8.1 The Sources of External Finance #Notebook

 8.1 The Sources of External Finance #Notebook

The financial system connects savers to spenders or investors to entrepreneurs in two ways, via markets, and via financial intermediaries. But most of the real action, however, takes place behind closed doors in banks, non-bank financial companies, and other institutional lenders.

Most companies are small and most small companies finance most of their activities by borrowing from their suppliers or, sometimes, their customers. Most such financing ultimately comes from loans, bonds, or stock. 

Companies that extend trade credit act, as nonbank intermediaries, channeling equity, bonds, and loans to small companies. This makes sense because suppliers usually know more about small companies than banks or individual investors do.

A $1,000 year-long bank loan renewed each year for 20 years would count as $20,000 of bank loans, while the sale of $1,000 of equities would count only as $1,000. 

Most external finance does not come from the sale of stocks or bonds. 

In less economically and financially developed countries, an even higher percentage of external financing comes to nonfinancial companies via intermediaries rather than markets.

Why are bank and other loans more important sources of external finance than stocks and bonds? 

Why does indirect finance, via intermediaries, trump direct finance, via markets? 

Why are most of those loans collateralized? 

Why are loan contracts so complex? 

Why are only the largest companies able to raise funds directly by selling stocks and bonds? 

Why are financial systems worldwide one of the most heavily regulated economic sectors?

Those questions can be answered in three ways: transaction costs, asymmetric information, and the free-rider problem.