Chapter 9

Transactions Costs, Asymmetric Information,

and the Structure of the Financial System

 Brief Chapter Summary and Learning Objectives

9.1 Obstacles to Matching Savers and Borrowers (pages 255–257)
Analyze the obstacles to matching savers and borrowers.
• Because of transactions costs and information costs, savers receive a lower return on their
investments and borrowers must pay more for the funds they borrow.
9.2 The Problems of Adverse Selection and Moral Hazard (pages 257–270)
Explain the problems that adverse selection and moral hazard pose for the financial system.
• Adverse selection is the problem investors experience in distinguishing low-risk borrowers from
high-risk borrowers before making an investment.
• Regulations, collateral, and financial intermediaries help to reduce adverse selection, but do not
eliminate it.
• Moral hazard is the problem investors experience in verifying that borrowers are using their funds as
intended.
• Corporate boards of directors, incentive contracts, and financial intermediaries help to reduce, but
not eliminate, moral hazard.
9.3 Conclusions About the Structure of the U.S. Financial System (pages 270–274)
Use economic analysis to explain the structure of the U.S. financial system.
• Loans are the primary source of funds for small-to-medium-sized firms, while the bond market is the
primary source of funds for large corporations.
• Financial intermediaries are continually searching for ways to earn a profit by expediting the flow of
funds from savers to borrowers.

 Key Terms
Adverse selection The problem investors
experience in distinguishing low-risk borrowers
from high-risk borrowers before making an
investment;.
Asymmetric information The situation in which
one party to an economic transaction has better
information than does the other party.
Information costs The costs that savers incur to
determine the creditworthiness of borrowers and
to monitor how they use the funds acquired.
Collateral Assets that a borrower pledges to a
lender that the lender may seize if the borrower
defaults on the loan.
Credit rationing The restriction of credit by
lenders such that borrowers cannot obtain the
funds they desire at the given interest rate.
Economies of scale The reduction in average cost
that results from an increase in the volume of a
good or service produced.
Private equity firm (or corporate restructuring

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 Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 107

Moral hazard The risk that people will take
actions after they have entered into a transaction
that will make the other party worse off; in
financial markets, the problem investors
experience in verifying that borrowers are using
their funds as intended.
Net worth The difference between the value of a
firm’s assets and the value of its liabilities.
Principal–agent problem The moral hazard
problem of managers (the agents) pursuing their
own interests rather than those of shareholders
(the principals).
firm) A firm that raises equity capital to acquire
shares in other firms to reduce free-rider and
moral hazard problems.
Relationship banking The ability of banks to
assess credit risks on the basis of private
information about borrowers.
Restrictive covenant A clause in a bond contract
that places limits on the uses of funds that a
borrower receives.
Transactions costs The cost of a trade or an
exchange; for example, the brokerage commission
charged for buying or selling a financial asset.
Venture capital firm A firm that raises equity
capital from investors to invest in startup firms.

 Chapter Outline
Teaching Tips

Students often remark that their money and banking course seems to jump from one topic to the next, without
providing a framework for understanding how the pieces fit together. This chapter should help students to
understand the relationship among some of the key topics of the course. The chapter focuses on how financial
markets and financial intermediaries deal with problems of transactions costs and asymmetric information.
The unifying theme of the chapter’s discussion is the idea that many of the aspects of the financial system
evolved to deal with the information costs that arise from asymmetric information. The main problems arising
from asymmetric information—adverse selection and moral hazard—are discussed at length. When students
grasp these ideas, recent developments in the financial system become easier to understand.

The chapter discusses the role of financial intermediaries in reducing adverse selection and moral hazard
problems. Through this discussion, students can begin to understand better the crucial role of intermediaries in
the financial system. An alternative, more descriptive, approach tends to leave students with the vague idea
that financial markets provide funds to large firms and intermediaries provide funds to small firms, but with no
clear understanding of why.

Should You Crowd-Fund Your Startup?

