Eco. 521 –Online Discussion/Quiz 7-12-2022 (Economic Analysis of Financial Structure)

NAME: NWALI, LAZARUS SUNDAY
DEPARTMENT: ECONOMICS
REGISRERATION NUMBER: PG/MSC/20/94550
COURSE: MONETARY ECONOMICS (ECO. 521)

Economic Analysis of Financial Structure

INTRODUCTION

A Financial structure can be defined as a mix of financial markets, institutions, instruments and operators( services) that describe how financial activities are organized in an economy at a given period.

These components outlined in the definition make up a modern financial system.
Financial system allows funds to be *allocated, * invested, * and moved between economic sectors and as well enable individuals and companies to share the associated risks.

Generally speaking, the Financial Structure of any economy is designed to bring about economic growth and development. Through efficient financing, *firms and industries are expected to expand, * new firms should emerge, * SMEs are to be favored and promoted. Et cetera.

The Financial system is a fully regulated sector of the economy due to its important determinant to the healthiness of the general economy. It must stand on an efficient structure that can alleviate market frictions among intermediaries and as well provide information and avenues for risk sharing.

However, the economic benefits from financial system may differ across economies depending on the pattern of their intermediation.

The financial system is therefore categorized
into;

1. Bank-based and
2. Market-based.

In the bank-based, financial intermediaries are banks who create a pattern of intermediation of thorough client interaction and legal environment necessary to play important roles of;

1. Mobilization of funds( savings): sources out funds from surplus sectors and puts them up for sale to investors.

2. Allocation of credit: directs funds to specific sectors and individuals with substantial collaterals for investment purpose.

3. Facilitating hedging

4. Pricing of risks.

Notably in bank-based financial system, capital stocks are not the primary source of external financing for businesses.
Rather, financial intermediaries particularly banks, serve as generators of funds to finance business.

THE EIGHT PUZZLES BUT FACTS ABOUT THE FINANCIAL SYSTEM

For a deeper understanding of the modus operandi of the financial System, it is paramount to examine the 8 puzzles and then back them up with the economic analysis the substantial transaction and information costs and how the

1. Stocks are not the most popular source of external financing for businesses.

Puzzle: why is the stock market less important than other sources of financing businesses?

2. Financial intermediaries (ex., banks) are the primary source of
external finance for businesses.

Puzzle: what makes bank so important to the workings of the financial system?

3. The financial system is one of the most heavily regulated
sectors of the economy.

Puzzle: why are financial markets so regulated throughout the world ?

4. Indirect finance, which involves the activities of financial intermediaries, is more important than direct finance, in which businesses raise funds directly from lenders in securities markets.

Puzzle: why are financial intermediaries and indirect finance so important in financial markets?

5. Only large, well established companies can easily raise funds in the stock and bond markets.

Puzzle: why do only large, well known corporations have the ability to raise funds in securities markets?

Individuals and smaller businesses that are not well established rely heavily on banks for external funds; only rarely do they attempt to obtain external funds through bond and stock issue.

6. Many debt contracts (business and household) are secured
with collateral (property pledged to the lender in the event the
borrower defaults)

puzzle: why is collateral such an important feature of debt contract?.

7. Issuing marketable securities(whether debt or equity) is not the primary way in which businesses finance their operations.

Puzzle: why don’t businesses make more extensive use of debt and equity security issues to finance their activities?

8. Debt contracts are complicated legal documents that place
restrictions on the borrower. (ex., Most car loans require the
borrower to maintain insurance on the purchased vehicle.)

puzzle: why are debt contracts so complex and restrictive?

Transaction Costs in Relation to Puzzle 3
Recall puzzle 3: “Why are financial intermediaries and indirect finance so important in financial markets?”
Puzzle 3 concerns why financial intermediaries (primary commercial banks) play such a large role in this debt financing. Why don’t businesses simply sell debt issue in securities markets rather than going through the hassle of securing loans from financial intermediaries?
Part of the explanation to puzzle 3 is that obtaining debt financing through a financial intermediary rather than through a securities market can significantly reduce transaction costs. This reduction occurs for two main reasons.
Reason 1: financial intermediaries help to match borrowers and lenders, cutting down on their search costs. For borrowers with special needs and circumstances, these search costs can be very high.
Reason 2: financial intermediaries engage in asset transformation, which allows them to reduce transaction costs by taking advantage of various “economies of scale.”
More precisely, financial intermediaries pool together funds from many different lenders under contractual terms that these lenders find attractive — e.g., withdrawal upon demand (liquidity). They then use these pooled funds to create new types of loan instruments specifically tailored to the special needs and circumstances of those who borrow from them. This asset transformation can take a wide variety of forms. For example, it may take the form of mutual fund transactions in which many small lenders buy shares of large diversified stock or bond portfolios. Or it may take the form of savings and loan transactions in which the funds from many small deposit accounts are pooled together to finance mortgages.
This pooling generally permits financial intermediaries to significantly reduce transaction costs by taking advantage of economies of scale, a reduction in costs per dollar loaned as the size (scale) of the loan principal increases.
Take for instance a two different case scenario where (a) the resources of ten different lenders are pooled together by a financial intermediary to construct a single loan contract with a borrower Mr. Bright for a loan principal of $1000,000, with each lender contributing $100,000.

