate the lender in the event of a default. But with a large down payment, the homeowner has a substantial stake in the house, so even if the price falls, the mortgage can likely be ___ even if the borrower defaults. From the perspective of the mortgage lender, the homeowner's equity serves exactly the same function as ___ in a business loan.

moral hazard excess limited liability collateral

Debt does go a long way toward eliminating the ___ problem inherent in equity finance, but it doesn't finish the job. Because debt contracts allow owners to keep all the profits in ___ of the loan payments, they encourage risk taking. Lenders need to find ways to make sure borrowers don't take too many risks. Unfortunately, borrowers' ___ has the same effect that an insurance policy has on the insured. People with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their ___, if any.

rose above up

During the 1990s, a concerted attempt was made to align managers' interests with those stockholders. Executives were given stock options that provided lucrative payoffs if a firm's stock price ___ a certain level. This approach worked until managers found ways to misrepresent their companies' profitability, driving ___ stock prices temporarily so they could cash their options. Accounting methods have been reformed in an attempt to reduce such abuses, but at this writing, no one has devised a foolproof way of ensuring that managers will behave in the owners' interest instead of their own.

financial system financial system financial system

Ensuring that the best investment opportunities and highest-quality borrowers are funded is extremely important. Any country that wants to grow must ensure that its ___ works. When a country's ___ crumbles, its economy fails with it. Without a stable, smoothly functioning ___, no country can prosper.

diversification

Imagine that there 10,00 times as many deposits and 10,000 times as many mortgages. Next, picture each of those deposits cut up into 10,000 pieces, each assigned to a different loan. That is, each contributes 10 cents to each loan. That's ___! And because the bank specializes in taking deposits and making loans, it can minimize the cost of setting up all the necessary legal contracts to do this.

savers borrowers safekeeping

Goldsmiths were the original bankers. To keep their gold and jewelry safe, they had to construct vaults. Soon people began asking the goldsmiths to store gold for them in return for a receipt to prove it was there. It didn't take long for someone to realize that trading the goldsmith's receipts was easier than trading the gold itself. The next step came when the goldsmith noticed that there was quite a bit of gold left in the vault at the end of the day, so that some of it could safely be lent to others. The goldsmiths took the resources of those with gold to spare - the ___ of the day - and channeled them to individuals who were short - the ___. Today, banks are the places where we put things for ___ - not just gold and jewelry, but our financial wealth as well. We deposit our paychecks and entrust our savings to a bank or other financial institution because we believe it will keep our resources safe until we need them.

moral hazard collateralized restrictive covenants

If someone weren't watching over your shoulder, you might take the money you borrowed for a business project and fly off to Tahiti. To address the risk that sellers might take the money and run, eBay developed buyers' insurance. In the financial world, intermediaries insure against this type of ___ by monitoring both the firms that issue bonds and those that issue stocks. Car dealers provide an interesting example of how this process works. Dealers have to finance all those shiny new cars that sit on the lot, waiting for buyers to show up. One way to do this is with a bank loan that is ___ by the cars themselves. But the bank doesn't completely trust the dealer to use the loan proceeds properly. Every so often, the bank manager will send an associate to count the number of cars on the lot. The count tells the manager whether the dealer is using the borrowed funds properly. In monitoring the dealer this way, the bank is enforcing the ___ contained in the loan contract. Because banks specialize in this type of monitoring, they can do it more cheaply than individual borrowers and lenders.

will not principal-agent problem

If you buy a stock, how do you know the company that issued it will use the funds you have invested in the way that is best for you? The answer is that it almost surely ___. You have given your funds to managers, who will tend to run the company in the way most advantageous to them. The separation of your ownership from their control creates what is called a ___, which can be more than a little costly to stockholders. Witness the luxurious offices, corporate jets, limousines, and artwork that executives surround themselves with, not to mention the millions of dollars in compensation they pay themselves. Managers gain all these personal benefits at the expense of stockholders.

small savers safekeeping and accounting services payments system liquidity risk information costs

In their role as financial intermediaries, financial institutions perform five functions: (1) pooling the resources of ___; (2) providing ___, as well as access to the ___; (3) supplying ___ by converting savers' balances directly into a means of payment whenever needed; (4) providing ways to diversify ___; and (5) collecting and processing information in ways that reduce ___. As we go through these, you'll see that the first four have to do with lowering transactions costs. That is, by specializing and providing these services to larger numbers of customers, a financial firm can reduce the cost of providing them to individual customers. As in other fields, experts can do a better job than others, and more cheaply at that. The fifth function on the list, collecting and processing information, is a category all by itself.

market system market system

In theory, the ___ may seem neat and simple, but the reality is that economic growth is a messy, chaotic thing. The flow of information among parties in a ___ is particularly rife with problems - problems that can derail real growth unless they are addressed properly.

high worst asymmetric information

Information plays a central role in the structure of financial markets and financial institutions. Markets require sophisticated information to work well; when the cost of obtaining that information is too ___, markets cease to function. Information costs make the financial markets, as important as they are, among the ___ functioning of all markets. The fact is, the issuers of financial instruments - know much more about their business prospects and their willingness to work than potential lenders or investors - those who would buy their bonds and stocks. This ___ is a serious hindrance to the operating of financial markets. Solving this problem is one key to making our financial system work as well as it does.

cross national borders

International banks handle transactions that ___. That may mean taking deposits from savers in one country and providing them to investors in another country. It may also mean converting currencies in order to facilitate transactions for customers who do business or travel abroad.

