Patterns of financing corporations differ across countries, but one key fact emerges. Studies of the major developed countries, including the United States, Canada, Great Britain, Japan, Italy, Germany, and France, show that when businesses go looking for funds to finance their activities, they usually obtain them indirectly through financial intermediaries and not directly from securities markets.* Even in the United States and Canada, which have the most developed securities markets in the world, loans from financial intermediaries are far more important for corporate finance than securities markets are. The countries that have made the least use of securities markets are Germany and Japan; in these two countries, financing from financial intermediaries has been almost ten times greater than that from securities markets. However, with the deregulation of Japanese securities markets in recent years, the share of corporate financing by financial intermediaries has been declining relative to the use of securities markets.
Although the dominance of financial intermediaries over securities markets is clear in all countries, the relative importance of bond versus stock markets differs widely across countries. In the United States, the bond market is far more important as a source of corporate finance: On average, the amount of new financing raised using bonds is ten times the amount using stocks. By contrast, countries such as France and Italy make use of equities markets more than the bond market to raise capital.
*See, for example, Colin Mayer, "Financial Systems, Corporate Finance, and Economic Development," in Asymmetric Information, Corporate Finance, and Investment, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1990), pp. 307-332.
how to find a good lawyer to produce an airtight loan contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Instead of a loan contract (which may not be all that well written) costing $500, a bank can hire a topflight lawyer for $5,000 to draw up an airtight loan contract that can be used for 2,000 loans at a cost of $2.50 per loan. At a cost of $2.50 per loan, it now becomes profitable for the financial intermediary to lend Carl the $1,000.
Because financial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people like Carl with productive investment opportunities. In addition, a financial intermediary's low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. For example, banks provide depositors with checking accounts that enable them to pay their bills easily. In addition, depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.
Risk Sharing Another benefit made possible by the low transaction costs of financial institutions is that they can help reduce the exposure of investors to risk; that is, uncertainty about the returns investors will earn on assets. Financial intermediaries do this through the process known as risk sharing: they create and sell assets with risk characteristics that people are comfortable with, and the intermediaries then use the funds they acquire by selling these assets to purchase other assets that may have far more risk.
Low transaction costs allow financial intermediaries to do risk sharing at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold. This process of risk sharing is also sometimes referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors.
Financial intermediaries also promote risk sharing by helping individuals to diversify and thereby lower the amount of risk to which they are exposed. Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. (Diversification is just another name for the old adage that "you shouldn't put all your eggs in one basket.") Low transaction costs allow financial intermediaries to do this by pooling a collection of assets into a new asset and then selling it to individuals.
Asymmetric The presence of transaction costs in financial markets explains, in part, why financial
Information: intermediaries and indirect finance play such an important role in financial markets.
Adverse Selection An additional reason is that in financial markets, one party often does not know and Moral Hazard enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked than the lender does. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into and after.2
Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.
To understand why adverse selection occurs, suppose that you have two aunts to whom you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a conservative type who borrows only when she has an investment she is quite sure will pay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come across a get-rich-quick scheme that will make her a millionaire if she can just borrow $1,000 to invest in it. Unfortunately, as with most get-rich-quick schemes, there is a high probability that the investment won't pay off and that Aunt Sheila will lose the $1,000.
Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of course, because she has so much to gain if the investment pays off. You, however, would not want to make a loan to her because there is a high probability that her investment will turn sour and she will be unable to pay you back.
If you knew both your aunts very well—that is, if your information were not asymmetric—you wouldn't have a problem, because you would know that Aunt Sheila is a bad risk and so you would not lend to her. Suppose, though, that you don't
^Asymmetric information and the adverse selection and moral hazard concepts are also crucial problems for the insurance industry (see Chapter 12).
know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt Louise because Aunt Sheila would be hounding you for the loan. Because of the possibility of adverse selection, you might decide not to lend to either of your aunts, even though there are times when Aunt Louise, who is an excellent credit risk, might need a loan for a worthwhile investment.
Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lenders 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.
As an example of moral hazard, suppose that you made a $1,000 loan to another relative, Uncle Melvin, who needs the money to purchase a word processor so he can set up a business typing students' term papers. Once you have made the loan, however, Uncle Melvin is more likely to slip off to the track and play the horses. If he bets on a 20-to-1 long shot and wins with your money, he is able to pay you back your $1,000 and live high off the hog with the remaining $19,000. But if he loses, as is likely, you don't get paid back, and all he has lost is his reputation as a reliable, upstanding uncle. Uncle Melvin therefore has an incentive to go to the track because his gains ($19,000) if he bets correctly are much greater than the cost to him (his reputation) if he bets incorrectly. If you knew what Uncle Melvin was up to, you would prevent him from going to the track, and he would not be able to increase the moral hazard. However, because it is hard for you to keep informed about his whereabouts—that is, because information is asymmetric—there is a good chance that Uncle Melvin will go to the track and you will not get paid back. The risk of moral hazard might therefore discourage you from making the $1,000 loan to Uncle Melvin, even if you were sure that you would be paid back if he used it to set up his business.
Study Guide Because the concepts of adverse selection and moral hazard are extremely useful in understanding the behavior we examine in this and many of the later chapters (and in life in general), you must understand them fully. One way to distinguish between them is to remember that adverse selection is a problem of asymmetric information before entering into a transaction, whereas moral hazard is a problem of asymmetric information after the transaction has occurred. A helpful way to nail down these concepts is to think of other examples, for financial or other types of transactions, in which adverse selection or moral hazard plays a role. Several problems at the end of the chapter provide additional examples of situations involving adverse selection and moral hazard.
The problems created by adverse selection and moral hazard are an important impediment to well-functioning financial markets. Again, financial intermediaries can alleviate these problems.
With financial intermediaries in the economy, small savers can provide their funds to the financial markets by lending these funds to a trustworthy intermediary—say, the Honest John Bank—which in turn lends the funds out either by making loans or by buying securities such as stocks or bonds. Successful financial intermediaries have higher earnings on their investments than small savers, because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn a profit.
As we have seen, financial intermediaries play an important role in the economy because they provide liquidity services, promote risk sharing, and solve information problems. The success of financial intermediaries in performing this role is evidenced by the fact that most Americans invest their savings with them and obtain loans from them. Financial intermediaries play a key role in improving economic efficiency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. Without a well-functioning set of financial intermediaries, it is very hard for an economy to reach its full potential. We will explore further the role of financial intermediaries in the economy in Part III.
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At least once in every person’s life comes a time when the need is great and the resources are few. It can be hard enough to make ends meet on a decent wage, but, when the times get tough and the money just is not there to meet the need, a person can easily despair.