Introduction

This chapter explains how financial markets and financial intermediaries deal with the problems of
transactions costs and information costs. The unifying theme of the chapter’s discussion is the idea that
many aspects of the financial system evolved to deal with the costs that arise from asymmetric
information. The main problems arising from asymmetric information—moral hazard and adverse
selection—are discussed at length. The chapter discusses the role of financial intermediaries in reducing
adverse selection and moral hazard problems. In performing this role financial intermediaries provide a
source of funds for firms that would have difficulty financing their operations through financial markets.
This discussion of the crucial role of intermediaries in the financial system lays the foundation for the
understanding of the recent 2007-2008 financial crises that led to the global economic downturn.

I. Obstacles to Matching Savers and Borrowers

Financial markets match borrowers to savers and if these markets are efficient as the EMH suggests then
savers can use the information contained in market prices to make informed portfolio decisions. There are
however obstacles to the smooth functioning of financial markets, namely transaction and information
costs.
Recall: EMH assumed that all participants have symmetric information. In reality all parties do not have
symmetric information, e.g. borrowers are more well-informed about risks of projects they seek finances
for than are lenders.
Asymmetric information describes the situation in which one party in a transaction has better
information than the other.
Asymmetric information => inefficiencies in the sense that NOT all gains to trade are realized. The lower
the impact of asymmetric information, the higher the efficiency in the market.
This asymmetry increases information and transaction costs in financial markets. Financial institutions
and intermediaries have evolved to reduce such costs.
Transactions costs ≡ costs of buying and selling financial instruments. Brokerage commissions,
minimum investment requirements, and lawyers’ fees are all examples of transactions costs.
Information costs are the costs that savers incur to determine the credit-worthiness of borrowers and to
monitor how borrowers use the acquired funds. Such costs increase the cost of raising funds that
borrowers must pay and lower expected returns to savers => reduce market efficiency.
There exist profit opportunities for institutions that can provide services which reduce such costs
particularly for small savers and borrowers. E.g. mutual funds sell shares to many individuals and invest
in a diversified portfolio.
Financial intermediaries reduce transactions costs by exploiting economies of scale in handling costs of
transactions and information gathering (= reduction in average cost with increase in size of
investment/transaction). Small investors can combine their purchases through an intermediary, who
spreads legal and technical costs of transactions.

Informational asymmetries give rise to the following two problems:

1. Adverse selection 2. Moral hazard

II. Adverse Selection ( hidden information  ‘lemons problem’)

Adverse selection occurs in markets any time that there are characteristics known by one transacting
party but not the other.
Example from product markets: Seller has better information about quality of the product than does the
buyer.
The idea of ‘adverse selection’ is often explained using the ‘used car market’ where a poor quality used
car is referred to as a lemon. (See schematic version in footnote to these notes. For a numerical exposition
see notes on NYU Classes titled “More on asymmetric information (from a basic micro course)”.
In financial markets, adverse selection refers to a lender’s problem of distinguishing good-risk applicants
from bad-risk applicants before making an investment decision
How does adverse selection affect the markets’ ability to channel funds from lenders to borrowers?
In the stock market:
Suppose 2 firms – a high-risk and a low-risk company - issue stock to raise equity capital in the financial
market, and investors cannot distinguish between them i.e. cannot asses a company’s risk levels.
Consider a stock market example. If 90% of the firms in the market are good firms and 10% are lemon
firms. The good firm’s share of stock is worth $50 and the lemon firm’s stock is worth $40. Then:
Expected value = (0.9*$50) + (0.1*$40) = $49
So, you would be willing to pay $49 for a share of stock, but to a good firm this is below the fundamental
value of the stock.
Investors will assign the same (average) value to the 2 stocks. The low-risk firm is undervalued and high-
risk firm is over-valued => the low-risk firm incurs a higher cost of borrowing in the stock market =>
scope for cost reduction  inefficiency or waste of resources. The “lemons problem” refers to the
situation where asymmetric information in a market leads to adverse selection problems with the result
that trading becomes costly. Lemons problems make lending in equity markets more costly.
In the bond market:
Consider a scenario in which interest rates are edging up i.e. the interest rate on the default-free Treasury
bond is increasing (=> with stable, spreads, all rates rise). In a rising interest rate environment only high-
risk firms will find it profitable to sell corporate bonds to raise capital. When cost of raising capital is on
the rise investors and lenders expect the low-risk companies to restrict their borrowing activity and hence
are reluctant to lend as much. Lemons problem in the bond market leads to credit rationing, which
involves a restriction in the availability of credit  inefficient resource allocation.
Adverse selection curbs the opportunities for growth of physical capital by curbing the availability of low
cost funds to good companies and this reduces overall production and employment opportunities in an
economy.

