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THEORY OF FINANCIAL STRUCTURE (Facts (Banks important source(external…
THEORY OF FINANCIAL STRUCTURE
Facts
Banks important source(external finance).
Financial system heavily regulated.
Indirect(important), direct(not too important).
Only large, well established firms have accessed to securities markets.
Issuing marketable debt and equity securities not the primary funding source.
Collateral is prevalent feature of debt contract.
Stock not most important(External financing).
Debt contracts extremely complicated legal documents with restrictive covenants.
Transaction Cost.
Effects:
Increase costs in economic exchange.
Hinder flows of funds.
Types:
Bargaining cost.
Policing and enforcement cost.
Search and information cost.
Expenses incurred when buying or selling a good or service.
How to reduce:
Economies scale.
Develop expertise to lower transaction cost.
Asymmetric Information.
Financial intermediaries.
Financial institutions.
Insurance,Takaful, Unit Trusts
Financial markets.
Effects
Adverse Selection
Tools to solve:
Government regulation to increase information.
Financial intermediation.
Private production and sale of information.
Collateral and net worth.
Moral Hazard
Agency problem(conflict of interest)
Tools to solve:
Government regulation to increase information.
Financial intermediation.
Production of information(monitoring)
Moral hazard(debt contract)
Tools to solve:
Monitoring and enforcement of restrictive covenant.
Financial intermediation.
Net worth.
Peach VS Lemon
Peach
The exchange fulfill the expectation of parties involved, then the parties would be happy, sweet situation.
Lemon
Any of the party is unhappy with the outcome of the transaction, it would cause a sour situation.
Problems(Stock&Bond)
Investors only willing to pay a price reflecting the average quality of issuing firms.
Good firms owner's not willing to sell.
Problem in distinguishing between good and bad firms.
The transaction had not been able to be executed.
Financial Crisis
Factors.
Increases in interest rates.
Increases in uncertainty.
Government fiscal imbalances.
Deterioration of financial sector balance sheets.
The stages.
Second stage: Currency crisis.
Third stage: Currency crisis to full-fledged financial crisis.
Initial stage : Run up to the currency crisis.