Chapter 8
An Economic Analysis of Financial Structure
The development of the literature in economics on asymmetric information and financial
structure in recent years now enables financial institutions to be taught with basic economic
principles rather than placing emphasis on a set of facts that students may find boring and so will
forget after the final exam. This chapter provides an outline of this literature to the student and
provides him or her with an economic understanding of why our financial system is structured
the way it is. In addition, it emphasizes the ideas of adverse selection and moral hazard, which
are basic economic concepts that are useful in understanding principles of bank credit risk
management in Chapter 9, principles of bank regulation in Chapter 10, the economics of
financial regulation in Chapter 11, and financial crises in Chapters 12 and 13.
Two applications give students practice with using the concepts in the earlier asymmetric
information analysis. They examine the role of financial development on economic growth and
whether China is a counter-example to the importance of financial development. Students find
these applications to be very stimulating because there is something inherently exciting about
economic growth. These applications can be skipped without loss of continuity, especially for
courses focusing on financial institutions.