Line of Credit

Is essentially a preapproved loan that can be drawn on whenever a customer needs funds; intermediaries offer these to both individuals and businesses, which are similar to overdraft protection for checking accounts; home equity these, credit card cash advances, and business these are examples; like a deposit account, these provide a customer with access to liquidity, except that in this case withdrawals may exceed deposit balances; to offer this service profitably, a financial intermediary must specialize in liquidity management; that is, it must design its balance sheet so that it can sustain sudden withdrawals.

Net Worth

Is the owner's stake in a firm, the value of the firm's assets minus the value of its liabilities; under many circumstances, this serves the same purpose as collateral; if a firm defaults on a loan, the lender can make a claim against the firm's this.

specialization comparative advantage transactions cheap

It would be a disaster if we didn't have a convenient way to pay for things. By giving us one, financial intermediaries facilitate the exchange of goods and services, promoting ___. Remember that in efficient economies - those that manage to get the most output from a given set of inputs - people and companies concentrate of the activities at which they are best and for which their opportunity cost is lowest. This principle of ___ leads to specialization so that each of us ends up doing just one job and being paid in some form of money. But as specialization increases, more and more trading must take place to ensure that most of us end up with the goods and services we need and want. The more trading, the more ___; and the more financial transactions, the more important it is that those transactions be ___. If getting hold of money and using it to make payments were costly, that would put a damper on people's willingness to specialize. Financial intermediaries, by providing us with a reliable and inexpensive payments system, help our economy function more efficiently.

Safekeeping and Accounting

Keeping depositors' savings safe, giving them access to the payments system, and providing them with accounting statements that help them track their income and expenditures.

Adverse Selection

Lenders can't distinguish good from bad credit risks, which discourages transactions from taking place. Solutions to hidden attributes problem include: 1. Government-Required Information Disclosure 2. Private Collection of Information 3. Pledging of Collateral to Insure Lenders Against the Borrower's Default 4. Requiring Borrowers to Invest Substantial Resources of Their Own

Moral Hazard

Lenders can't tell whether borrowers will do what they claim they will do with the borrowed resources; borrowers may take too many risks. Solutions to the hidden actions problem include: 1. Requiring Managers to Report to Owners 2. Requiring Managers to Invest Substantial Resources of Their Own 3. Covenants That Restrict What Borrowers Can Do With Borrowed Funds

trustworthy trustworthy information asymmetry information asymmetries

One of the biggest problems individual savers face is figuring out which potential borrowers are ___ and which are not. Most of us do not have the time or skill to collect and process information on a wide array of potential borrowers. And we are understandably reluctant to invest in activities about which we have little reliable information. The fact that the borrower knows whether he or she is ___, while the lender faces substantial costs to obtain the same information, results in an ___. Very simply, borrowers have information that lenders don't. By collecting and processing standardized information, financial intermediaries reduce the problems of ___ create. They screen loan applicants to guarantee that they are creditworthy. They monitor loan recipients to ensure that they use the funds as they have claimed they will.

bookkeeping and accounting services

Our financial lives are extraordinarily complex, and we need help keeping track of them. Financial intermediaries do the job: They provide us with ___, noting all our transactions for us and making our lives more tolerable in the process.

Diversifying Risk

Providing investors with the ability to diversify even small investments.

information financial contracts

Recall how buyers and sellers in the used-car market developed ways to address the problem of distinguishing good from bad cars. The answer here is similar. First, because the problem is caused by a lack of information, we can create more ___ for investors. Second, we can provide guarantees in the form of ___ that can be written so a firm's owners suffer together with the people who invested in the company if the firm does poorly. This type of arrangement helps persuade investors that a firm's stocks and bonds are of high quality.

fire managers significant stake

Solutions to the moral hazard problem in equity finance are hard to come by. Information on quality management can be useful, but only if owners have the power to ___ - and that can be extremely difficult. Requiring managers to own a ___ in their own firm is another possibility.

Free Rider

Someone who doesn't pay the cost to get the benefit of a good or service, and on this on stock market analysis is easy to do.

Collateral

Something of value pledged by a borrower to the lender in the event of the borrower's default; is said to back or secure a loan; houses serve as this for mortgages, cars for car loans; if the borrower fails to keep up with the mortgage or car payments, the lender will take possession of the house or car and sell it to recover the borrowed funds; in circumstances like these, adverse selection is less of a concern that's why this is so prevalent in loan agreements.

hidden attributes default

While government-required disclosure and private information collection are crucial, they haven't solved all the ___ problems that plague investors and the firms they invest in. Fortunately, other solutions exist. One is to make sure that lenders are compensated even if borrowers ___. If a loan is insured in some way, then the borrower isn't a bad credit risk.

information

Why are financial intermediaries so important? The answer has to do with ___.

repay a loan screens certifies free-rider

Your personal credit score tell a lender how likely you are to ___. The credit rating company ___ you and then ___ your credit rating. If you are a good credit risk with a high credit score, you are more likely than others to get a loan at a relatively low interest rate. Note that the company that collects your credit information and produces your credit score charges a fee each time someone wants to see it. This overcomes the ___ problem.