(b) Ten different lenders individually write up ten different loan contracts with Mr. Jones, each for a loan principal of $100,000.

Option A leads to a reduction in transaction costs through economies of scale

Adverse Selection in Relation to Puzzles 1–7
The principal solution to problem of adverse selection in financial markets is the elimination of the asymmetry in information that exists between buyers and sellers of financial assets prior to purchase agreements.
This also takes to explain the puzzles 1, 4,5 & 7.

Low-risk borrowers are willing to pay to communicate information about their attributes and prospects, and lenders are willing to pay for information about borrower attributes and prospects. This provides a profit opportunity to those who are willing and able to specialize in gathering this type of information.
However, private production and sale of information does not completely resolve adverse selection problems in securities markets, however, because of “free-rider” problems.
A free-rider problem occurs when people who do not pay for information take advantage of the information that other people have paid for by observing and mimicking their behavior.
As a consequence of free-rider problems, private provision of information in securities markets tends to be underprovided. In this case, the small newly-established firms are put to demerits of obtaining external funds in securities markets because lenders lack the information needed to verify their financial soundness. Unlike the large well-established firms who find it easier obtaining external funds in securities markets because lenders are more confident about their quality.
Consequently, small and newly found businesses fall back to banks rather thn securities markets for their external finance their business activities
This is why the adverse selection analysis helps to explain puzzles 1, 2, and 6 — why debt and equity issue in securities markets is not the major source of external funds for most borrowers, especially for individuals and small businesses.
Due to the importance of the financial sector to the government, it comes in to regulate the securities markets in such a way that the security issuers, themselves, are encouraged or required to reveal accurate information about their attributes and prospects- information disclosure, thereby leading to what to what explains puzzle 5 — the fact that the financial sector is one of the most heavily regulated sectors of the economy.
Although government regulations encouraging and requiring information disclosure lessen adverse selection problems, they do not eliminate them. Security issuers still have more information about their financial condition than purchasers, in spite of disclosure regulations.
Financial intermediaries such as banks have an easier time ensuring accurate and complete information disclosure and hence the reduction or elimination of adverse selection problems.
Most importantly, banks can profitably specialize in information gathering about particular types of loans, e.g., home mortgage loans, or loans to businesses in a particular type of industry. Free-rider problems are avoided by banks because most of their loans are private, i.e., they are not traded on an open market.
Also, banks may be able to force borrowers to reveal their true type (high or low risk) through special loan contract provisions.
For example, borrowers may be required to pledge some of their own assets as collateral, which the bank can claim if the borrower defaults.
In addition, collateral provisions reduce the consequences of adverse selection for banks because they reduce the losses incurred by the banks in case of default.
This now leads to explain puzzle 7 — why collateral is a prevalent feature of debt contracts for both households and businesses.

Moral Hazard in Relation to Puzzles 1-5 and 7-8
Moral hazard arises in a financial market after a financial transaction has taken place, when the seller of a financial asset has an incentive to conceal information and to act in a way that may not reflect the interests of the buyer of the financial asset.

