Chapter 9
Transactions Costs, Asymmetric Information,
and the Structure of the Financial System
Brief Chapter Summary and Learning Objectives 
9.1 Obstacles to Matching Savers and Borrowers (pages 255–257)
Analyze the obstacles to matching savers and borrowers.
Because of transactions costs and information costs, savers receive a lower return on their
investments and borrowers must pay more for the funds they borrow.
9.2 The Problems of Adverse Selection and Moral Hazard (pages 257–270)
Explain the problems that adverse selection and moral hazard pose for the financial system.
Adverse selection is the problem investors experience in distinguishing low-risk borrowers
from high-risk borrowers before making an investment.
Regulations, collateral, and financial intermediaries help to reduce adverse selection, but do not
eliminate it.
Moral hazard is the problem investors experience in verifying that borrowers are using their
funds as intended.
Corporate boards of directors, incentive contracts, and financial intermediaries help to reduce,
but not eliminate, moral hazard.
9.3 Conclusions About the Structure of the U.S. Financial System (pages 270–274)
Use economic analysis to explain the structure of the U.S. financial system.
Loans are the primary source of funds for small-to-medium-sized firms, while the bond market
is the primary source of funds for large corporations.
Financial intermediaries are continually searching for ways to earn a profit by expediting the
flow of funds from savers to borrowers.
Key Terms 
Adverse selection The problem investors
experience in distinguishing low-risk borrowers
from high-risk borrowers before making an
investment;.
Asymmetric information The situation in which
one party to an economic transaction has better
information than does the other party.
Information costs The costs that savers incur to
determine the creditworthiness of borrowers and
Collateral Assets that a borrower pledges to a
lender that the lender may seize if the borrower
defaults on the loan.
Credit rationing The restriction of credit by
lenders such that borrowers cannot obtain the
funds they desire at the given interest rate.
Economies of scale The reduction in average cost
that results from an increase in the volume of a
good or service produced.
to monitor how they use the funds acquired.
Moral hazard The risk that people will take
actions after they have entered into a transaction
that will make the other party worse off; in
financial markets, the problem investors
experience in verifying that borrowers are using
their funds as intended.
Net worth The difference between the value of a
firm’s assets and the value of its liabilities.
Principal–agent problem The moral hazard
problem of managers (the agents) pursuing their
own interests rather than those of shareholders
(the principals).
Private equity firm (or corporate restructuring
firm) A firm that raises equity capital to acquire
shares in other firms to reduce free-rider and
moral hazard problems.
Relationship banking The ability of banks to
assess credit risks on the basis of private
information about borrowers.
Restrictive covenant A clause in a bond contract
that places limits on the uses of funds that a
borrower receives.
Transactions costs The cost of a trade or an
exchange; for example, the brokerage commission
charged for buying or selling a financial asset.
Venture capital firm A firm that raises equity
capital from investors to invest in startup firms.
Chapter Outline 
Teaching Tips
Students often remark that their money and banking course seems to jump from one topic to the next,
without providing a framework for understanding how the pieces fit together. This chapter should help
students to understand the relationship among some of the key topics of the course. The chapter focuses
on how financial markets and financial intermediaries deal with problems of transactions costs and
asymmetric information. The unifying theme of the chapter’s discussion is the idea that many of the
aspects of the financial system evolved to deal with the information costs that arise from asymmetric
information. The main problems arising from asymmetric information—adverse selection and moral
hazard—are discussed at length. When students grasp these ideas, recent developments in the financial
system become easier to understand.
The chapter discusses the role of financial intermediaries in reducing adverse selection and moral hazard
problems. Through this discussion, students can begin to understand better the crucial role of
intermediaries in the financial system. An alternative, more descriptive, approach tends to leave students
with the vague idea that financial markets provide funds to large firms and intermediaries provide funds
to small firms, but with no clear understanding of why.
Should You Crowd-Fund Your Startup?
Many startup companies have difficulty in obtaining funding. In recent years, a new way to fund startups,
crowd-funding, has emerged. Crowd-funding involves raising small amounts of money from large
numbers of people. Though crowd-funding is likely to help entrepreneurs by providing a new source of
financing, small investors participating in crowd-funding face the problem of asymmetric information
because the startups raising funds are likely to know much more about how likely they are to be
successful than are small investors.
9.1 Obstacles to Matching Savers and Borrowers (pages 255–257)
Learning objective: Analyze the obstacles to matching savers and borrowers.
A. The Problems Facing Small Investors
Transactions costs are the costs people incur in making direct financial transactions, including
legal fees and the time needed to identify profitable investments. Information costs are costs
that savers incur to determine the creditworthiness of borrowers and to monitor how borrowers
use the acquired funds. Because of transactions costs and information costs, savers receive a
lower return on their investments and borrowers must pay more for the funds they borrow.
