The three main asymmetric information problems that arise in financial markets

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 (.washingtonpost.com/ezra-klein/2009/11/adverse_selection_in_the_credi.html”>http://voices.washingtonpost.com/ezra-klein/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

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