Financial Systems in Developing vs Developed Countries

Study Notes

Main source of funding in companies in developing countries comes from banking debts.
In contrast, in advanced economies, non-bank loans, bonds, and equity are also significant sources of funding.

Stocks/equity are not the most important sources of external financing for businesses.
Issuing marketable debt and equity securities is not the primary way businesses finance their operations.
Indirect finance, involving financial intermediaries, is more important than direct finance.
Financial intermediaries, especially banks, are the most important source of external funds for businesses.
The financial system is heavily regulated due to asymmetric information.

Only large, well-established corporations have easy access to securities markets to finance their activities.

Collateral is a prevalent feature of debt contracts for both businesses and households.
Debt contracts are extremely complicated legal documents with restrictive covenants that regulate the borrower's activity.

Financial intermediaries reduce transaction costs by taking advantage of economies of scale and developing expertise.
They bundle funds together to reduce per-dollar transaction costs and accumulate expertise to reduce risk.

In bilateral trading, one side has more information than the other, leading to market distortions.
Asymmetric information results in two problems: adverse selection and moral hazard.

Adverse selection occurs when one party in a transaction has more information about a product or service than the other party.
It takes place before the transaction, and examples include the second-hand car market, life insurance, IPOs, and bank loans.

Moral hazard occurs when the borrower has incentives to engage in undesirable activities, making it less likely that the loan will be paid back.
It occurs after the contract is signed, and the borrower deviates from the contract by undertaking undesirable activities.