The concept of adverse selection helps to explain why indirect finance is more important than direct finance as a source of business finance.

Question

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Adverse selection occurs when one party in a transaction has more information than the other, leading to the potential for the party with less information to make poor choices. In the context of finance, this means that lenders may be hesitant to provide direct finance (such as issuing a loan) because they may not have full information about the borrower's ability to repay the loan. Indirect finance, where a financial intermediary such as a bank assesses the risk of the borrower and then lends on their behalf, can help mitigate this adverse selection problem. Therefore, indirect finance is likely to be more important as a source of business finance than direct finance.

The Concept of Adverse Selection Helps to Explain Why Indirect