Many startup companies have difficulty in obtaining funding. In recent years, a new way to fund startups,
crowd-funding, has emerged. Crowd-funding involves raising small amounts of money from large numbers of
people. Though crowd-funding is likely to help entrepreneurs by providing a new source of financing, small
investors participating in crowd-funding face the problem of asymmetric information because the startups
raising funds are likely to know much more about how likely they are to be successful than are small investors.

9.1 Obstacles to Matching Savers and Borrowers (pages 255–257)

Learning objective: Analyze the obstacles to matching savers and borrowers.
A. The Problems Facing Small Investors
Transactions costs are the costs people incur in making direct financial transactions, including legal
fees and the time needed to identify profitable investments. Information costs are costs that savers

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108 Hubbard & O’Brien • Money, Banking, and the Financial System, Second Edition

incur to determine the creditworthiness of borrowers and to monitor how borrowers use the acquired
funds. Because of transactions costs and information costs, savers receive a lower return on their
investments and borrowers must pay more for the funds they borrow.
B. How Financial Intermediaries Reduce Transactions Costs
Financial intermediaries are able to reduce transactions costs, thereby facilitating financial
transactions involving small investors as well as small-to-medium-sized firms. Ways that financial
intermediaries can reduce transactions costs include taking advantage of economies of scale, which
reduces the average cost of transactions by engaging in a high volume of transactions, and
specialization, which enhances efficiency.

9.2 The Problems of Adverse Selection and Moral Hazard (pages 257-270)
Learning Objective: Explain the problems that adverse selection and moral hazard pose for the financial
system.
Asymmetric information describes the situation in which one party to an economic transaction has better
information than does the other party. In financial transactions, the borrower typically has more
information than the lender.
A. Adverse Selection
Adverse selection is the problem investors experience in distinguishing low-risk borrowers from
high-risk borrowers before making an investment. Economist George Akerlof used the example
of the used car market to illustrate the problem. Because potential car buyers lack the information to
distinguish good cars from bad cars, or “lemons,” the market price is likely to be lower than the
value of a good car, but higher than the value of a lemon. As a result, there is a tendency for most
used cars sold to be lemons. To reduce the costs of adverse selection, car dealerships act as
intermediaries between buyers and sellers. Because investors may be unable to distinguish good
firms from lemon firms, investors are reluctant to invest in firms unless there is a great deal of
information available on them. This information problem makes it difficult for small-to-medium-
sized firms to raise external funds.

The Securities and Exchange Commission (SEC) requires publicly traded firms to disclose financial
statements as well as material information that may affect the price of a firm’s stock. Although these
regulations reduce the likelihood of adverse selection, they do not eliminate it. Some private firms,
such as Moody’s and Dunn and Bradstreet, attempt to collect information about companies to help
investors to better judge the quality of borrowers.

To reduce the problems caused by asymmetric information, lenders often require borrowers to pledge
some of their assets as collateral, which the lender can claim if the borrower defaults. Investors often
reduce the chance of adverse selection by restricting their lending to high net worth firms because
these firms have more to lose in case of default.

Financial intermediaries, particularly banks, specialize in gathering information about the default risk
of borrowers. Among the tools used are credit reports and relationship banking.

Teaching Tips
The Making the Connection, Has Securitization Increased Adverse Selection Problems in the
Financial System? on pages 263–264 explores the possible role of securitization in contributing to the
financial crisis. Students can compare the potential benefits of securitization with the possibility that it
could result in adverse selection. This comparison also helps promote discussion about one aspect of
financial reform—requiring banks to hold a portion of mortgage-backed securities that they sell.

