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Asymmetric Information and the Role of Financial intermediaries

1 Observations

1. Issuing debt and equity securities (direct nance) is not the primary source for external

nancing for businesses.

2. Financial intermediaries (indirect nance) are the most important source of external

funds.

3. Only large, well-established corporations have easy access to securities markets to

nance their activities.

4. The nancial system is among the most heavily regulated sectors of the economy.

5. Collateral is a prevalent feature of debt contracts.

6. Debt contracts usually place substantial restrictive covenants on the borrowing

rms.

2 Existence of Financial intermediaries (FI)

1. Economies of scale in monitoring borrowers: FI as a delegated monitor.

2. Asset Transformation (by transforming illiquid loans into liquid deposits)

3. Expertise in information production: Economies of scope by providing multiple

nancial services (banking, underwriting, and insurance) to their customers.

3 Asymmetric Information: Adverse Selection (The Lemons Problem)

Sellers have more information about the quality of the products than buyers do. But the information is private information to the sellers. If quality cannot be assessed, the buyer is willing to pay at most a price that reects the average quality. Then, sellers of good quality items will not want to sell at the price

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for average quality. Thus, poor quality goods (the lemons), whose value is below the

averaged price, will drive out good quality goods (the bad drives the good out of the

market). The buyer will be less willing to buy because all that is left in the market is

poor quality items.

A similar lemons problem arise in the secu rities markets. Suppose there are good

borrowers (borrowers with a lower risk of default) and bad borrowers (borrowers with a

higher risk of default).

Types of Borrowers Rate of Returns Prob. of Success

Good Borrowers

Bad Borrowers

n

n

5%

15%

30%

50%

0.5

0.5

0.7

0.3

Note that the asymmetric information is because

(1) Bad borrowers are poor in quality ex ante, not because of actions taken by bor-

rowers ex post .

(2) The type of borrowers is private information.

Note that the expected return of good borrowers is 10% and that of bad borrowers is -

6%. Given limited liability, bad borrowers are willing to pay at most 15% (0.7*0%+0.3*50%)

of interest for loans (or on securities issued). If the market interest rate is between 10%

and 15%, the good borrowers will be driven out of the market.

3.0.1 Solutions

1. Private production and sale of information

Free-rider problem

2. Government regulation to increase information disclosure

3. Financial intermediation

(1) Banks screen borrowers to sort out good borrowers from bad borrowers

(2) credit rationing: if it is still dicult to sort out good borrowers from bad

ones, or if the cost of screening is too expensive, banks ration the amount of loans and/or

the number of people get nanced, rather than raising the loan interest rate .

Suppose at the current interest rate, there are a lot of borrowers try to apply for the loans

(excess demand). Basic Economics tells us that raising interest rate will clear the market.

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But the bank realizes that raising interest rate will drive more good borrowers out of the market and those who are still willing to borrow at a higher interest rate are mostly bad borrowers, and these bad borrowers are more likely to default. Thus, the expected return of the bank at a higher interest rate may be lower than that at a lower interest rate. Thus, rather than raising the loan interest rate, the bank maintains a lower interest rate, at which there is excess demand for loans, and limits the amount of loans each applicant can borrow. 4. Collateral and net worth Default is the primary concern for lenders. Adverse selection cau ses a problem for the functioning of nancial markets because when bad borrowers (borrowers with a higher risk of defaulting on their debts) get nanced, they are more likely to default. Requiring collateral reduces the problem of adverse se lection by limiting the loss of lenders in case of default. Net worth of borrowers (assets net of liabilities) serves as a similar role as collateral.

4 Asymmetric Information: Moral Hazard

Note that the asymmetric information is because (1) The ex post actions taken by the borrowers, not due to their quality ex ante . (2) The action taken by the borrowers is private information.

4.1 Moral Hazard in Equity Contracts: The Principal-Agent Problem

Due to separation of ownership and control of the rm, managers (agents) pursue personal benets and power rather than the pro tability of the shareholders (principles). This is also called the Principal-Agent Problem. Suppose a manager (on behalf of shareholders) can choose a good or a bad investment project I :

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Types of Investment Projects Prob. of Success Private Bene t

Good

p H

0

Bad where p H >p L .

The private benet BI can be considered to be actions taken by the managers (agents)

who commit fraudulent conducts, such as hiding prots, diverting funds for their own

benets, or pursuing corporate strategies (e.g., acquisition), to enhance their personal

wealth and power, rather than maximize prots for shareholders (principles). Thus, the

probability of success for the project will be lower.

p L

BI

The choice of project is private information.

If the manager is paid a wage rate w , and

p H wI < p L wI + BI,

then the manager will choose the bad project. This says that if B is large enough, the

manager has an incentive to choose the bad project.

This also implies that the wage wI paid to the manager must be high enough to induce

him to select the good project:

4.1.1 Solutions

w

B p H p L

.

1. Production of information: shareholders monitor by frequently auditing the rm.

Free-rider problem

2. Government regulation

Enact laws to set up standard accounting principals deter criminal attempts. Enforce

punishment on fraudulent conducts.

3. Financial Intermediation

Venture capitalists

4. Debt Contracts: lenders choose to hold bonds rather than equities. Thus, the rm

pays a xed amount of interest (coupon payments) no matter what the rm’s prot is.

