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Information Asymmetry in Banking Sector: Non-Random Aspect of Default
Information Asymmetry in Banking Sector: Non-Random Aspect of Default
The main result of the information asymmetry in the banking sector is just one thing that is
Non-Performing Assets. The very existence of banks is often interpreted in terms of its
superior ability to overcomes three basic problems of information asymmetry, namely ex-
ante, interim and ex-post information asymmetry, over an individual lender. It may be seen
that in the Indian context, a bank often fails to overcome these problems due to various non-
random factors as discussed below.
Irrespective of the size of the project, almost 70-75 percent of the investment is
financed by banks and financial institutions and 25-30 percent comes from the promoters as
their contribution in the form of capital. In other words, major part of the investment in all the
projects is financed by banks and financial institutions. It is the job of the banker to properly
scrutinise the projects and stay away from unviable and un-bankable projects. The bank’s role
is to screen potential projects to determine expected return and risk from the not very
objective data presented by the demanders of funds. Clearly, the bank’s credit department
takes the centre stage, because it is through its evaluation of potential investment
opportunities the bank productively invests idle deposits mobilised from the household sector
in the public interest. Term project proposals require detailed scrutiny as compared to
working capital proposals, particularly keeping in view the future growth prospects of the
project and that of the industry. The decision of the term loan is irreversible and any wrong
decision could result in bad investment. There may exist situations where many borrowers
hide information while borrowing and once the loans are granted they default. When banks
fail to detect them adverse selection problems result. Adverse selection of the projects
without properly scrutinising their viability has led to substantial accumulation of NPA in the
banks. The following situations lead to failure to overcome ex-ante information asymmetry
and thereby cause adverse selection of borrowers.
a) Lack of organisational learning in the bank - repeated lending to same person or group
of persons with similar dubious characteristics
Organizational learning on the part of the bank is very important in controlling the growth
of NPA. It is obvious that with the experience of repeated lending over a period of time to
varieties of borrowers, a bank can identify a particular type of borrower who is more likely to
default. But in practice it fails to learn from the past. Due to several constraints, whether
internal or external, like political interference, it cannot bar these potential defaulters. For
instance, loans have been extended to
i) industries in the negative list circulated by IDBI, department of industries and RBI.
ii) Existing accounts which have gone irregular, i.e. ever-greening of accounts.
iii) A party which is irregular on existing accounts in a different branch of the same bank.
iv) Several projects with promoters or directors with doubtful integrity.
While examining long term viability, both foresight as well as proper scrutiny is lacking
on the part of the bank. Inefficient decisions have resulted in many newly born projects
turning sick or closing down. There are instances in which instalments and interest have
become due before the commencement of commercial production. Such accounts are
considered as NPA, which reflects improper scrutiny and failure in considering moratorium
period on a realistic basis.
c) Political interference
Political leaders/organisations wield enormous power over the banks in granting loans
to particular borrowers. It pays the political leaders to encourage default by the borrowers, in
the absence of an efficient legal system. For instance, rural panchayats are responsible for
recommending loans, but once the loan is disbursed, these rural political bodies take no
initiative to ensure that the loan is serviced and repaid. There are many instances where big
companies received a large volume of loans under political influence and were able to escape
punishment after default. Examples include UB Engineering promoted by Vijay Mallya, an
MP in the Rajya Sabha and Mukand Steel promoted by Viren Shah, current governor of West
Bengal. Earlier, loan melas and debt write off under political pressure have also contributed
to NPA problem of which further discussion will be made in the next section.
This theory was brought forward by Stephen Ross and Solomon Ezra in 1977.They observed
that from empirical studies, firms that increase significantly dividend payment had a
corresponding increase in share prices whereas those firms that omitted or reduced
significantly dividend payment had a corresponding decline in share prices. This in his
opinion suggested that investors prefer dividend to capital gains.
These announcements are closely anticipated and followed because investors believe they
can provide information about the company’s financial health. Generally, dividend signalling
is done by the company when it changes the amount of dividend to be paid to shareholders.
Miller and Modigliani (1961) work sustains that, in a perfect capital market, a firm value is
independent of the dividend policy. However, some years later, Bhattacharya (1979), John
and Williams (1985) and Miller and Rock (1985) developed the signalling theory classic
models, showing that, in a world of asymmetric information, better informed insiders use the
dividend policy as a costly signal to convey their firm’s future prospect to less informed
outsiders. So, a dividend increase signals an improvement on a firm’s performance, while a
decrease suggests a worsening of its future profitability. Consequently, a dividend increase
(decrease) should be followed by an improvement (reduction) in a firm’s profitability,
earnings and growth. Moreover, there should be appositive relationship between dividend
changes and subsequent share price reaction.