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 Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 109

B. Moral Hazard
Moral hazard is the problem investors experience in verifying that borrowers are using their funds as
intended.
Economists refer to the possibility that managers will pursue objectives different from those of
shareholders as a principal-agent problem. The shareholders, as owners of the firm, are the
principals, while the top managers, who are hired to carry out the owners’ wishes, are the agents.
Corporate boards of directors may be able to reduce moral hazard, but not eliminate it. Incentive
contracts are used to better align the goals of top managers with the goals of shareholders. Although
options contracts can reduce moral hazard, they can at times also increase it by leading managers to
make decisions not in the best interests of shareholders.
A key way investors try to reduce moral hazard in bond markets is by writing restrictive covenants
into bond contracts. Restrictive covenants either place limits on the uses of the funds the borrower
receives or require that the borrower pay off the bond if the borrower’s net worth drops below a
certain level.

Financial intermediaries can reduce moral hazard problems:

Commercial banks specialize in monitoring borrowers and have developed effective techniques for
ensuring that the funds they loan are actually used for their intended purpose.

Venture capital firms raise funds from investors and use the funds to make investments in small
startup firms; often take large ownership stakes in small startup firms; and have employees serve on
boards of directors.

Private equity firms (or corporate restructuring firms) have helped to establish a market for
corporate control, which can reduce moral hazard problems in the financial system by providing a
means to remove top management that is failing to carry out the wishes of shareholders.

9.3 Conclusions About the Structure of the U.S. Financial System (pages 270–274)
Learning Objective: Use economic analysis to explain the structure of the U.S. financial system.
The discussion in section 9.1 and section 9.2 help explain three key features of the financial system:
1. Loans from financial intermediaries are the most important external source of funds for small-to-
medium-sized firms.
2. The stock market is a less important source of external funds to corporations than is the bond market.
3. Debt contracts usually require collateral or restrictive covenants.

Transactions costs and information costs drive a wedge between savers and borrowers, lowering the
interest rate savers receive and raising the interest rate borrowers must pay. Financial intermediaries are
continually searching for ways to earn a profit by expediting the flow of funds from savers to borrowers.

Teaching Tips
You can use the second key feature of the financial system presented on page 272 to explore how information
costs affect the sources of financing. Ask students to discuss why the bond market is a more important source
of financing for corporations than the stock market. This discussion will help them understand how investors
consider the problem of moral hazard when making investment decisions.

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110 Hubbard & O’Brien • Money, Banking, and the Financial System, Second Edition

 Solutions to the End-of-Chapter Questions, Problems, and Data

Exercises
9.1 Obstacles to Matching Savers and Borrowers
Learning objective: Analyze the obstacles to matching savers and borrowers.

Review Questions
1.1 Transactions costs are the costs of a trade or an exchange. Information costs are the costs that savers
incur in determining the creditworthiness of borrowers and to monitor how they use the funds
acquired. Savers with small amounts of money to invest rarely make loans directly to individuals or
firms because transactions costs and information costs make small transactions very expensive
relative to the return.

1.2 Financial intermediaries, such as commercial banks and mutual funds, channel funds from savers
to borrowers. Financial intermediaries are important to the financial system because they match
savers and borrowers by reducing transactions costs and information costs.

Problems and Applications

1.3 Financial intermediaries are able to take advantage of economies of scale, such as standardized legal
contracts, specialized loan officers, and sophisticated computer systems, to reduce transactions and
information costs. If everyone were perfectly honest, the differences in transactions costs between
financial intermediaries and small savers would decline, but not disappear. Evaluating loans would
be easier, but still necessary because perfectly honest people may propose business ideas that have
too low a chance of succeeding, and loans would still need to be processed. Additionally, financial
intermediaries would still have economies of scale in sophisticated computer systems such as
automated teller machine networks.

1.4 The Internet has reduced information and transactions costs. The Internet allows many financial
transactions to be conducted online, thereby reducing their costs. The Internet also makes it much
easier for investors to gather information on firms, thereby reducing information costs.

1.5 Writing bank records in ledgers would not have had significant economies of scale because bank
workers would have written in ledgers one by one and there would be little average cost reduction in
workers writing in 20 ledgers versus writing in only 10 ledgers. The computer, however,
significantly increased economies of scale in recording bank records. One computer could store
thousands of bank records nearly as easily as it could store 10, and the bank would need to purchase
the software for entering the records would only once (for a given version of the software.)