Puzzle 1 concerns why businesses do not make more extensive use of equity (stock) issue to raise external funds. One reason inhibiting this use is a particular type of moral hazard associated with the ownership of common stock.
When a business is organized in corporate form, its owners are its common stockholders. In general, the managers of a corporation own only a small fraction of the outstanding common stock shares of the corporation. Consequently, there is a separation of ownership from control. That is, the owners of the corporation (called the principals) are not the same people as the managers of the corporation (called the agents of the owners).
.
This separation of ownership from control constitutes a special form of moral hazard, referred to in economics as a principal-agent problem.
Consequently, common stockholders have an incentive to monitor the activities of managers to protect themselves against principal-agent problems. However, the system is not devoid of the free-rider problems making it particularly difficult to carry out effective monitoring.
For these reasons, common stockholding is less desirable than it would be in the absence of principal-agent problems, making it harder for businesses to raise external funds through equity issue.
This moral hazard analysis helps to explain puzzle 1 with regard to common stocks — i.e. why common stocks are not the most important source of external financing for businesses.
More so, as with adverse selection, the persistence of principal-agent problems due to free-rider problems gives government an incentive to regulate financial markets. For example, most countries have laws that require corporations to adhere to standard accounting principles and that impose penalties for managerial fraud (e.g., embezzlement of profits).
This helps to explain puzzle 5 — why the financial sector is among the most heavily regulated sectors of the economy.
More generally, banks and other financial intermediaries specializing in private loans can avoid free-rider problems in the face of moral hazard. With private loans, a bank is assured that no one else can free-ride on its monitoring and enforcement efforts. Consequently, the bank has an incentive to include in its loan contracts various restrictive covenants — i.e., provisions aimed at reducing moral hazard — and to spend time and resources on monitoring to ensure their enforcement. The restrictive covenants generally take the following forms:
(a) prohibitions against undesirable behavior by borrowers (e.g., excessive risk-taking)
(b) encouragement of desirable behavior by borrowers (e.g., insurance coverage, maintenance of a minimum level of net worth, etc.)
(c) collateral requirements; and
(d) provision of pertinent information in the form of periodic accounting and income reports.
This analysis of how financial intermediaries effectively deal with moral hazard helps to explain puzzles 1 through 4 — why financial intermediaries play a more important role than securities markets in channeling funds from lenders to borrowers.
It also helps to explain puzzle 7 — the common inclusion of collateral provisions in debt contracts with financial intermediaries.
Finally, it helps to explain puzzle 8 — why debt contracts entered into with financial intermediaries tend to be complicated legal documents containing numerous restrictive covenants.

Name: ODOEMENAM PEACE OGECHI
Email address: peaceogechiodoemenam@gmail.com
REG. NO.: PG/MSC/20/92280

INTRODUCTION
In discussing the Economic Analysis of Financial Structure, one must be a able to be conversant with the terms, Economic Analysis and Financial Structure.
What is Economic Analysis?
Economic Analysis entails the evaluation or analysing topics or issues from the view point of an economist. It is the study of economic systems. Economic analysis essentially involves the accessing or examining of costs and benefits.The beginning of Economic Analysis involves rating projects based on economic feasibility to help appropriate allocation of resources. It drives at analyzing the welfare impact of a project.
It may also be an anlysis of production procedure. The analysis aims to ascertain how effectively or successfully the economy or something within it is operating. For example, an economic analysis of financial structure partly aims at examining the financial maximization of financial participant.
According to research, Economists believe that economic analysis is a well structured, systematic and organized approach to find out what the most effective use of scarce resources is.
The three main elements of Economic Analysis are:
1. Identification and valuation of costs in line to an investment
2. Identification and estimation of benefits to be obtained from an investment
3. Relating the costs with benefits to examine the suitability of the investment.

