CHAPTER An Economic Analysis of Financial Structure LE A RNI NG OB J ECTI VES After studying this chapter you should be able to depict how asymmetric information results in adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets express how government regulation, the private production and sale of information, and financial intermediaries can lessen, but cannot eliminate, asymmetric information problems discuss why securities regulators are introducing new rules and regulations, such as the Sarbanes-Oxley Act in the United States PRE VI EW A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities But how does the financial system make sure that your hard-earned savings get channelled to Paula the Productive Investor rather than to Benny the Bum? This chapter answers that question by providing an economic analysis of how our financial structure is designed to promote economic efficiency The analysis focuses on a few simple but powerful economic concepts that enable us to explain features of our financial system such as why financial contracts are written as they are and why financial intermediaries are more important than securities markets for getting funds to borrowers The analysis also demonstrates the important link between the financial system and the performance of the aggregate economy, which is the subject of the last part of the book BASI C FACT S ABO UT FI NA NCI AL STRU CT U RE THRO UG HO U T TH E WO RLD 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 The financial system channels billions of dollars per year from savers to people with productive investment opportunities If we take a close look at financial structure all over the world, we find eight basic facts, some of which are quite surprising, that we need to explain in order to understand how the financial system works 166