9.2 The Problems of Adverse Selection and Moral Hazard

Learning objective: Explain the problems that adverse selection and moral hazard pose for the financial
system.

Review Questions

2.1 Adverse selection is the problem investors experience in distinguishing low-risk borrowers from
high-risk borrowers before making an investment. Moral hazard is the risk that people will take
actions after they have entered into a transaction that will make the other party worse off. The
“lemons problem” refers to the adverse selection problem that arises from asymmetric information.
Because potential investors have difficulty in distinguishing good borrowers from bad

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 Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 111

borrowers, these investors offer good borrowers terms they are reluctant to accept. Because
banks specialize in gathering information, they are better able to overcome this problem.

2.2 The Securities and Exchange Commission (SEC) is a federal government agency that regulates
U.S. stock and bond markets. The SEC’s primary role is to reduce adverse selection by requiring
the disclosure of financial and accounting information from all publicly traded firms. The SEC
was founded in 1934 in an attempt to alleviate the asymmetric information problem that became
apparent following the stock market crash of 1929. The SEC has been successful in reducing the
cost of asymmetric information, but it has not eliminated it completely.

2.3 Relationship banking is the ability of banks to assess credit risks on the basis of private information
about borrowers. Banks have less risk because of the additional information they collect about the
borrower. The borrower gets a lower interest rate because he or she is a lower risk to the bank.

2.4 The principal-agent problem is an example of moral hazard and occurs when managers (agents)
follow their own self interest rather than the interest of the shareholders (principals).

2.5 Venture capital firms raise funds from investors to invest in start-up firms. Private equity firms raise
funds to acquire shares in established firms with the intention of reducing moral hazard problems.
Crowd-funding raises small amounts of investment funds for startup firms from large numbers of
people on social networking sites. So, crowd-funding plays a role that is more similar to the role
played by venture capital firms than to the role played by private equity firms.

Problems and Applications

2.6 a. Yes. Landlords know more about the quality of the property, and therefore its true value, than
renters. For example, landlords know more about how well an apartment’s heating and air
conditioning systems work, whether the apartment has problems with insects, and whether the
apartment is quiet, than will potential renters.
b. Landlords with bad apartments will attempt to charge a higher price than they otherwise would
receive in the absence of this information asymmetry, while landlords with good apartments will
have trouble renting them for their true value because potential renters will be suspicious that the
apartments have hidden defects. So, there is the possibility of the “lemons problem” of bad rental
properties driving good rental properties out of the market.
c. The rental property market and the used car market are similar in that the landlord and the current
car owner know more about the property or the car than the potential renter or buyer. However, the
landlord and car owner differ in that the landlord is not selling the apartment, merely renting it. So, if
a landlord wants the tenant to renew the lease, the landlord will be forced to maintain the property so
that its value approaches the rental rate. This incentive to maintain the property would be similar to
the car dealer offering a warranty.

2.7 The asymmetric problem in this used car example is adverse selection. It is likely that only a lemon
would be put up for sale after being driven just 2,000 miles. A buyer could deal with the problem by
having a mechanic inspect the car or by getting a warranty from the dealer (or a buyer might simply
trust the dealer’s reputation for selling reliable cars).

2.8 a. The problem is adverse selection.

b. The consequences will be that healthy people will have difficulty buying insurance at a reasonable
price because they will have trouble convincing insurance companies that they are healthy and
unlikely to file many claims to have their healthcare bills reimbursed.

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112 Hubbard & O’Brien • Money, Banking, and the Financial System, Second Edition

2.9 a. Banks would be reluctant to lend to startups for two key reasons: 1) There is substantial risk that
startups would fail, particularly during sluggish economic times, and 2) banks want to continue to
recover from the consequences of the financial crisis and recession by improving the quality of their
loans (loaning to borrowers who are likely to pay back the loans).
b. Startups might have an easier time obtaining equity investments from small investors through
crowd-funding sites than obtaining loans from banks because: 1) Small investors are not investing
large amounts of money, 2) the social networking sites reach large numbers of people, and 3) small
investors may enjoy funding innovative, new ideas even though the returns on their investments are
low.