What is Financial Structure?
Before we look at Financial Structure, let’s see what financial system means: A Financial System is a set of institutions (insurance companies, banks, stock exchange etc.) that permits the exchange of funds (Beck, T., Cull, R., & Jerome, A.) 2005.
Financial Structure entails long-term as well as short-term financial instruments to augment capital for the organization (Ahmed, A. D., & Wahid, A. M.) 2011. All the items present in the Liabilities side of the Balance Sheet are a part of the Financial Structure.
There are four financial tools- the Bank Loans, Non Bank Loans, Bonds and Stocks used by banks to finance their activities using external funds.
Types of Financial Structure
There are two parts of Financial Structure–
• Equity Capital
• Debt Capital
Let’s discuss both of them below:
Equity Capital – Equity Capital is the capital brought into the business by its investors. It is what the company owes to their shareholders and owners of the company. There are two types of equity capital namely contributed capital and Retained earnings. While contributed capital is the money that both owners and shareholders have invested in the company, retained earnings are a part of the company’s profits that is kept aside for the business reinvestment.
Debt Capital – Debt Capital is the money borrowed by the organization from individuals and institutions which must be paid back with interest. It includes Long-term Bonds that have extended repayment terms, and the borrowers have to pay interest on them periodically. The principal amount is payable at the time of maturity. It also includes Short-term commercial instruments, which on the other hand, have a lesser repayment period, and firms use it to raise capital for their immediate needs. A firm needs a mixture of these two financial tools to finance its operations.
The Basic Facts about the Financial System
• The issuance of new stock and bond offerings are not the most important or primary source of external financing for business, as such, are not popular ways for businesses to externally finance their operations.
• Bank and all other financial intermediaries are the primary source of external finance for businesses.
• The financial system is one of the most heavily regulated sectors of the economy.
• Large companies only can easily raise funds in the stock markets and bond markets.
• With collateral, many debt contracts like household and business are secured.
• Debt contracts are complicated legal documents that place restrictions on the borrower. (ex., Most car loans require the borrower to maintain insurance on the purchased vehicle.)
Transaction Costs
A. Small investors and small businesses encounter sizeable transaction costs when interacting with the direct finance channel of the financial market.
B. Financial intermediaries, via indirect finance, provide small investors and businesses access to financial markets by reducing transaction costs.
1. By pooling funds from these participants, financial intermediaries reduce the per-unit transaction costs (economies of scale).
2. Financial intermediaries have developed an expertise in evaluating financial opportunities
Asymmetric Information in Financial Markets
A. Adverse selection is an asymmetric information problem that occurs before a transaction takes place.
1. The lemons problem
a. If a buyer cannot assess the quality of an asset, he/she, at most, is willing to pay a price that reflects the average quality.
b. The seller of a high quality item, however, will not want to sell at that lower average price.
c. The buyer then will not purchase anything because the only things that remain in the market are the low quality items (i.e., the lemons).
2. Tools to help solve the adverse selection problem
• Private firms collect and produce information distinguishing good and bad firms, and then sell that information to saver/lenders.
i. Free-rider problem – non-paying people use information other people have paid for.
ii. Paying customers might not want to buy information others are getting for free.
• The government regulates the securities market by requiring firms to provide certain information about themselves free of charge.
• Financial intermediaries are experts in producing information to distinguish between good and bad firms.
i. Banks avoid the free-rider problem by directly lending to good credit risks.
ii. Large, well-known firms are more likely to borrow directly from savers because savers have better information on the firm, and the firm does not incur the costs from using financial intermediaries.
• Collateral reduces the consequences of adverse selection by reducing the saver/lender’s loss in the event of a default.
• A high net worth gives firms more cushion against a default in case an investment goes bad. That is, it reduces the consequences of the adverse selection problem.
B. Moral hazard is an asymmetric information problem that occurs after a transaction takes place.
1. Moral hazard in equity contracts: the principle-agent problem.
• Mangers who own a small fraction of a business (agent) have incentives to act in their own interest and not maximize profits for the equity owners (principles).
• Tools to minimize the principle-agent problem.
i. Stockholders can monitor management via frequent auditing and checking in on management, but this process is costly and reduces profits.
ii. Government regulations make profit verification easier (standard accounting principles) and impose stiff criminal penalties on people who commit fraud by hiding and stealing profits.
iii. Venture capital firms pool resources of investors to help budding businesses expand, but usually insist on having their own people participate as mangers of the business (i.e., board of directors) to monitor operations.
iv. A debt contract is an alternative to equity investment because it can be structured to pay investors a monthly payment. As long as the payment is being made, investors do not care if the managers are acting in the best interest of the business.
2. Moral hazard in debt markets
• Borrowers have an incentive to undertake riskier investments than lenders/savers would prefer.
• Tools to minimize moral hazard in debt contracts.
i. Collateral provides the borrower with an incentive to behave in a way the lender expects.
ii. Restrictive covenants can be included in debt contracts but need to be monitored and enforced.
a. Covenants to discourage undesirable behavior
b. Covenants to encourage desirable behavior
c. Covenants to keep collateral valuable
d. Covenants to provide information
Example: Financial Development and Economic Growth in Developing Countries
A. Countries with underdeveloped financial systems (financial repression) often have slower economic growth because they cannot resolve the problems from asymmetric information.
1. Countries with poor private property rights cannot take full advantage of collateral.
2. Countries with a poor legal system cannot enforce covenant restrictions.
3. Countries with weak accounting standards make it difficult to determine good firms from bad firms.
B. The banks in many of these countries have no profit motive because they are owned by the government. They direct capital to themselves or their favorite sectors and not to the most productive use.
In conclusion, the financial services view of financial structure emphasizes the importance of the overall level and quality of financial services rather than the institutional arrangements through which the services are provided (Dolar & Meh, 2002). Hence, the issue is not about bank versus market but the creation of a conducive environment for both banks and market to perform their growth enhancing roles.
References
Ahmed, A. D., & Wahid, A. M. (2011). Financial structure and economic growth link in African countries: A panel cointegration analysis. Journal of Economic Studies, 38(3), 331–357. https://doi.org/10.1108 /01443581111152436 Arestis, P., Luintel, A., & Luintel, K. (2004). Does financial structure matter? The Levy Economic Institute, No. 399 , 1–29. https://doi.org/ 10.1. 1.172.5135
Beck, T., Cull, R., & Jerome, A. (2005). Bank privatization and performance: Empirical evidence from Nigeria. Journal of Banking & Finance, 29(8-9), 2355–2379. https://doi.org/10.1016/j.jbankfin.2005.03.018 Financial Structure and Economic Growth Nexus in Nigeria 131 Beck, T., & Levine, R. (2002). Industry growth and capital allocation. Journal of Financial Economics, 64(2), 147–180. https://doi.org/10 .1016/S0304-405X(02)00074-0 Bencivenga, V. R., & Smith, B. D. (1991). Financial Intermediation and Endogenous Growth. Review of Economic Studies, 58(2), 195–209. https://doi.org/10.2307/2297964 Boyd, J. H., & Smith, B.D. (1992). Intermediation and the Equilibrium Allocation of Investment Capital: Implications for economic development. Journal of Monetary Economics, 30(3), 409-432. https://doi.org/10.1016/0304-3932(92)90004
Christopoulos, D. K., & Tsionas, E. G. (2004). Financial development and economic growth: evidence from panel unit root and cointegration tests. Journal of Development Economics, 73(1), 55–74. https://doi.org/10.1016/j.jdeveco.2003.03.002
Davino, C., Furno, M., & Vistocco, D. (2014). Quantile Regression: Theory and Applications (First). West Sussex: John Wiley & Sons Ltd.
Demirguc-kunt, A., Feyen, E., & Levine, R. (2012). The Evolving Importance of Banks and Securities Markets. The World Bank Economoc Review, 27(3), 496-490. https://doi.org/10.1093/ wber/lhs022 Dolar, V., & Meh, C. (2002). Financial structure and economic growth: A non-technical survey. Bank of Canada Working Paper, No.2002-24
Dudley, W., & Hubbard, G. (2004). How Capital Markets Enhance Economic Performance and Facilitate Job Creation. Global Markets Institute: Goldman Sachs