Measures to reduce impact of adverse selection: (read on your own or attend recitation)
(a) To deal with lemons problems, most industrialized countries set requirements for information
disclosure for firms that desire to sell securities in financial markets (e.g. SEC requirement of annual
financial statements using standard accounting practices).
i) Such disclosure does not eliminate lemons problems because some firms are too young to have much
information to disclose and lemons firms will try to present their information in the best possible light.
ii) Private firms have tried to reduce the costs of adverse selection by collecting information on individual
borrowers and selling the information to savers. Although savers pay for this information, they benefit
from the quality of information collected by agencies (e.g. Moody’s Investor Service, Value Line,
Morningstar etc) that specialize in it. Such firms don’t eliminate adverse selection problems – only help
minimize associated costs.
iii) Information gathering firms are hurt by free riders, who are individuals who gain access to the
information without paying for it (=> these firms raise price of information they sell).
(b) When borrowers invest little of their own money in their business, their loss is small if they default on
their bonds.
i) Lenders often require borrowers to pledge some of their own assets as collateral, which the lender
claims if the borrower defaults. Collateral reduces the likelihood of adverse selection because lemon
borrowers are less likely to put their own funds in high-risk projects.
ii) If lenders can make a claim on net worth, (the difference between a firm’s assets and liabilities), in the
event that a borrower defaults on its loans, then the borrower will be more cautious about risky
investments. Bond holders have the first claim on net worth of a bankrupt firm (the remaining is
distributed to shareholders).
(c) Financial intermediaries reduce adverse selection problems to financial market participants by
specializing in gathering information about the default risk of many borrowers. In addition to information
like credit reports that is widely available to the public, they have access to specific information on a
borrower that is not accessible by the public.
Relationship banking: The ability of banks to assess credit risks on the basis of private information about
borrowers. (Read on your own).
The information advantage banks gain from relationship banking allows them to reduce the costs of
adverse selection. Under relationship banking, they hold most of the loans they make. Hence, they avoid
the free-rider problem in information gathering by holding loans they make. If they resold those loans
their actions can signal and freely make public the information they hold. Other competing investors
would then have the information for free if banks sold such loans.
Banks’ informational advantage in reducing costs of adverse selection via relationship banking accounts
in large part for their role in providing external financing => small and medium sized firms approach a
bank for finances rather than go to the capital markets to raise funds.
(Work through solved problem 9.2 on page 294 of the text)
Read on your own ‘Apply the concept’ pages 292 -2294

III. Moral Hazard (hidden action)

Even after paying for information to eliminate high-risk firms (i.e. mitigating the adverse selection
problem) a lender faces another problem – monitoring the borrower.
Moral hazard arises when one party to a transaction cannot monitor what the other is doing.
Example: An insurance company cannot monitor how careful you are in avoiding accidents
Note:
Moral hazard is a post-contractual incentive problem  having entered into a contract one party has an
incentive to change behavior in a way that is detrimental to the other party and the latter party is unable to
monitor the former. This is different from adverse selection, which is a pre-contractual information
problem.
In financial markets, moral hazard refers to a lender’s inability to verify that borrowers are using their
funds as intended. A borrower not using borrowed funds as intended puts a lender’s resources at risk. In a
broad sense moral hazard is the problem of fraud in financial markets.
In the stock market:
Borrower has better (asymmetric) information than the lender as to how exactly borrowed funds will be
used. The cost of monitoring raises the cost of funds to the borrowers.
The federal government and the business community itself regulate reporting by firms to reduce the
chance of fraud in equity financing. Such regulations require the use of standard accounting practices and
make misreporting to shareholders a federal offense punishable by fines and imprisonment.
Another version of this information problem in equity financing, called the principal-agent problem,
arises from the behavior of a firm’s agents, who have different goals than the principals.
The shareholders (owners of a corporation) are the principals and the managers are the agents
The principal-agent problem type of moral hazard arises when managers do not own much of the firm’s
equity and thus do not have the same incentive to maximize the firm’s value as the owners do.
Managers often run firms to satisfy their personal goals of acquiring prestige and power rather than
increasing profits and shareholder returns. Managers have an incentive to underreport profits so that they
can reduce dividends and retain the use of the funds.
To reduce this problem, the SEC requires managers to issue financial statements.
Boards of directors meet infrequently and may not be independent of top managers. Investors elect board
of directors to represent them. But they are not a complete solution.
Some boards of directors use incentive contracts to align the goals of managers with the goals of
shareholders. (Part of manager compensation is tied to firm performance.)
Compensation tied to the firm’s profits, however, may lead managers to undertake risky investments.
No single-shareholder can afford the cost of monitoring mangers and even if some do the others will free
ride taking away the incentive to do so.
In the bond market:
Because the debt contract promises a regular interest payment and return of principal, the lender does not
need to incur any monitoring costs (associated with use of funds) as long as he receives these payments.
Debt financing reduces, but does not eliminate, moral hazard problems relative to equity financing. A debt
contract allows the borrower to keep any profits that exceed the fixed amount of the debt payment. As a
result borrowers have an incentive to assume greater risk (to earn higher profits) than is in the interest of
the lender.
Moral hazard in debt financing is often reduced through the use of restrictive covenants in the contract,
which impose requirements on borrowers.
Restrictive covenant: A clause in a bond contract that places limits on the uses of funds that a borrower
receives.
Such covenants may (i) place restrictions on risk-taking e.g. prohibiting the purchase of another business
until debt is repaid (ii) require a borrower to maintain a reasonable level of net worth in liquid assets or
require that entrepreneurs/managers place a part of their own funds at risk (iii) require the borrower to
maintain the value of any collateral offered to the lender (e.g. insurance payments on a car loan).
Note: There is a cost of monitoring if firms are complying with the restrictive covenants. Also, such
covenants cannot protect the lender against every possible risky activity a borrower can engage in.
Financial intermediaries deal with moral hazard through monitoring.
Financial intermediaries, particularly banks, reduce the free-rider problem in information gathering and
earn a profit by acting as delegated monitors for their small savers. Banks have standard effective
techniques to make sure funds they lend out are used for the stated/intended purpose. Banks may give out
loans in stages (not all at once) and may include restrictive covenants.
When any intermediary holds a large block of shares in a firm it has an incentive of monitor the use of
funds and can do so at a lower average cost.
Venture capital firms, which raise equity capital from investors and invest in start-ups/emerging or
growing firms, monitor management’s actions closely. A large ownership stake in a firm enables venture
capitalists to closely monitor borrowers => reduces the principal-agent problem.
Corporate restructuring firms, which raise equity capital to acquire large blocks of equity in mature
firms, often take direct control of the firm and ease their ability to monitor.
Large investors, like venture capital firms or corporate restructuring firms, often have more success than
small investors in reducing the free-rider problem that arises in gathering information on the behavior of
corporate managers. This is because the target firms are not publicly traded companies. As a result,
borrowers know they cannot take advantage of the free-rider problem involved in monitoring and hence
do not attempt to violate restrictive covenants.
Note: Read on your own “Apply the concept” pages 299- 301

