Special Topic Two

SPECIAL TOPIC TWO
Asymmetric information
and
Regulation of Financial Markets
Compiled By Alem H(PhD)

ASYMMETRIC INFORMATION

An Overview of the Financial System
 Provides for efficient flow of funds from sav-
ing to investment by bringing savers and borrow-
ers together via financial markets and financial
institutions.
 A financial system consists of institutional units

and markets that interact, typically in a complex
manner, for the purpose of
mobilizing funds for investment and
providing facilities, including payment sys-
tems, for the financing of commercial activ-
Compiled By Alem H(PhD) 3
Components of Financial System
• Financial institutions within the system is
primarily to intermediate between those that
provide funds and those that need funds, and typ-
ically involves transforming and managing risk.
• Financial markets provide a forum within

which financial claims can be traded under es-
tablished rules of conduct and can facilitate the
management and transformation of risk.
Components of Financial System
• Financial System:
– Savers
– Users
– Financial Institutions
– Financial Markets
• Funds can be transferred between users and
savers directly or indirectly.

Flows of Funds Through the Financial System

Methods of funds transfer
1.Direct financing
2. Indirect financing

Direct Financing
• The simplest way for funds to flow.
• Borrowers borrow directly from lenders in finan-

cial markets by selling financial instruments
which are claims on the borrower’s future in-
come or assets.
• Securities are assets for the person who buys
them
• They are liabilities for the individual or firm that

issues them Compiled By Alem H(PhD)
Direct Financing
• DSU and SSU find each other and bargain
• SSU transfers funds directly to DSU
• DSU issues claim directly to SSU
• Preferences of both must match as to-
-Amount
-Maturity
-Risk
-Liquidity

Direct Financing
• Efficient for large transactions if prefer-
ences match.
• DSUs and SSUs “seize the day”—

 DSUs fund desired projects immedi-
ately.
 SSUs earn timely returns on savings.
• Direct markets are “wholesale” markets.
 Institutional arrangements common.
Institutional arrangements common in direct finance.
• Private placements.
• Investment bankers
• Brokers and dealers bring buyers and sellers of

direct claims together.

Brokers and dealers
Brokers and dealers bring buyers and sellers of
direct claims together.
Brokers buy or sell at best possible price for

their clients.
Dealers “make markets” by carrying inventories

of securities.
– buy at “bid price;” sell at “ask price”

– “Bid-ask spread” is dealer’s gross profit

Direct Financing
Advantages Disadvantages
 Avoids costs of intermedia-  Assessment of risk, es-
tion pecially default risk
 Matching of preferences
 Increases range of securi-  Liquidity and mar-
ties and markets ketability of a security
 Search and transaction
costs

Indirect Finance

Indirect Finance
Instead of savers lending/investing directly with
borrowers, a financial intermediary (such as a
bank) plays as the middleman:
 the intermediary obtains funds from savers
 the intermediary then makes loans/investments

with borrowers

Indirect Financing
(“Financial Intermediation”):
• Financial intermediaries “transform”
claims:
– raise funds by issuing claims to SSUs;
– use funds to buy claims issued by
DSUs.
• Claims can have unmatched characteristics:
– SSU has claim against intermediary;

Indirect Finance
 Needed because of
 transactions costs,
 risk sharing, and
 asymmetric information

Transaction costs
1. Financial intermediaries make profits
by reducing transactions costs
2. Reduce transactions costs by develop-
ing expertise and taking advantage of
economies of scale
3. Provide liquidity services

Risk sharing:
• Risk sharing : Asset Transformation& Diversifi-
cation
• FI’s low transaction costs allow them to reduce
the exposure of investors to risk, through a
process known as risk sharing
– FIs create and sell assets with lesser risk to one
party in order to buy assets with greater risk

from another party
Risk sharing:
– Asset transformation is, for example, when a
bank takes your savings deposits and uses the
funds to make, say, a mortgage loan. Banks
tend to “borrow short and lend long” (in terms
of maturity).
– This process is referred to as asset transfor-

mation, because in a sense risky assets are
turned into safer assets for investors
Risk sharing: Diversification
 Financial intermediaries also help by providing
the means for individuals and businesses to di-
versify their asset holdings.
 Low transaction costs allow them to buy a

range of assets, pool them, and then sell rights
to the diversified pool to individuals.