Question: Write in details and clearly explain the Economic Analysis of Financial Structure.

Economic analysis of the financial structure is an analysis of the functions of the financial structure in an economy and how they are geared towards promoting economic efficiency. It tries to establish the relationship between the financial system and the performance of the economy, and how it impacts on the economic growth of a nation.
The financial system is an economic arrangement that facilitates the flow of funds from the surplus unit (savers) to the deficit spending unit (borrowers and investors). The goal is to ensure the efficient distribution of resources to facilitate growth. The financial institutions serve as intermediaries between lenders and borrowers. They provide and avenue for people in need of funds to borrow without necessarily having to meet the lenders. The institutions include: banks, investment companies, mutual funds, and insurance companies.
When we talk about the financial system or the financial structure, there are some misconceptions people have about it, such as:
1. Stocks are regarded as the most vital source of external financing for businesses: People think stocks contribute a large proportion of finance to businesses, however, they contribute just a small proportion. This is so because there is high volatility, thereby making returns on investment not to be guaranteed. Again, it is only well established, large corporations that can bear that risk and have an easy access to the securities market, to obtain finance for their business operations and activities.
2. Easy Access to Finance from Securities Markets: This is often a thought by people that any business can obtain a loan but in reality, it is only large, well-established corporations that can easily access funds from the securities markets to finance their activities. have easy access to securities markets to finance their activities. Individuals and smaller businesses that are not well established are not likely to obtain funds from the securities markets, especially through the issuance of marketable securities. Thus, they can only turn to banks to obtain such loan as they need.
3. Direct finance is more important than indirect finance: Direct finance is the raising of funds by business organizations, directly from lenders in the financial markets. Indirect finance on the other hand, is the raising of funds through the involvement of financial intermediaries. People often think direct finance is more important but in reality, indirect finance is more important. Financial intermediation is the main route for transferring funds from the surplus saving unit to the deficit spending unit.
4. Banks are not the most important source of external funds: Since most businesses cannot source for funds through the issuance of marketable securities, banks are able to provide them with external finance. The primary source of finance to businesses is loans and most of them are from banks. Thus, they are now the most important as it concerns sourcing of external funds.
5. Heavy Regulation: The financial system is regulated to promote the provision of of information and minimize information asymmetry. With proper regulation by the government, there will be stability of the financial system.
6. Collateral: Most debt contracts are secured with collateral. Collateral is a property or asset that a borrower pledges to a lender in the event of default, if the borrower is unable to meet pay back. Collateralized debt is often the most common type of debt because lenders want to ensure that their fund is safe in the hand of the borrower and in the event of loss, the collateral pledged will serve as a refund to the lender.
Analysis of Financial Market Costs and their Effects in an Economy
There are two types of costs that affect participants in the financial market. These are:
1. Transaction costs
2. Information costs
Transaction Costs: These are costs incurred by making a transaction or an economic exchange. Individuals become limited when they do not have enough resources to engage in a business transaction and since there are costs incurred when performing those transactions, the individuals in question are hindered from continuing in such businesses, which could even yield profit in the longrun. Thus, they lose out, both in performing the business, in the income that would have been generated and in the profits that would have yielded in the longrun.
Due to the transaction cost problem, financial intermediaries have come to bridge that gap by allowing both savers and borrowers the opportunity to participate and benefit from the financial markets.
Two major ways to solve the problem of transaction cost are through the use of:
i. Economies of scale.
ii. Expertise.

