2 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 saving to
investment by bringing savers and borrowers
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 systems,
for the financing of commercial activity.
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
typically involves transforming and managing risk.
• Financial markets provide a forum or system

within which financial claims can be traded under
established 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
financial markets by selling financial instruments
which are claims on the borrower’s future income
or assets.
• Securities are assets for the person who buys them
and they are liabilities for the individual or firm
that issues them

Direct Financing
• Deficit Spending Unit(DSU) and Surplus Spending
Unit (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 preferences
match.
• DSUs and SSUs “seize the day”—

✓ DSUs fund desired projects immediately.
✓ 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 bring buyers and sellers of direct claims
together.
❑Brokers buy or sell at best possible price for their
clients. They are an agent or an intermediary
❑A dealer is an individual who is willing to buy and
sell securities on his own behalf with his money.
✓They are independent and take their own decisions.
❑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 ➢ Assessment of risk,
intermediation especially default risk
➢ Matching of preferences
➢ Increases range of ➢ Liquidity and marketability of a
securities and markets 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;
–Intermediary has claim against DSU.

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

1. Transaction costs and Liquidity
i. Financial intermediaries make profits by
reducing transactions costs
ii. Reduce transactions costs by developing
expertise and taking advantage of economies
of scale
iii. Provide liquidity services

2. Risk sharing:
• Risk sharing : Asset Transformation& Diversification
• 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
transformation, 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
diversify 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.

3.Asymmetric Information
✓Asymmetric information is, just as the term
suggests, unequal, disproportionate, or lopsided
information.
✓It is typically used in reference to some type of
business deal or financial arrangement where one
party possesses more, or more detailed,
information than the other.
Copyright © 2011 Pearson

2 - 22
Canada Inc.
3.Asymmetric Information
Two types of asymmetric information
a. Adverse Selection
• Asymmetric Information before transaction occurs
✓ Potential borrowers most likely to produce adverse outcomes are
ones most likely to seek loans and be selected.
b. Moral Hazard
• Asymmetric information after transaction occurs
• Hazard that borrower has incentives to engage in
undesirable 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
Financial 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

surrounding any investment project puts the
borrower’s ability to repay in question.
markets
❑As significant as it may seem, this obstacle can be
reasonably 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
information 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

information 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

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

required return.
• Let us look at an example using the notation we will
employ 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 successful,
CFs , = $300; if it fails, CF f = $0. The probability 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 return by
investing his money in, for example, government 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 10 per cent.
• 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 assets 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 =  s (1 + rL ) L +  f CF f
(1 + r ) L =  s (1 + rL ) L
(1 + r )
= (1 + rL )
s
• 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 resources
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 revenues.
• 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
result, and both lender and borrower rely on such
probabilities at the time of deciding to enter the
contract.
• Accordingly, even though it may look
counterintuitive, they do not care about the
effective outcome but only the expected one.
• Here we examine a case where borrowers and
lenders do not have access to the same
information.
• 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 factors surrounding the
problem of asymmetric information.
• This asymmetry concerns the lender whenever the
borrower can use this information profitably at the
lender’s expense, and is connected with the following
circumstances:
(i) The borrower violates the contract by hiding
information 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 borrower’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 happened.
• The importance of repayment risk becomes clearer with a

counterexample.
• We will suppose that the announced probability of success
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 interest in

any event, regardless of whether the borrower states the
probability of success as 70 per cent or 90 per cent.
• In other words, if the debt is safe, asymmetric information is
irrelevant, since the borrower is unable to rely on her limited
liability.
• Important lessons can be learned by looking at the problem 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 establishes

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 [CFS − (1 + rL ) L ]
1 + rL
=  s [CFS − ( ) L]
 'S
S
=  s CFS − (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
interest 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 borrower 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 incentive 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
Intermediaries
• 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
Information
• Asymmetric information in financial markets

means that investors may be subject to adverse
selection and moral hazard problems that may
hinder the efficient operation of financial
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
company, must obtain a charter from the state or the federal
government
─ Only if they are upstanding citizens with impeccable

credentials 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
inspection,
─They must make certain information available
to the public.
Regulation: Restriction on Assets and
Activities
▪ Restrictions on the activities and assets of intermediaries
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 regulations
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 during
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 improve
control over the money supply
▪ One such regulation is reserve requirements, which make it
obligatory 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

2 Special Topic Two

Uploaded by

Copyright:

Available Formats

2 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

2 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 and

• Financial markets provide a forum or system

Compiled By Alem H(PhD) 5

Compiled By Alem H(PhD) 6

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

• DSUs and SSUs “seize the day”—

• Brokers and dealers bring buyers and sellers of direct

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:

Compiled By Alem H(PhD)

▪ risk sharing, and

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

▪ Low transaction costs allow them to buy a range of

Compiled By Alem H(PhD)

Copyright © 2011 Pearson

Introduction and Applications

❑In the first place, the intrinsic uncertainty

❑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

• A financial contract will be written only if the expected

• This is the so called participation constraint or

• This minimum floor is known as the opportunity cost or

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

• However, the borrower is not forced to use personal assets to

• 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

• There is asymmetric information in a financial

• Although we will be more detailed later on, for the moment

• and the lender’s expected income falls:

• The importance of repayment risk becomes clearer with a

• In that case, the lender can recover principal and interest in

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

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

• Table 1.1 Project properties

Pre-determined project Adverse selection Monitoring costs

Choosing between Moral hazard

Compiled By Alem H(PhD)

• Asymmetric information in financial markets

Compiled By Alem H(PhD)

– moral hazard problems in financial markets and

Compiled By Alem H(PhD)

Compiled By Alem H(PhD)

─ Individuals or groups that want to establish a

─ Only if they are upstanding citizens with impeccable

Compiled By Alem H(PhD)

▪ There are stringent reporting requirements for