Asymmetric Information
3. Two types of asymmetric information
a. Adverse Selection
• Asymmetric Information before transaction occurs
• Potential borrowers most likely to produce adverse out-
comes are ones most likely to seek loans and be selected
Copyright  2011 Pearson

2 - 22
Canada Inc.
Asymmetric Information II
b. Moral Hazard
• Asymmetric information after transaction occurs
• Hazard that borrower has incentives to engage in un-
desirable activities making it more likely that loan
won’t be paid back
• E.g. Borrowed funds are used for another purpose.
Copyright  2011 Pearson

2 - 23
Canada Inc.
Asymmetric Information
Asymmetric Information in Finan-
cial Markets
Introduction and Applications

Ricardo N. Bebczuk(2003)
Asymmetric information problems in financial
markets
A debt contract establishes the legal rights and
obligations for those who receive financing
(borrowers) and those who provide it
(lenders).
In the first place, the intrinsic uncertainty sur-

rounding any investment project puts the bor-
rower’s ability to repay in question.
markets
 As significant as it may seem, this obstacle can be rea-
sonably overcome by estimating the probability of full
reimbursement and consequently adjusting the interest
rate.
 The second hindrance, the borrower’s fragile promise

loyally to obey the contract, can be more difficult to
surmount.
 An experienced observer will note that a borrower can

attempt to disguise the true nature of a project or, once
in possession of borrowed funds, divert them to other
uses or conceal the true outcome of his investment.
markets
These issues are known as asymmetric informa-
tion problems. Conflicts of interests will arise if
these factors hamper the lender’s profitability.
The origin of these obstacles and their effects on

financial markets are the issues that we will study
in this chapter.
Economic characteristics of financial contracts
• In order to understand the implications of asymmetric in-

formation on financial markets we first need to explore
the fundamental relationship between borrower and
lender.
• A financial contract will be written only if the expected

profit of the lender and the borrower is equal to or higher
than the next best alternative project.
• This is the so called participation constraint or indi-

vidual rationality constraint: no rational individual
will take part in an investment either with negative ex-
pected return, or with a profit that does not reach a min-
imum required level of expected return, determined by
the investment opportunity that is forgone for this par-
ticular business.
• This minimum floor is known as the opportunity cost

or required return.
• Let us look at an example using the notation we will em-
ploy throughout our discussion. We will suppose there is
only one productive project, with initial investment I =
$100.
• One year later it offers two possible cash flows: if suc-
cessful, CFs , = $300; if it fails, CF f = $0. The proba-
bility of success αs, is 0.7 and the probability of failure
α f = (1 − αs) is 0.3. The expected value EV of the
project is:
EV = αs CFs + α f CF f
= 0.7 × $300 + 0.3 × $0
= $210
• Does this project satisfy the conditions for the writing
of a financial contract?
• To answer this question, we need more information.
• First, let us assume that the initial investment is $100

and the required return r is 10 per cent.
• This indicates that a lender who finances the project
through a $100 loan, L, could obtain a 10 per cent re-
turn by investing his money in, for example, govern-
ment bonds or simply making a bank deposit.
• He will not lend money at less than 10 per cent; nor will
the lender be able to charge a higher interest rate, since
borrowers will arrange loans with other banks charging
• The project involves a risk for the bank because, if it
fails, the entrepreneur cannot repay the debt and goes
bankrupt, transferring CF f to the bank.
• However, the borrower is not forced to use personal as-

sets to pay for the capital and interest owed. This feature
of the contract is known as limited liability.
• Under the simple case in which CF f = 0, the loan’s interest rate

allows the bank to achieve its opportunity cost (1 + r)L
(
1
r
)L
(
1
sr
)
L
LCF
f f  
(
1
r)
L(
s1
r
L)
L 
(
1 r)
(
1 r )
s
L
• In the previous example, the resulting rate is:

• rL = (1 + 0.1) -1=1.1
0.7 0.7
• rL = 0.57 = 57 per cent
• Whenever CF f < (1 + r)L, the loan’s interest rate will
be greater than the bank’s required rate of return, rL >
r.
Given that the bank will participate in the project, let us
see if the borrower is satisfied with the contract.
• Assuming the borrower does not use personal re-
sources for funding, the project will be attractive as far
as it yields any positive return.
• The borrower’s expected profit Eπ is:
• Eπ = αs [CFs − (1 + rL )L]
=0.7*[$300-(1+0.57)*$100]
=$100
• As the project satisfies the economic demands of both
parties, we can then conclude that the project will go
forward.
• It is evident that both the borrower and the lender expect

