CHAPTER An Economic Analysis of Financial Structure 183 the use of monitoring and restrictive covenants A key finding from our analysis is that the existence of the free-rider problem for traded securities such as stocks and bonds indicates that financial intermediaries, particularly banks, should play a greater role than securities markets in financing the activities of businesses Economic analysis of the consequences of adverse selection and moral hazard has helped explain the basic features of our financial system and has provided solutions to the eight facts about our financial structure outlined at the beginning of this chapter To help you keep track of the tools that help solve asymmetric information problems, Table 8-1 provides a listing of the asymmetric information problems and tools that can help solve them In addition, it lists how these tools and asymmetric information problems explain the eight facts of financial structure described at the beginning of the chapter TA B L E - Asymmetric Information Problems andTools to Solve Them Asymmetric Information Problem Adverse selection Moral hazard in equity contracts (principal agent problem) Moral hazard in debt contracts Tools to Solve It Explains Fact No Private production and sale of information 1, Government regulation to increase information Financial intermediation 3, 4, Collateral and net worth Production of information: monitoring Government regulation to increase information Financial intermediation Debt contracts Net worth and collateral Monitoring and enforcement of restrictive covenants Financial intermediation 3, Note: List of facts: Stocks are not the most important source of external financing Marketable securities are not the primary source of finance Indirect finance is more important than direct finance Banks are the most important source of external funds The financial system is heavily regulated Only large, well-established firms have easy access to securities markets Collateral is prevalent in debt contracts Debt contracts have numerous restrictive covenants