1. The three main asymmetric information problems that arise in
financial markets are as listed in the text: adverse selection,
principle-agent, and moral hazard. These problems are generally
defined as when one party has more pertinent information than
the other; thereby pitting one with an advantage or disadvantage
(1). This is relevant in the financial world where lenders and
borrowers are constantly interacting without perfect
communication of information.
In adverse selection scenarios, a lender/creditor/insurer/etc. is
faced with an undesirable result after a sale is made. With
regards to insurance, “It describes a situation wherein an
individual’s demand for insurance (the propensity to buy
insurance and the quantity purchased) is positively correlated
with the individual’s risk of loss (higher risks buy more
insurance), and the insurer is unable to allow for this correlation
in the price of insurance”. (2) This is very similar to the “Lemons
effect”, in which increasing costs in a risk based market has a
tendency to decrease the low-risk participators — resulting in a
perpetually increasingly riskier market. To account for this,
different insurers and lenders vary premiums and interest rates
based on information available to them about each individual
client. The most common example of this is when a lender is
faced with a defaulted loan. The creditor is often not faced with
information prior to the sale that would have lead them to believe
that the payee would be unable or unwilling to repay this loan.
This may be due to a lack of investigation by the creditor or the
pure unavailability or inaccuracy of information.
The agent-principal problem is generally defined as one where
one entity is able to make decisions that may affect the other
party bound to them contractually, without impunity. A simple
example of this is that a student is granted a student loan for
scholarly expenses, but instead uses that money to finance an
extravagant party. The lender is at a loss after the student has
spent the loan, and the student is left with nothing more than
bottle cans (redeemable for deposit) as a means of repayment. A
more practical but subtle use of this principle occurs with every
dining experience in America. The waiter/waitress may provide
extra coffee, free appetizers, a likable personality, and overall
excellent service — in the hopes that they will receive a tip
proportionate to the experience. However, there is little
guarantee that the customer will reciprocate with a generous tip.
“Think about it: when you go to a restaurant, you are entering a
contract to pay a specific amount for a meal. Yet, diners actually
choose to pay more than what is required. It’s not illegal not to
tip, so why are people basically giving away their money?” (3)
“In economic theory, a moral hazard is a situation where a party
will have a tendency to take risks because the costs that could
result will not be felt by the party taking the risk” (4) Moral hazard
is a specific type of information asymmetry where one party has
more information than the other. The individual with greater
knowledge about the transaction may also have more protection
from the consequences associated with risks associated with the
transaction. In an abstract manner, this was demonstrated by the
‘too big to fail’ banks in the recent global financial crisis, where
governments were subject to the actions of those they supported
and insured. “According to the World Bank, of the nearly 100
banking crises that have occurred internationally during the last
20 years, all were resolved by bailouts at taxpayer expense.” (5)
A more pragmatic example would be a basic credit card, where
lenders maintain a fluctuating line of credit with a customer
because they have little control over how the LOC is spent.
Beyond logic and a perpetual cascade of insurance companies,
there are many tools available to the financial world to shield
against these problems. The largest and most effective tool
seems to be transparency of information. Publicly audited
financial statements have allowed investors and creditors
insights into the quarterly activities of publicly traded companies,
and individual creditors a method to provide for private
industries. There are also many private institutions that
investigate and provide information on the activities of institutions
and individuals to better educate lenders. Privately provided
information is prey to the free-rider effect, in which people that
did not contribute to the production of the information (directly or
indirectly) will obtain and use that information. Due to this, it is
often not cost effective for an individual to obtain information
through private means.
There are also the major credit rating agencies (Moody’s, S&P,
etc.) that provide information on securities as well as other
financial products and agencies. These agencies are paid to
produce and provide information on multiple aspects of the
global and local economies. This information protects lenders
and investors by providing additional information than what is
provided by their respective payees.
Finally, there are government regulations that restrict the
movement in financial markets in such a way to move towards
more predictable and stable trends. For example, banks are
insured by the FDIC in order to protect savers from their banks
(in order to prevent bank runs). Many Student loans are backed
by the federal government in America in order to protect lenders
in unstable economies, while allowing students access to funds.
Almost every financial agreement between two or more parties is
subject to rules and regulations that are dictated by governments
to ensure consistency and some security to all parties involved.
John
2.