(as opposed to obtain with certainty) a profit, because
financial contracts are claims on uncertain future rev-
enues.
• The project’s actual value will be either $300 or $0, and

not the expected value of $210.
• Uncertainty, however, means that probabilities
need to be assigned a priori to every possible re-
sult, and both lender and borrower rely on such
probabilities at the time of deciding to enter the
contract.
• Accordingly, even though it may look counterin-
tuitive, they do not care about the effective out-
come but only the expected one.
• Here we examine a case where borrowers and
lenders do not have access to the same informa-
tion.
• There is asymmetric information in a financial

contract when the borrower has information that
the lender ignores or does not have access to.
• Although we will be more detailed later on, for

the moment we want to identify the crucial fac-
tors surrounding the problem of asymmetric in-
• This asymmetry concerns the lender whenever the bor-
rower can use this information profitably at the lender’s
expense, and is connected with the following circum-
stances:
(i) The borrower violates the contract by hiding informa-
tion about the characteristics and the revenues of the
project
(ii) The lender does not have sufficient information or
control over the borrower to avoid cheating
(iii) There is debt repayment risk and the borrower has
limited liability.
• We can illustrate the problem with the prior example,
presuming that
(i) the borrower knows the true probability of success
to be 70 per cent, but reports 90 per cent to the lender;
(ii) the lender has no way to verify what the borrower
maintains;
(iii) as before, if the project fails, the loan is not paid.
Based on this information, the lender charges an interest
rate
• rL = 22.2 per cent (1.1/0.9 = 1.222), so that the bor-
rower’s expected benefit rises:
Eπ = 0.7 × [$300 − 1.222 × $100] = $124.5 > $100.0
• Eπ = 0.7 × [$300 − 1.222 × $100] = $124.5 > $100.0
• and the lender’s expected income falls:

• E ILender = 0.7 × (1.222 × $100) = $85.5 < $110
• It follows that if the borrower had not misrepresented
the information, none of the above would have hap-
pened.
• The importance of repayment risk becomes clearer with

a counterexample.
• We will suppose that the announced probability of suc-
cess is again lower than the real one, but in the worst
scenario the cash flow is CF f = $110.
• In that case, the lender can recover principal and inter-

est in any event, regardless of whether the borrower
states the probability of success as 70 per cent or 90 per
• In other words, if the debt is safe, asymmetric informa-
tion is irrelevant, since the borrower is unable to rely on
her limited liability.
• Important lessons can be learned by looking at the prob-
lem more formally.
• Let us rewrite the borrower’s expected profit and the
expected income of the lender:
Eπ = αs [CFs − (1 + rL )L]
= αs CFs − αs (1 + rL )L
=EV − αs (1 + rL )L
 The bank’s expected income E ILender is given by:
E ILender = αs (1 + rL )L
• The formulas reveal the potential conflict of interests
that lie between borrower and lender.
• First note that Eπ + E ILender = EV: The contract estab-

lishes how the cash flows of the project are distributed
between the two parties.
• If the borrower can conceal the true risk of the project

and deliberately overestimate the probability of success,
then α's > αs(in our example, 0.9 > 0.7), the borrower
will retain a larger part of the expected value.
• The expected value is:
E    s [ CF S  (1  rL ) L ]
1  rL
  s [ CF S ( )L]
 'S
S
  s CF S  (1  r ) L
 'S
S
 EV  (1  r ) L
 'S
• where we use the lender’s income statement introduced
earlier to define rL (note that the bank determines the in-
terest rate based on the declared probability of success,
α‘s. ).
• The ratio αs/ α's is a good measure of the level of
asymmetric information.
• The lower this ratio, the larger the benefit of the bor-
rower at the expense of the lender.
• It can be easily seen that, under symmetric information,
the announced probability of success coincides with the
real one and the expected profit becomes:
Eπ =EV − (1 + r )L
• The borrower appropriates the expected value of the
project, net of the lender’s required return. Because this
profit is smaller than under cheating, there is a clear in-
centive to exploit the information advantage.
• Table 1.1 Project properties
Before disbursement After disbursement
Pre-determined project Adverse selection Monitoring costs
Choosing between Moral hazard

projects
REGULATION OF FINANCIAL MARKETS

Regulation of Financial Markets
 Main Reasons for Regulation
1.Increase Information to Investors
• Decreases adverse selection and moral hazard
problems
2.Ensuring the Soundness of Financial Intermedi-
aries
• Prevents financial panics
• Chartering, reporting requirements, restrictions
on assets and activities, deposit insurance, and
anti-competitive measures
3.Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics
Regulation Reason: Increase Investor Informa-
tion
• Asymmetric information in financial markets

means that investors may be subject to ad-
verse selection and moral hazard problems
that may hinder the efficient operation of fi-
nancial markets and may also keep investors
away from financial markets
• Regulation takes care of this aspect

Regulation Reason:
Increase Investor Information
• Such government regulation can reduce
– adverse selection and
– moral hazard problems in financial markets and
increase their efficiency by increasing the amount
of information available to investors.

Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)
 To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
─ Restrictions on Entry
─ Disclosure
─ Restrictions on Assets and Activities
─ Deposit Insurance
─ Limits on Competition
─ Restrictions on Interest Rates

Regulation: Restriction on Entry
 Restrictions on Entry
─ Regulators have created very tight regulations as to who is
allowed to set up a financial intermediary
─ Individuals or groups that want to establish a

financial intermediary, such as a bank or an insurance com-
pany, must obtain a charter from the state or the federal gov-
ernment
─ Only if they are upstanding citizens with impeccable creden-

tials and a large amount of initial funds will they be given a
charter.

Regulation: Disclosure
 Disclosure Requirements
 There are stringent reporting requirements for

financial intermediaries
─Their bookkeeping must follow certain strict
principles,
─Their books are subject to periodic inspec-
tion,
─They must make certain information avail-
able to the public.

Regulation: Restriction on Assets and Activi-
ties
 Restrictions on the activities and assets of inter-
mediaries helps to ensure depositors that their
funds are safe and that the bank or other financial
intermediary will be able to meet its obligations.
– Intermediary are restricted from certain risky
activities
– And from holding certain risky assets, or at
least from holding a greater quantity of these
risky assets than is prudent
Regulation: Restrictions on Interest Rates
 Competition has also been inhibited by regula-
tions that impose restrictions on interest rates that
can be paid on deposits
 These regulations were instituted because of the
widespread belief that unrestricted interest-rate
competition helped encourage bank failures dur-
ing the Great Depression
 Later evidence does not seem to support this
view, and restrictions on interest rates have
been abolished

Regulation Reason:
Improve Monetary Control
 Because banks play a very important role in determining the supply
of money (which in turn affects many aspects of the economy),
much regulation of these financial intermediaries is intended to im-
prove control over the money supply
 One such regulation is reserve requirements, which make it oblig-
atory for all depository institutions to keep a certain fraction of their
deposits in accounts with the Federal Reserve System (the Fed), the
central bank in the United States
 Reserve requirements help the Fed exercise more precise control
over the money supply

Special Topic Two

Uploaded by

Copyright:

Available Formats

You might also like

Special Topic Two

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Special Topic Two

Uploaded by

Copyright:

Available Formats

SPECIAL TOPIC TWO

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

 A financial system consists of institutional units

• Financial markets provide a forum within

Compiled By Alem H(PhD) 5

Compiled By Alem H(PhD) 6

Compiled By Alem H(PhD)

• Borrowers borrow directly from lenders in finan-

• They are liabilities for the individual or firm that

Compiled By Alem H(PhD)

• DSUs and SSUs “seize the day”—

• Brokers and dealers bring buyers and sellers of

Compiled By Alem H(PhD)

Brokers buy or sell at best possible price for

Dealers “make markets” by carrying inventories

– buy at “bid price;” sell at “ask price”

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

 the intermediary then makes loans/investments

Compiled By Alem H(PhD)

• Claims can have unmatched characteristics:

– SSU has claim against intermediary;

 risk sharing, and

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

party in order to buy assets with greater risk

– This process is referred to as asset transfor-

 Low transaction costs allow them to buy a

Compiled By Alem H(PhD)

Copyright  2011 Pearson

Copyright  2011 Pearson

Introduction and Applications

In the first place, the intrinsic uncertainty sur-

 The second hindrance, the borrower’s fragile promise

 An experienced observer will note that a borrower can

The origin of these obstacles and their effects on

• In order to understand the implications of asymmetric in-

• A financial contract will be written only if the expected

• This is the so called participation constraint or indi-

• This minimum floor is known as the opportunity cost

• First, let us assume that the initial investment is $100

• However, the borrower is not forced to use personal as-

• Under the simple case in which CF f = 0, the loan’s interest rate

• In the previous example, the resulting rate is:

• It is evident that both the borrower and the lender expect

• The project’s actual value will be either $300 or $0, and

• There is asymmetric information in a financial

• Although we will be more detailed later on, for

• and the lender’s expected income falls:

• The importance of repayment risk becomes clearer with

• In that case, the lender can recover principal and inter-

• First note that Eπ + E ILender = EV: The contract estab-

• If the borrower can conceal the true risk of the project

• Table 1.1 Project properties

Before disbursement After disbursement

Pre-determined project Adverse selection Monitoring costs

Choosing between Moral hazard