Economies of Scale: These are reduction in cost or the cost advantages that an organization enjoys as a result of engaging in large scale production. Economies of scale solve the problem of transaction cost when the resources and funds of many investors are pulled together, such that costs decrease with each increase in investment or output. By pulling the funds of many investors together, financial intermediaries reduce transaction cost, such that what would accrue to each individual investor would be far smaller than what it would have been, had the investors performed their transactions individually. Financial intermediaries, by pulling resources together take advantage of lower transaction costs because of their large size and these they can now transfer to the individual investors.

Also, financial intermediaries are able to provide their customers with liquidity services, help them to diversify and reduce their exposure to risk. These can have a positive impact on the economy. On the part of savers, this allows them to put to adequate use their idle funds by releasing them to the financial intermediaries. On the part of borrowers (investors), it encourages them to invest because they are able to raise the funds they want from the same financial intermediaries. The resultant effective of this is positive growth in the economy. Thus, financial intermediaries bridge the gap between savers and borrowers.

Expertise. Financial intermediaries are able to lower transaction costs through their expertise in business. They allow their customers to enjoy some services such as allowing shareholders to write cheques for bill-paying and pay them high dividends as a result of high interest rates.

Information Costs (Asymmetric information): This is the insufficient information a party to a transaction has, which can pose as a hindrance to the party making efficient decision. This is an existent problem in the financial market and this is one role financial intermediaries play. Often times, one party does not have enough information about the other party to make accurate decisions. The way lack of information affect economic behavior is Agency Theory. Lack of information creates problems- both before and after a transaction occurs and this as such divides asymmetric information into two:
i. Adverse Selection: This is an information problem that arises before a transaction occurs. For instance, the rate at which bad credit risk individuals seek for loan is often higher because there is a tendency that they will not pay back. Knowing this, credit givers can decide not to give credit to anyone, thereby hindering good credit risk individuals from receiving loans.
ii. Moral Hazards: This information problem arises after a transaction has occurred. The borrower may decide to engage in activities that could use up the fund and make it less likely for the fund to be paid back. This decreases the probability of loan repayment and should the lender know, he may be unwilling to release funds.

The Lemons Problem: This is a problem that arises as a result of asymmetric information. It is a situation where buyers, because they cannot assess the quality of goods in the market only want to pay a small amount, while sellers with such high quality products are unwilling to sell at the amount the buyers are offering. This continues and gets to the point where the buyers are unwilling to continue buying for fear of purchasing goods with low quality and because those are the only goods remaining in the market (low quality goods).

Solutions to the Adverse Selection Problem
When there is no asymmetric information, the lemons problem become s non-existent. Both buyers and sellers will be willing to engage in business transactions. This is because buyers are able to tell the quality of goods and as such, go for them. Sellers on the other hand are able to sell because they can get a fair price for their products. This is so in the sale and purchase of securities. Therefore, to solve the problem of asymmetric information, do the following:

1. Private Production and Sale of Information: This solution entails providing adequate information about borrowers, to lenders, that will help them make adequate decisions. This can be done by private organizations collecting information to differenciate good firms from bad ones, and selling the information gathered. Such information can be the statement of financial position of the firms and their other activities.