The three main asymmetric problems that arise in financial markets are adverse
selection, moral hazard and the principal-agent problems. The asymmetric
information is an inequality where one party doesn’t know enough about the other
party to make an accurate decision. An example of this is a borrower who takes
out a loan usually has better information about the potential returns and risk
associated with investment projects for which the funds are earmarked than the
lender does. The lack of information will create a problem in the financial system
on two fronts: before the transaction is entered into and after (Mishkin pg. 39)
Adverse selection is one problem of asymmetric information. This problem is
created before the transaction occur and in financial markets this occurs when the
potential borrowers who are the likely produce undesirable outcome, the bad credit
risk are the ones who usually seek out a loan and are most likely to be selected.
Due to this lenders might not make any loans even through good credit risk exist
in the marketplace. An example of adverse selection is in the credit card market.
Ezra Klein ask the question in his article “Adverse selection in the credit card
market?” he points out how credit cards are become harder to get and less valuable
to hold due to the sharp recession and consumers aren’t paying back loans and
new regulations are being blocked off so the profits are suffering. Also he states
that more people are gravitating towards debit cards and people are responsible
enough to not want credit cards (http://voices.washingtonpost.com/ezraklein/2009/11/adverse_selection_in_the_credi.html).
Moral hazard is another problem that is created by asymmetric information after
the transaction occurs. The risk is that the borrower might engage in activities that
are undesirable from the lenders point of view because it is less likely that the loan
will be paid back and because of this, lenders may decide that they would rather
not make the loan (Mishkin pg. 40). In the “Moral Hazard and The Crisis” an
example of moral hazard was pointed out when Jamie Dimon the C.E.O of J.P.
Morgan stated that his bank never tested its portfolio against the possibility that
the housing market would fall. As noted that J.P. Morgan was of all of the big
banks that was least enmeshed in the subprime market and it didn’t contemplate
that the housing market would crash. And a big reason f was the financial crisis
was a moral hazard because the big banks assumed that if things went wrong they
would end up bailed out
(http://www.newyorker.com/online/blogs/jamessurowiecki/2010/01/moral-hazardand-the-crisis.html).
Equity contracts are subject to a particular type of moral hazard which is the
principal-agent problem. So when a manager owns a small fraction of the firm
they work for, the stockholders who own the most are the principal are not the
same people as the managers of the firm who are the agent of the owners. So the
separation of the two is the agent may act in their own interest rather than the
principal because the agent has less incentive to maximize profits than the
stockholder-owner (Mishkin pg. 173). In the article “Solving The Principal Agent
Problem: Apple Insist That Executives Must Hold Company Stock” it mentions
how over the number of years trying to solve the principal/agent problem is that
they hire people to do things for them and they run into the problem because the
incentives aren’t going to lead them towards the path that will help benefit the
principal. Apple have tried many things to combat this issue like giving stock
options out to the management to grow the stock and letting them profit out of
having doing so (http://www.forbes.com/sites/timworstall/2013/03/01/solving-theprincipal-agent-problem-apple-insists-that-executives-must-hold-company-stock/ ).
In looking into the three main asymmetric information problems there has to be
tools that will help address these issues. The tool to help solve these problems
involve the private production and sale of information, government regulation to
increase information in the financial markets, the importance of collateral and net
worth to debt contracts and the use of monitoring and restrictive covenants . The
existence of the free-rider problem for traded security shows that financial
intermediaries in particular banks should play a greater role than the securities
markets in financing the activities of business. So for adverse selection the tools to
helps solve it would be private production and sale of information, government
regulation to increase information, financial intermediation, collateral and net
worth. In Moral hazard in equity contract s or the principal-agent problem the
tools are production of information: monitoring, government regulation to increase
information, and financial intermediation. And the tools for moral hazard for debt
contracts are collateral and net worth, monitoring and enforcement of restrictive
covenants, and financial intermediation (Mishkin pg. 178). In the article “Solving
Information Asymmetry: How Today’s Companies Are Empowering Consumers
and Creating More Efficient Markets” it points out that a growing number of
companies are emerging that shift this asymmetry of information back to balance-arming consumers with the same information that businesses have long had. This
shift toward a more balanced distribution of information benefits consumers and
quality businesses alike. With full information, consumers are able to see through
marketing schemes, overpriced products and inferior goods and services. They can
then offer their business to the companies that offer the highest quality offerings
for the most reasonable price. And by increasing transparency and trust between
buyers and sellers through equal access to information, these companies are
helping to create more efficient markets and this is a tool that is helping the market
(http://www.huffingtonpost.com/grace-nasri/solving-informationasymm_b_3870302.html).
In conclusion to this topic we see both sides to this issue which show the negatives
of asymmetric information and what are the tools that can help prevent this by
consumers having the access to the this information so they can make a conscious
decision in what they are getting involved into. Also the financial intermediaries
can make good decision on giving out loans to people who will be able to pay
back and not being high risk so that are the things that help bring both sides closer
together. Larry
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