What is the main puzzle of financial structure?
Why indirect finance (via intermediaries) dominates direct finance.
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| Term | Definition |
|---|---|
| What is the main puzzle of financial structure? | Why indirect finance (via intermediaries) dominates direct finance. |
| What is indirect finance? | Borrowing and lending through financial intermediaries. |
| What is asymmetric information? | When one party has more or better information than the other in a transaction. |
| What is adverse selection? | Problem that occurs before a transaction when borrowers most likely to produce adverse outcomes seek loans. |
| What is moral hazard? | Problem that occurs after a transaction when borrowers engage in riskier behavior. |
| Why do financial intermediaries exist? | To reduce transaction costs and information problems. |
| What are transaction costs? | Costs associated with buying or selling financial instruments. |
| How do intermediaries reduce transaction costs? | By economies of scale and expertise. |
| What are economies of scale? | Cost advantages from producing large volumes of financial services. |
| What is a free-rider problem? | When others benefit from information or monitoring paid for by someone else. |
| How does adverse selection affect credit markets? | It discourages lending to high-risk borrowers. |
| What is collateral? | Assets pledged to secure a loan. |
| How does collateral reduce adverse selection? | It aligns incentives and reduces lender risk. |
| What is net worth? | Assets minus liabilities |
| How does moral hazard arise in equity contracts? | Managers may not act in shareholders' best interests. |
| What is the principal-agent problem? | The conflict of interest between owners and managers. |
| How can monitoring reduce moral hazard? | By observing and controlling borrower behavior. |
| Why is costly state verification an issue? | Monitoring borrowers is expensive, reducing efficiency. |
| How do financial intermediaries address moral hazard? | Through screening, monitoring, and enforcing contracts. |
| What are restrictive covenants? | Clauses that limit borrower behavior to protect lenders. |
| How do restrictive covenants reduce risk? | They prevent excessive risk-taking or misuse of funds. |
| What role do banks play in mitigating information problems? | They specialize in collecting private information and monitoring borrowers. |
| Why do equity markets play a smaller role in financing? | Because of asymmetric information and monitoring costs. |
| How do debt contracts address moral hazard? | They fix payments, reducing the need to monitor profits. |
| What is financial repression? | Government restrictions that limit access to credit and competition. |
| Why do developing countries rely heavily on banks? | Because of weak legal systems and poor information environments. |
| What is relationship banking? | Long-term relationships that help overcome information asymmetries. |
| Why are collateral requirements common in lending? | They mitigate adverse selection and moral hazard. |
| What causes credit rationing? | Information asymmetry and limited monitoring capacity. |
| What is the lemons problem? | When good-quality borrowers exit the market due to information asymmetry. |
| What does the lemons problem lead to? | Credit rationing or market breakdown. |
| What is the role of government in financial markets? | To ensure transparency and reduce information problems. |
| What is signaling in finance? | Actions by informed parties to convey information credibly. |
| What is screening in finance? | Actions by lenders to distinguish between high- and low-risk borrowers. |
| Why is equity financing less common than debt? | Because monitoring equity is more costly. |
| What is the main reason for financial intermediation? | To solve information and transaction cost problems. |
| What are venture capital firms? | Specialized intermediaries that provide equity financing and active monitoring. |
| How do moral hazard and adverse selection affect financial crises? | They amplify risk-taking and reduce lending. |
| Why do banks maintain long-term client relationships? | To mitigate asymmetric information and improve credit decisions. |
| What is credit rationing? | When lenders limit loan size or deny credit even if borrowers are willing to pay higher rates. |