(1) No need to monitor the borrowers all the time.

(2) Raise the incentive of the entrepreneur to work harder.

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4.2

Moral Hazard in Debt Markets

Borrowers issuing debts have incentives to take on projects that are riskier than the lenders

would like (The moral hazard problem in equity contracts is that managers have incentive

to be lazy (pursue their own private benet), while in debt contract they tend to be too

heady).

Consider a manager who borrow $10,000 from a lender, paying 10% of interest rate.

He has two choices:

Types of Investment Projects Rate of return Prob. of Success

Safe

Risky

15%

1

n

5%

0.9

100%

0.1

The expected return of the risky project is 14.5%, which is lower than that of the safe

project 15%. However, to the borrower

(1) The safe project gives a net return to the borrower 5%.

(2) For the risky project, the return to the borrower is

(i) if the project succeed, he receives a rate of return (1 + 100%) (1 + 10%) = 90%.

(ii) if the project fails, he receives (1 + 5%) (1 + 10%) = 5%. However, due to limited

liability, it is equal to 0%.

Thus, the expected return to the borrower is 9% (0.9 · 0% + 0.1 · 90%). The borrower

will choose the risky project.

4.2.1 Solutions

1. Net worth and collateral

If the lender requires the borrower to pledge collateral, or if the borrower has a higher

net worth, the borrower has more at stake in the investment. The borrower’s incentive to

commit moral hazard will be reduced (incentive compatible).

2. Monitoring and Enforcement of Restrictive Covenants

But by whom?

3. Financial Intermediation

Banks monitor rms intensively and enforce restrictive covenants.

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Conict of Interest

Recall that nancial intermediaries produce information and achieve economies of scope by providing multiple nancial services (banking, underwriting, and insurance) to their customers. However, economies of scope in information production may lead to potential problem:

conicts of interest. Conict of interest is a type of moral hazard problem that arises when an institution has multiple objectives and, as a result, has con icts between those objectives (provide multiple nancial services): conceal information or disseminate misleading information. This is important because this lowers the quality of information in nancial markets and increases asymmetric information problems. This makes nancial markets less e- cient in channeling funds into productive investment opportunities. This has become one of the most important issues in corporate governance. Why do conict of interest arise?

5.1 Underwriting and Research in Investment Banking

Information produced by researching on companies is used to underwrite the securities and sell to the investors. Conict of interest arises between brokerage and underwriting services because the bank is attempting to simultaneously serve two client groups (security-issuing rms and security-buying investors). For example, in order not to lose its customer (Corporation A) to other competitors, the investment bank conceals negative information of Corporation A and underwrites securities on its behalf, and then sell these securities to investors. Another common practice of conicts of interest is Spinning, which occurs when an investment bank allocates hot, but underpriced, IPOs to executives of other companies in return for their companies’ future business with the investment banks.

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5.2

Commercial Banking vs. Investment Banking

A commercial bank makes loans to Corporation A and later receives negative private information about Corporation A. In order to keep Corporation A from defaulting on its loans, the bank conceals the negative information of Corporation A and underwrite securities on its behalf. This shifts default risk from the bank (depositors and the bank) to those investors who purchase the securities (bondholders).

5.3 Auditing and Consulting in Accounting Firms

An accounting rm may provide its clients with auditing services and also nonauditing services (consulting) such as taxes, accounting, and management information system. The conict of interest here is that auditors may provide an overly favorable audit to solicit or retain audit business.

5.4 Credit Rating and Consulting

Credit ratings that reect the probability of default provided by credit-rating agencies determine the pricing (interest rates) of debt securities. Conicts of interest arise because:

(1) The debt issuers are those who pay the credit rating agencies. Thus, a credit rating agency has an incentive to grant a favorable rating to its client. (2) Credit rating agencies often provide consulting services to debt issuers and earn large sum of fees, on advising them the structure their debt issues, i.e., review the man- agement of paying out cash ow, etc At the same time, they are giving credit ratings to exactly these securities.

5.5 Cross Holdings between Commercial Banks and Firms

For example, keiretsu in Japan comprises of a group of rms and nancial institutions. Close relationship between rms and nancial institutions may create moral hazard prob- lems: the banks in the keiretsu may continue to make loans to its rms ineciently, sacricing the interest of depositors and bank shareholders.

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5.6

Solutions to Con ict of Interest

5.6.1 Sarbanes-Oxley Act of 2002 (Public Accounting Return and Investor Protection Act)

1. To increases supervisory oversight to monitor and prevent conicts of interest, the Act

establishes a Public Company Accounting Oversight Board to monitor accounting rms, and increases the SEC’s budget.

2. Makes it illegal for a registered public accounting rm to provide any nonaudit

service to a client contemporaneously with an impermissible audit.

3. Beefs up criminal charges for white-collar crime and obstruction of ocial investi-

gations.

4. Requires the CEO and CFO to certify that nancial statements and disclosures are

accurate.

5.

Requires members of the audit committee to be independent.

5.6.2

Global Legal Settlement of 2002

1. Requires investment banks to sever the link between research and securities underwrit-

ing.

2. Bans spinning.

3. Imposes nes on accused investment banks

4. Requires investment banks to make their analysts’ recommendations public.

5. Over a 5-year period, investment banks are required to contract with at least 3

independent research rms that would provide research to their brokerage customers.

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