2.10 When buying a used car, buyers should always be aware of information asymmetry. The seller
typically knows more about the car than the buyer. Sellers of financial instruments also have more
information than the buyers of financial instruments. Because of this asymmetry, buyers should be
cautious.

2.11 a. Securitization is the process of combining (bundling) loans, such as mortgages, into securities that
can be sold on financial markets.
b. When the loans are bundled together and sold off, the bank that issued the loan doesn’t bear the cost
if the borrower fails to pay back the loan. The bank that issues the loan makes its money by originating
and selling the loans on the secondary market. This process creates a moral hazard problem.
c. The investors did not know that the securities contained bad commercial real estate loans. It is
highly unlikely that these securities had high enough interest rates to compensate investors for the
additional risk because during this period the market consistently underestimated the risk involved
with mortgage-backed securities.

2.12 You should agree. Only the most financially sound firms are likely to take advantage of the offer.
As a result, the remaining firms who do not pay off their credit lines early are likely to be riskier
borrowers. So, American Express is likely to suffer adverse selection with respect to the remaining
firms using this credit line product.

2.13 Moral hazard is less likely to be a problem in scenario (b), because when a manager receives a
percentage of the firm’s profits, the manager’s objective will be closer to the shareholders’ objective
of maximizing the firm’s profits.

2.14 a. Stock options provide an incentive for the managers to make decisions that increase the stock’s
value, which is what shareholders want.
b. The exercise price is the price at which the buyer of an option has the right to buy or sell the
underlying asset. In this case, the exercise price was the price that the KB Home CEO could buy
stock. By backdating the options to an earlier date when the stock price was lower, the CEO is able
to purchase shares of the company at a cheaper price and then resell the stock at the current higher price.
c. The information problem involves the principal-agent problem, which is the moral hazard problem
of managers pursuing their own interests rather than those of shareholders.

2.15 a. Unlike crowd-funding sites, venture capital funds often take a large ownership stake in a startup firm
and frequently place their own employees on the board of directors or have them serve as managers.

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 Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 113

b. Crowd-funding sites reduce the transactions costs faced by small investors who want to make equity
investments in startups by acting as a financial intermediary. The crowd-funding sites identify
startup firms and ensure that the investors’ funds are invested in accordance with federal securities
laws. Crowd-funding sites probably somewhat reduce asymmetric information problems by
screening firms that request permission to solicit investors on their sites, but substantial asymmetric
information problems still remain. Crowd-funding sites may be subject to moral hazard problems
because they keep a percentage of the funds they raise but they do not make equity investments in firms
and so they are not exposed to the risk that the firms may fail.

9.3 Conclusions About the Structure of the U.S. Financial System

Learning objective: Use economic analysis to explain the structure of the U.S. financial system.

Review Questions
3.1 The owners’ personal funds and profits are the primary sources of funds for small- to medium-sized
firms. Loans—particularly mortgage loans—from financial intermediaries are the most important
source of external funds for small- to medium-sized firms. See Figure 9.1 on page 270 of the text.

3.2 The bond market is the most important method of debt financing for corporations. See Figure 9.2,
panel (a) on page 271 of the text.

3.3 The three key features are: 1) Loans from financial intermediaries are the most important external
source of funds for small to medium sized firms. Financial intermediaries can reduce the transaction
costs of borrowing for small firms. 2) The stock market is a less important source of external funds
to corporations than is the bond market. There is less moral hazard involved with bonds than with
stocks. 3) Debt contracts usually require collateral or restrictive covenants. The purpose of the
collateral and restrictive covenants is to reduce moral hazard.