The free-rider problem (a situation where people who have not paid for an information are able to get a hold of it, because they have been paid by others) can however impact on this solution. If this continues, private organizations may not be able to sell enough of the information they have gathered, inorder to make profit, and this can negatively affect the quantity and quality of information available in the market. This will inturn bring about the continuous interference of the lemons problem, brought about by asymmetric information, in the efficient functioning of the securities markets.
2. Government Regulation: To help solve the free-rider problem, the government can produce adequate information that will help investors to distinguish good firms from the bad ones. These information can be made available at no cost. They can also eliminate the free-rider problem by regulating the securities market in a way that will make firms to release every necessary information. The problem of asymmetric information has created the need for government regulation, to help ensure efficiency of the system.
3. Financial Intermediation: Financial intermediation through financial intermediaries help to source information and as such, separate the good firms from the bad ones. After it has made the distinction, it acquires funds from the surplus lending unit and makes them available to the investors (the borrowers). Through this process, the financial intermediaries make more profit from interests charged on loans.
Financial intermediaries solve the free-rider problem by providing loans to private individuals and firms, rather than purchasing securities. Thus, the problem of asymmetric information is solved.
4. Collateral and Net Worth: Collateral is a promise a borrower promises to pay to the lender, in the event of default. When there is a collateral, lenders become more willing to give funds to borrowers, because they have the authority to sell the property, should the borrower default.
Net worth on the other hand shows the value of a firm’s assets. It is the difference between assets and liabilities. Where a borrower has a high networth, show it default, the lender can lay claims to the net worth, sell it and use the proceeds from the sale to balance off the losses from the loan.,

Moral Hazards: The Principal-Agent Problem: This is a situation where by an agent who is meant to act in the interest of the principal, acts in his own interest, because he has just a little stake and as well less incentive to maximize profit. This problem however would not arise if the principal has all information about the acts of the agent.
To solve this principal-agent problem that arises as a result of asymmetric information in the form of moral hazards, firms should be monitored, their activities checked and accounts audited; government should regulate them by putting in place laws and systems that will force them to adhere strictly to avoid any form of punishment or fine; financial intermediaries should play a role by using all verification means; and through the use of debt contracts.

Conclusion: The importance of the existence of financial intermediaries cannot be overemphasized. They provide indirect finance, and help to bridge the gap between lenders and borrowers (the deficit spending and the surplus lending units), thus contributing to the growth of an economy.

NAME: ONOH ELIS MOSES
DEPARTMENT: ECONOMICS
REGISRERATION NUMBER: PG/MSC/20/93074
COURSE: MONETARY ECONOMICS (ECO. 521)

Economic Analysis of Financial Structure

A vibrant Economy requires a good functional financial system. That is one that efficiently moves funds from people who save (lenders) to people who have productive investment opportunities (borrowers) and this is possible because of how the financial structure is designed to promote economic efficiency.
The financial system is complex in structure and function throughout the world. It includes many different types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on—all of which are regulated by government.

8 Basic Facts about the Financial System
There are some basic facts about the financial structure that needs to be evaluated in order to better understand how financial system works.

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. 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.
An important feature of financial markets is that they have substantial transaction and information costs. An economic analysis of how these costs affect financial markets provides us with a deeper understanding of the 8 financial system facts and of how our financial system works.

Transaction Cost and Assymetric Information:
Evaluating and solving the Problems of Transaction cost and Assymetric information which arises in the Financial Market would help us to evaluate deeper the above listed financial system facts, which will in turn give us a better understanding of Fnancial System in general and how the Financial structure of a country can influence it’s Economy.

Transaction Cost
Small investors and small businesses encounter sizeable transaction cost when interacting with the direct finance channel of the financial market, example the commission cost for a stockbroker is very high and the amount used to purchase bonds are very expensive to the average person.
Financial intermediaries, via indirect finance, provide small investors and businesses access to financial markets by reducing transaction costs. By pooling funds from these participants, financial intermediaries reduce the per-unit transaction costs (economic of scale).
Financial intermediaries have developed an expertise in evaluating financial opportunities. The presence of transaction costs in financial markets explains in part why financial intermediaries and indirect finance play such an important role in financial markets (fact 3).

Asymmetric Information in Financial Markets
One party’s insufficient knowledge about the other party involved in a transaction to make accurate decisions—is an important aspect of financial markets. The presence of asymmetric information leads to the problem of adverse selection and moral hazard.
A. Adverse Selection is an asymmetric information problem that occurs before a transaction takes place.

