. There are eight basic facts about

. There are eight basic facts about U.S. financial structure. The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; the fifth recognizes that financial markets are among the most heavily regulated sectors of the economy; the sixth states that only large, well-established corporations have access to securities markets; the seventh indicates that collateral is an important feature of debt contracts; and the eighth presents debt contracts as complicated legal documents that place substantial restrictions on the behavior of the borrower.
2. Transaction costs freeze many small savers and borrowers out of direct involvement with financial markets. Financial intermediaries can take advantage of economies of scale and are better able to develop expertise to lower transaction costs, thus enabling their savers and borrowers to benefit from the existence of financial markets. 3. Asymmetric information results in two problems: adverse selection, which occurs before the transaction, and moral hazard, which occurs after the transaction. Adverse selection refers to the fact that bad credit risks are the ones most likely to seek loans, and
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moral hazard refers to the risk of the borrower’s engaging in activities that are undesirable from the lender’s point of view 4. Adverse selection interferes with the efficient functioning of financial markets. Tools to help reduce the adverse selection problem include private production and sale of information, government regulation to increase information, financial intermediation, and collateral and net worth. The free-rider problem occurs when people who do not pay for information take advantage of information that other people have paid for. This problem explains why financial intermediaries, particularly banks, play a more important role in financing the activities of businesses than securities markets do. 5. Moral hazard in equity contracts is known as the principal–agent problem, because managers (the agents) have less incentive to maximize profits than stockholders (the principals). The principal–agent problem explains why debt contracts are so much more prevalent in financial markets than equity contracts. Tools to help reduce the principal–agent problem include monitoring, government regulation to increase information, and financial intermediation.
6. Tools to reduce the moral hazard problem in debt contracts include collateral and net worth, monitoring and enforcement of restrictive covenants, and financial intermediaries. 7. Conflicts of interest arise when financial service providers or their employees are serving multiple interests and have incentives to misuse or conceal information needed for the effective functioning of financial markets. We care about conflicts of interest because they can substantially reduce the amount of reliable information in financial markets, thereby preventing them from channeling funds to parties with the most productive investment opportunities. Three types of financial service activities have had the greatest potential for conflicts of interest: underwriting and research in investment banking, auditing and consulting in accounting firms, and credit assessment and consulting in credit rating agencies. Two major policy measures have been implemented to deal with conflicts of interest: the Sarbanes-Oxley Act of 2002 and the Global Legal Settlement of 2002, which arose from a lawsuit by the New York attorney general against the 10 largest investment banks.