Problems and Applications

3.4 Insurance companies don’t offer income insurance of this type for two key reasons: 1) Moral
hazard, meaning that once insured, you won’t work as hard and may actually want to be fired from
your job, and (2) adverse selection, meaning that people who are more likely to be fired or get small
raises would be more likely to buy such insurance.

3.5 Being honest would not eliminate the need for financial intermediaries. In a world of perfect
honesty, adverse selection would be reduced and moral hazard would be largely eliminated. But
adverse selection occurs not just because of dishonesty; it also occurs when one side of a transaction
unavoidably has more information than does the other side of the transaction. Also, financial
intermediaries experience economies of scale in making loans; these economies of scale would still
exist even in a world of perfect honesty.

3.6 Asymmetric information makes information costs for external funds higher than for internal funds.
Information costs do not necessarily imply that firms are able to spend less on expansion than is
economically optimal. The answer depends on the extent to which asymmetric information problems
are overcome through debt finance (loans and bonds), takeovers and threats of takeovers financed by
private equity firms, firms having high net worth, or shareholders exercising greater control of
public firms. If asymmetric information problems cannot be entirely overcome, then firms may in
fact spend less on expansion than would be economically optimal in the absence of such problems.

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114 Hubbard & O’Brien • Money, Banking, and the Financial System, Second Edition

3.7 a. Investment-grade corporate bonds are not free of default risk. These bonds had less default risk in
2012 than the bonds of some of Europe’s troubled economies, but more default risk than U.S.
Treasury securities.
b. Investors in these long-term bonds would also face interest-rate risk, where increases in interest rates
could substantially decrease the prices of the corporate bonds, causing capital losses.

3.8 The more complex the product, the more difficult it is for an investor to assess the risk of the product.
When investors buy simpler products, they typically have more information and can make more
informed choices about the products. The more complex deal is often one for which information
costs increase, which reduces the resulting return on the investment.

Data Exercise
D9.1 ScottTrade: $7. Ameritrade: $9.99 E-TRADE: $9.99. With only $200 to invest and a 5% rate of
return ($10), buying and selling the stock would cost approximately $20 in transaction fees,
compared to the gain of $10.

D9.2

a. Household net worth is the value of households’ total assets minus the value of their total liabilities.
b. During the ten recessions over the 1952 to 2012 period, household net worth typically either fell or
increased slowly just before a recession and rose after a recession. During the recession, the change
in household net worth varied across the recessions. For example:
 Household net worth declined during the 2007-2009 and 2001 recessions.
 Household net worth rose during the 1953-1954, 1957-1958, 1980, and 1981-1982 recessions.
 Household net worth declined and then rose during the 1960-1961, 1969-1970, and 1973-1975
recessions.
c. Household net worth declined by so much during the recession of 2007-2009 because of the large
decline in housing prices and the subsequent decline in stock prices. The decline in household net
worth would have decreased consumption spending, increasing the severity of the 2007-2009
recession.

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 Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the Financial System 115

D9.3

a. A nonfinancial corporation is a corporation that is not a financial firm that provides financial
services such as a commercial or investment bank. Examples of a nonfinancial corporation are
ExxonMobil and Microsoft. Corporate net worth is the value of corporations’ total assets minus the
value of their total liabilities. This amount is also called shareholders’ equity.
b. During the ten recessions over the 1952 to 2012 period, nonfinancial corporate net worth just before
a recession either fell or increased slowly in five recessions, and rose in five recessions. During
recessions, nonfinancial corporate net worth rose in six recessions, declined in one recession, and
was flat or fluctuated in three recessions. Just after the recessions, nonfinancial corporate net worth
rose in all but one recession.
c. Corporate net worth declined due to the decline in commercial real estate prices. For all but the
largest corporations, commercial real estate is a key source of collateral. The decline in net worth
and the decline in commercial real estate values combined with increased caution among lenders
made it more difficult for companies to borrow. With reduced access to credit, firms curtailed
expenditures relative to what they would have been otherwise.

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