Asymmetric Information

1
Asymmetric Information

• ADVERSE SELECTION AND MORAL HAZARD

2
WHAT IS ASYMMETRIC INFORMATION?

• In financial markets, one party often does not
  know enough about the other party to make
  accurate decisions. This inequality is called
  asymmetric information. For example, a borrower
  who takes out a loan has better information about
  the potential returns and risks associated with
  investment projects than the lender does. Lack of
  information creates problems in the financial
  system on two fronts before the transaction is
  entered into and after.

3
ACTIVITY

• David is a Banker. He has two aunts, named Louis
  and Sheila.
• Aunt Louise saves money and only borrows money
  when she needs it.
• Aunt Sheila likes to gamble and who has a
  get-rich plan, to become a millionaire, if she
  can just borrow 1000. Most of the time these
  plans or schemes never pay off.
• Which of these aunts is likely to ask David for a
  loan?

4
ADVERSE SELECTION

• Aunt Sheila, of course, because she keeps asking
  but David does not want to give her a loan she
  might not be able to pay back.
• If you know both of these aunts well if your
  information was NOT asymmetric you would not
  have a problem. You would know Aunt Sheila is a
  bad risk so you wouldnt lend to her.
• If you didnt know them very well you would most
  likely lend to Aunt Sheila cause she keeps asking
  you for the loan. Because of the possibility of
  adverse selection, you might decide not lend to
  either one of them even though Aunt Louise is a
  good credit risk.

5
MORAL HAZARD

• Moral hazard is the problem created by asymmetric
  information after the transaction occurs. Moral
  hazard is the risk (hazard) that the borrower
  might engage in activities that are bad (immoral)
  from the lenders point of view because the
  borrower might not pay backthe loan. Because of
  this, lenders might not want to make the loan.
• As an example, Clay makes a loan to Uncle Melvin
  for 1000 to buy a computer. After Clay makes
  the loan Uncle Melvin uses the 1000 to gamble on
  a horse race. If his horse wins he makes 20,000
  and lives very well. But if he loses, which is
  more likely, Clay does not get paid back and all
  Uncle Melvin loses is his reputation as a good
  uncle.

6
MORAL HAZARD

• If Clay knew what his Uncle would do he would
  keep him from going to the race track and would
  not be able to increase moral hazard. However,
  Clay does not know what his Uncle does because
  information is asymmetric. If Clay knew his uncle
  well the risk of moral hazard might discourage
  Clay from making the loan.

7
THE IMPORTANT ROLE OF FINANCIAL INTERMEDIARIES

• The problems created by adverse selection and
  moral hazard cause a problem to well-functioning
  markets. Financial Intermediaries can help with
  this problem.
• Larger financial intermediaries are better
  equipped to determine bad risks from good risks
  thus reducing the losses due to adverse
  selection. And they can also due a better job in
  monitoring parties they lend to thus reducing the
  losses due to moral hazard.
• Financial Intermediaries play an important role
  in the economy because they provide liquidity
  services, promote risk sharing, and solve
  information problems helping savers and
  borrowers.
• We will learn more about financial intermediaries
  later.