IV. Conclusions About the Structure of the US Financial System (read on your own)
_________________________________________________________________
Footnote:

Used car market (“lemons problem”) as a demonstration of adverse selection:

Buyers don’t know the quality of a used car on the market (peach/gem or a lemon?) Sellers know their
product. The buyer only knows what he is willing to pay for a lemon and a peach (peach is of course
valued more than a lemon). Since he can’t tell whether a car is a peach or a lemon he is willing to pay a
price that is no more that the average of the price of a lemon and a peach
At the average price

peaches with price > average price lemon with price < average price
held back are offered for sale

buyers know this

=> average price they are willing to pay for cars offered for sale falls further => more of the relatively
better quality cars are not offered for sale and buyers know this ……..average price they are willing to
pay falls further……until the price that buyers are willing to pay for cars that remain is 0 and no cars are
offered for sale  market unravels  market failure due to asymmetric information.

Example:
Peach/gem = good used car Lemon = bad used car
Both sides know probability = ½ probability = 1/2
True value $14,000 $10,000

Symmetric Info:
Both sides know true value: sells for $14,000 sells for $10,000
(all cars sell)
Neither side knows true value: sells for $12,000 sells for $12,000
(all cars sell for average price = ½(14000) = ½(10000) = 12,000)

Asymmetric Info:
Sellers know true value but buyers don’t
AND buyers are aware of this => Any buyer will offer no more than average price of $12,000
Each buyer is aware of the info disadvantage faced by buyers
He/she figures that only cars valued at $12,000 and below will be
offered by sellers  owners of peaches (good cars) worth more
than $12,000 will hold back their cars
=> each buyer then revises his/her belief about quality of cars
offered for sale
Revised belief: peaches with probability = ¼ and lemons with probability = 3/4
Now each buyer knows that no buyer will offer more than
¼(14000) + ¾(10000) = $11,000 < $12,000
Each buyer figures that only cars valued at $11,000 & below will be
 offered by sellers  owners of peaches (good cars) worth more
than $11,000 will hold back their cars
=> each buyer then revises his/her belief about quality of cars
offered for sale
Revised belief: peaches with probability = 1/6 and lemons with probability = 5/6
Now each buyer knows that no buyer will offer more than
1/6(14000) + 5/6(10000) = $10,666 < $11,000
………………………………….
………………………………….
………………………………….market unravels!
 average price tends to 10,000 as buyers are aware of their info
disadvantage expect owners of peaches will hold back

Why is this inefficient???

Answer: Good cars don’t sell i.e. there are buyers willing to pay $14,000 for a good car only if they can
tell for sure that the car is a peach and not a lemon. Lost sales  unrealized gains from trade (that
could have taken place in the absence of asymmetric info)

Note:
In the used car market dealers help. They sell peaches and lemons for prices close to true value – their
reputation is at stake
In the goods market in general, one way out is the use of warranties.