B. How Financial Intermediaries Reduce Transactions Costs
Financial intermediaries are able to reduce transactions costs, thereby facilitating financial
transactions involving small investors as well as small-to-medium-sized firms. Ways that
financial intermediaries can reduce transactions costs include taking advantage of economies of
scale, which reduces the average cost of transactions by engaging in a high volume of
transactions, and specialization, which enhances efficiency.
9.2 The Problems of Adverse Selection and Moral Hazard (pages 257-270)
Learning Objective: Explain the problems that adverse selection and moral hazard pose for the
financial system.
Asymmetric information describes the situation in which one party to an economic transaction has
better information than does the other party. In financial transactions, the borrower typically has
more information than the lender.
A. Adverse Selection
Adverse selection is the problem investors experience in distinguishing low-risk borrowers
from
high-risk borrowers before making an investment. Economist George Akerlof used the
example
of the used car market to illustrate the problem. Because potential car buyers lack the
information to
distinguish good cars from bad cars, or “lemons,” the market price is likely to be lower than the
value of a good car, but higher than the value of a lemon. As a result, there is a tendency for
most
used cars sold to be lemons. To reduce the costs of adverse selection, car dealerships act as
intermediaries between buyers and sellers. Because investors may be unable to distinguish
good
firms from lemon firms, investors are reluctant to invest in firms unless there is a great deal of
information available on them. This information problem makes it difficult for
small-to-medium-
sized firms to raise external funds.
The Securities and Exchange Commission (SEC) requires publicly traded firms to disclose
financial
statements as well as material information that may affect the price of a firm’s stock. Although
these
regulations reduce the likelihood of adverse selection, they do not eliminate it. Some private
firms,
such as Moody’s and Dunn and Bradstreet, attempt to collect information about companies to
help
investors to better judge the quality of borrowers.
To reduce the problems caused by asymmetric information, lenders often require borrowers to
pledge
some of their assets as collateral, which the lender can claim if the borrower defaults. Investors
often
reduce the chance of adverse selection by restricting their lending to high net worth firms
because
these firms have more to lose in case of default.
Financial intermediaries, particularly banks, specialize in gathering information about the
default risk
of borrowers. Among the tools used are credit reports and relationship banking.
Teaching Tips
The Making the Connection, Has Securitization Increased Adverse Selection Problems in the
Financial System? on pages 263–264 explores the possible role of securitization in contributing
to the financial crisis. Students can compare the potential benefits of securitization with the
possibility that it could result in adverse selection. This comparison also helps promote discussion
about one aspect of financial reform—requiring banks to hold a portion of mortgage-backed
securities that they sell.
B. Moral Hazard
Moral hazard is the problem investors experience in verifying that borrowers are using their
funds as intended.
Economists refer to the possibility that managers will pursue objectives different from those of
shareholders as a principal-agent problem. The shareholders, as owners of the firm, are the
principals, while the top managers, who are hired to carry out the owners’ wishes, are the
agents. Corporate boards of directors may be able to reduce moral hazard, but not eliminate it.
Incentive contracts are used to better align the goals of top managers with the goals of
shareholders. Although options contracts can reduce moral hazard, they can at times also
increase it by leading managers to make decisions not in the best interests of shareholders.
A key way investors try to reduce moral hazard in bond markets is by writing restrictive
covenants into bond contracts. Restrictive covenants either place limits on the uses of the funds
the borrower receives or require that the borrower pay off the bond if the borrower’s net worth
drops below a certain level.
Financial intermediaries can reduce moral hazard problems:
Commercial banks specialize in monitoring borrowers and have developed effective
techniques for ensuring that the funds they loan are actually used for their intended purpose.
Venture capital firms raise funds from investors and use the funds to make investments in
small
startup firms; often take large ownership stakes in small startup firms; and have employees
serve on
boards of directors.
Private equity firms (or corporate restructuring firms) have helped to establish a market for
corporate control, which can reduce moral hazard problems in the financial system by
providing a
means to remove top management that is failing to carry out the wishes of shareholders.
9.3 Conclusions About the Structure of the U.S. Financial System (pages 270–274)
Learning Objective: Use economic analysis to explain the structure of the U.S. financial system.
The discussion in section 9.1 and section 9.2 help explain three key features of the financial
system:
1. Loans from financial intermediaries are the most important external source of funds for
small-to-medium-sized firms.
2. The stock market is a less important source of external funds to corporations than is the bond
market. 3. Debt contracts usually require collateral or restrictive covenants.
Transactions costs and information costs drive a wedge between savers and borrowers, lowering
the interest rate savers receive and raising the interest rate borrowers must pay. Financial
intermediaries are continually searching for ways to earn a profit by expediting the flow of funds
from savers to borrowers.
Teaching Tips
You can use the second key feature of the financial system presented on page 272 to explore how
information costs affect the sources of financing. Ask students to discuss why the bond market is a more
important source of financing for corporations than the stock market. This discussion will help them
understand how investors consider the problem of moral hazard when making investment decisions.