Copyright © 2002 Pearson Education, Inc. Slide 11-1 Obstacles to Matching Savers and Borrowers Transactions costs: costs of buying and selling a financial instrument. Financial intermediaries exploit economies of scale  reduced transactions costs Information costs: costs to determine creditworthiness and monitor the use of funds.

Copyright © 2002 Pearson Education, Inc. Slide 11-2 Information Problems Asymmetric information: one party has better information than the other. Adverse selection: lender must sort good risks from bad risks. Bad risks get on line first … and stay on line longest Moral hazard: lend must verify that borrowers are using their funds as intended.

Copyright © 2002 Pearson Education, Inc. Slide 11-3 Adverse Selection Lemons problem: Asymmetric information  adverse selection. Raises lending costs. Leads to credit rationing. Many countries set information disclosure requirements if a firm sells securities.

Copyright © 2002 Pearson Education, Inc. Slide 11-4 Moral Hazard Regulations on reporting reduce the chance of fraud in equity financing. Principal-agent problem: managers have different goals than the firm’s owners. Debt financing reduces moral hazard problems relative to equity financing. Can’t chisel a bondholder like you can chisel a stockholder Moral hazard in debt financing is reduced with the use of restrictive covenants.

Copyright © 2002 Pearson Education, Inc. Slide 11-5 Information Costs and Financial Intermediaries Financial intermediaries specialize in gathering default risk information. Banks’ information advantage largely accounts for their role in providing external financing. Info sellers in financial markets (Moodys, S&P) face free rider problem Financial intermediaries deal with moral hazard through monitoring and collateral.

Copyright © 2002 Pearson Education, Inc. Slide 11-6 Figure 11.1 Sources of Finance for Business Firms

Copyright © 2002 Pearson Education, Inc. Slide 11-7 Figure 11.2 Remedies for Adverse Selection and Moral Hazard