The Lemons Problem: If a buyer cannot asses the quality of an asset, he/she at most, is willing to pay a price that reflects the average quality. The seller of a high quality item, however will not want to sell at that lower average price. The buyer then will not purchase anything because the only things that remain in the market are the low quality items (.i.e. the lemons). The presence of the lemons problem keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers. This explains fact 2—why marketable securities are not the primary source of financing for businesses in any country in the world. It also partly explains fact 1—why stocks are not the most important source of financing for American businesses

Tools to Help Solve the Adverse Selection Problem:
1. Production of Information by Private Firms: Private firms collect and produce information distinguishing a good and bad firms, and then sell that information to saver/lenders. But this does not solve the adverse selection problem because of the free-rider problem. The free-rider problem occurs when non-paying people use information other people have paid for. Paying customers might not want to buy information others are getting for free, which will weaken the ability of private firms to profit from selling information meaning that less information is produced in the marketplace, and so adverse selection (the lemons problem) will still interfere with the efficient functioning of securities markets.
2. Government Regulations: The government regulates the securities market by requiring firms to provide certain information about themselves free of charge. The asymmetric information problem of adverse selection in financial markets helps explain why financial markets are among the most heavily regulated sectors in the economy (fact 5).
Although government regulation lessens the adverse selection problem, it does not eliminate it. Even when firms provide information to the public about their sales, assets, or earnings, they still have more information than investors
3. Role of Financial Intermediaries: Financial intermediaries are experts in producing information to distinguish between good and bad firms. Banks avoid the free-rider problem by directly lending to good credit risks rather than by purchasing securities that are traded in the open market. Because of the adverse selection problem and since financial intermediaries in general and banks in particular hold a large fraction of nontraded loans, they should play a greater role in moving funds to corporations than securities markets do. This analysis thus explains fact 3 and 4: why indirect finance is so much more important than direct finance and why banks are the most important source of external funds for financing businesses.
Large well-known firms are more likely to borrow directly from savers because the better known a corporation is, the more information about its activities is available in the marketplace. This explains fact 6, which questions why large firms are more likely to obtain funds from securities markets, a direct route, rather than from banks and financial intermediaries, an indirect route.
4. Collateral: Collateral a property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default.
5. Net Worth: A high net worth gives firms more cushion against a default in case an investment goes bad. That is, it reduces the consequences of the adverse selection problem.

B. Moral Hazard is an asymmetric information problem that occurs after a transaction takes place. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts.

Moral Hazard in Equity Contracts: The Principle-Agent Problem.
Managers who own a small fraction of a business (agent) have incentives to act in their own interest and not maximize profits for equity owners (principals)

Tools to minimize the principle-agent problem
1. Frequent Auditing: Stockholders can monitor management via frequent auditing and checking in on management, but this process is costly and reduces profits.
2. Government Regulations make profit verification easier (standard accounting principles) and impose stiff criminal penalties on people who commit fraud by hiding and stealing profits.
3. Venture Capital Firms pool resources of investors to help budding businesses expand, but usually insist on having their own people participate as managers of business (.i.e. board of directors) to monitor operations
4. A Debt Contract is an alternative to equity investment because it can be structured to pay investors a monthly payment. As long as the payments is being made, investors do not care if the managers are acting in the best interest of the business.

Moral Hazard in Debt Markets: Borrowers have incentive to undertake riskier investment than lender/saver would prefer.

Tools to Minimize Moral Hazard in Debt Contracts
1. Net Worth: When borrowers have more at stake because their net worth (the difference between their assets and their liabilities) is high, the risk of moral hazard the temptation to act in a manner that lenders find objectionable will be greatly reduced because the borrowers themselves have a lot to lose. High net worth makes the debt contract incentive-compatible; that is, it aligns the incentives of the borrower with those of the lender.
2. Restrictive Covenants can be included in debt contracts but need to be monitored and enforced. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. The four types of restrictive covenants include;
a. Covenants to discourage undesirable behavior
b. Covenants to encourage desirable behavior
c. Covenants to keep collateral valuable
d. Covenants to provide information

Example: Financial Development and Economic Growth in Developing Countries
I. Countries with underdeveloped financial systems often have slower economic growth because they cannot resolve the problems from asymmetric information.
a. Countries with poor property rights cannot take full advantage of collateral
b. Countries with poor legal system cannot enforce covenants restrictions.
c. Countries with weak accounting standards make it difficult to determine good firms from bad firms
II. The bank in many of these countries have no profit motive because they are owned by government. They direct capital to themselves or their favorite sectors and not to the most productive uses