2.1 Assumptions
One of the most important assumptions of the signalling theory is that dividend change
announcements are positively correlated with share price reactions and future changes in
earnings. According to Brigham and Houston (2013), signalling theory is also banked by the
assumption that information is not equally available to all parties at the same time, and that
information asymmetry is the rule. Information asymmetries can result in very low valuations
or a sub-optimum investment policy. Signalling theory states that corporate financial
decisions are signals sent by the company's managers to investors in order to shake up these
asymmetries. These signals are the cornerstone of financial communications policy. In this
case, managers know more than investors, so investors will find "signals" in the managers'
actions to get clues about the firm. So the theory simply suggests that firm’s announcements
of an increase in dividend pay-outs act as an indicator of the firm possessing strong future
prospects.
Dividend decisions are frequently seen by investors as revealing information about a firm's
prospects therefore firms are cautious with these decisions. An information asymmetry exists
if firm managers know more about the firm and its future prospects than the investors.
When investors have incomplete information about the firm (perhaps due to opaque
accounting practices) they will look for other information in actions like the firm's dividend
policy.
Signalling is the idea that one agent conveys some information about itself to another party
through an action hence relying on signalling theory is justified. For instance, when managers
lack confidence in the firm's ability to generate cash flows in the future they may
keep dividends constant, or possibly even reduce the amount of dividends paid out.
Conversely, managers that have access to information that indicates very good future
prospects for the firm (e.g. high demand for its goods) are more likely to increase dividends.
Another argument is that a manager who has good investment opportunities is more likely to
"signal" than one who doesn't because it is in his or her best interest to do so.
Investors can use this knowledge about managers' behavior to inform their decision to buy or
sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling
it down when dividends do not meet expectations. This in turn, may influence the dividend
decision as managers know that stock holders closely watch dividend announcements looking
for good or bad news. As managers tend to avoid sending a negative signal to the market
about the future prospects of their firm, this also tends to lead to a dividend policy of a
steady, gradually increasing payment. Investors will notice this and choose to sell their shares
at good prices or retain them for good dividends. Firms are aware of this signaling effect, so
they will try not to send a negative signal that sends their stock prices down. In practice
changes in a firm’s dividend policy can be observed to have an effect on share prices. That is
to say an increase in dividend causes share prices to go up whereas decreases in dividend
would pull the share prices down. This pattern forced Stephen Ross to conclude contrary the
MM model that shareholders do in deed prefer dividend to future capital gains.
3.0 CONCLUSION
Investors view dividend changes as signals of management’s view of the future. Managers
hate to cut down dividends, so they also avoid raising dividends unless they think this is
sustainable. Therefore, a stock price increase at time of a dividend increase could reflect
higher expectations for future Earnings per Share (EPS), not a desire for dividends. The
signalling dividend theory concludes that dividend decisions are relevant and the higher the
dividend paid by the company, the higher its value. However, a firm should always make
decisions that will favour its long term objectives because the decision of investors and
shareholders should not be the leading force. In an uncertain world in which verbal
statements may be miss- interpreted or ignored a dividend action does provide a clear cut
means of making a statement that speaks louder than many words.
This explanation has identified moral hazard, in that the executives of financial institutions
responsible for originating loans (mortgages) to borrowers (homeowners) may have been
motivated to relax their standards in conceding these loans. Traditionally, the mortgage
model required a financial institution as the originating source for a loan to the borrower
(homeowner), and this institution retained the credit (default) risk. With the advent of
securitization, the traditional model gave way to the originate to distribute model, in which
financial institutions essentially sell the mortgages and distribute credit risk to investors
through mortgage-backed securities. Securitization meant that those issuing mortgages were
no longer required to hold them to maturity. By selling the mortgages to investors, the
originating financial institutions (that is, the institutions that issued the mortgages)
recuperated their funds, enabling them to issue more mortgages and in doing so generate
further transaction fees.
This may have produced moral hazard, as the executives of financial institutions that issue
mortgages and the mortgage brokers were increasingly motivated to focus on processing
mortgage transactions for fees rather than on ensuring credit quality. If the homeowner
(borrower) could not pay the mortgage, and was this was foreclosed, there was little impact
for the issuer.