Adverse selection

Question 1

Search goods

Answer 1

the quality of a good is known
beforehand.
• Examples: Flour, Petrol, a Big Mac, etc.
• The only problem for the consumer is
searching for the cheapest price, or the best
price/quality tradeoff

Question 2

Experience goods

Answer 2

the quality of a product only
becomes apparent some time after the purchase.
• Think of a restaurant meal (although you could
refuse to pay if it’s really bad), or a used car.
• So, it may be difficult to know the quality
beforehand, but sometime after the purchase it
becomes apparent what the quality was.
• So, in principle it is possible to write a contract on
the actual quality realization or ”Not satisfied,
money back” policies, etc

Question 3

Credence goods

Answer 3

difficult to determine quality

even after the fact.

Question 4

Example of credence good

Answer 4

Buying a stock is an example of a credence good:
difficult to tell if management did badly, or was just
dealing with difficult market circumstances, or took
some risky investment that didn’t pay off

Question 5

Pooling equilibrium is not a problem as long as

Answer 5

demand and supply is fixed,
Suppose buyers know the average quality of all
sellers, but not the quality of any particular seller.
• Then buyers are willing the pay for the average
quality of the pool, and all transactions happen at
a single pooling price.
• So low quality sellers benefit (get a higher price
than under symmetric information), and high
quality sellers lose out (get a lower price than
under symmetric information)

Question 6

When does pooling eq becomes a problem

Answer 6

• The real problem starts when seller can choose

whether to enter the market or not

Question 7

Adverse Selection

Answer 7

General Assumptions:
• products are of variable quality: ‘lemons’ or ‘peaches’;
• individual quality is only known to sellers;
• buyers only know average quality.
The consequence:
• ‘good’ and ‘bad’ products fetch the same ‘pool’ price;
• forcing high cost/high quality goods out.

Question 8

Akerlof shows that it is possible for a downward

spiral in price and quality to drive

Answer 8

the market out
of existence.
• i.e., there is no buyer willing to pay the
asking price for the average car on the
market.

Question 9

Fin services

Answer 9

• Fund Management: Mutual funds, Hedge
Funds, Pension Funds etc.
• Financial advice/agencies: from corporate
finance to insurance brokers
• Market making & broking transactions

Question 10

The retail financial services industry is similar

to

Answer 10

retail banking in that it deals with small
retail customers.
• But it is very different in other respects.
• This industry largely manages funds on behalf
of (or advises) clients who retain full
ownership and legal title.

Question 11

Main problem with retail investment services is

Answer 11

asymmetric information and consequent
adverse selection.
• Lack of expertise on part of buyers means they find
it hard to assess quality.
• Poor quality of asset management can be reflected
in:
• lack of necessary skills, investments
• lack of effort
• negligence
• incompetence
• dishonesty
• either separately or in combination.

Question 12

Minimum standards

Answer 12

• This raises the average performance and hence the price
clients are willing to pay, keeping the high quality managers
in the market

Question 13

Implications with minimum standards

Answer 13

1. Efficiency.
   • We establish a market but there is still market
   breakdown in the important sense that this is not a
   Pareto optimal situation
   • Compare this with the full information situation.
   • Most obvious, the low quality suppliers (and
   customers that like low quality product) are
   forced out of the market.
   • Arguably much better to have an exam (like the
   ‘knowledge’ test for taxi drivers) and then let a
   two-tier market develop.
2. Competition
   • These rules are clearly anticompetitive: by
   excluding suppliers they reduce the total supply
   and drive up the price.
   • In the example of the previous section with the
   minimum standard set at c=1, this is enough
   to cause a sellers market to emerge, with
   positive profits.
   • Minimum standards often raise entry costs,
   and so make markets less contestable.
   • Reasonable minimum standards vs curtailing
   market power is an important trade-off for
   regulators

Question 14

Who sets the min standards

Answer 14

The government or the industry itself

Question 15

the US the financial sector practiced complete self-regulation up to

Answer 15

the Securities and Exchange Act of

1934

Question 16

In the Netherlands the financial sector was only

formally regulated with the

Answer 16

Wet toezicht kredietwezen

(Wtk) in 1952

Question 17

Self regulation of min standards

Answer 17

• The industry forms a self-policing group with
barriers to membership based on some measure of
quality.
• e.g., have to pass to bar exam if you wish to be a
lawyer.
• The industry group then self-organizes mutual
monitoring and audit.
• These groups can become government sanctioned (the Financial Accounting Standards Board (FASB),
a group funded by industry that sets accounting
standards (Generally Accepted Accounting Principles,
GAAP) which are enforced by the SEC.)

Question 18

The risk with self-regulating

Answer 18

risk of too tight standards in
order to discourage competition.
• The problem with industry self-regulation is that
any time industry people get together the result is
usually collusion and anti-competitive agreements.

Question 19

what is the problem with government agency setting the minimum standards

Answer 19

government may have less expertise
to set the right standard, monitor behavior,
etc

Question 20

Legal system

Answer 20

At a minimum there is always criminal
law for deterring fraud and other forms of theft.
• But high standard of proof and the technical
nature of financial crime makes prosecution rate
low.

Question 21

Regulatory capture

Answer 21

Regulators
start seeing it as their job to protect the industry
from the public, rather than the public from the
industry.
• Civil servants working at regulator came from
industry.
• …See it as their job to ’help’ the industry rather
than police them.
• …Are looking for future jobs in industry.
• (although also some evidence that tough but
effective regulators nevertheless are highly
sought after by private industry)

Question 22

Another way of dealing with asymmetric info is

Answer 22

Reputation
• If customers know from your track record that
you are high quality, you don’t have to settle
for a pooling price.
• However in finance often the track record is too short
and too little informative (although naïve investors
will extrapolate too much anyway).
• In general it’s hard to establish reputation in
the case of a credence good

Question 23

Signaling

Answer 23

Suppliers undertake associated activity, which signals
high quality and is uneconomic for low quality suppliers to
provide.
• EXAMPLE: 3 year car warranty
• Signaling theory generally useful in finance.
• EXAMPLE: high dividend signals quality
management since poor managers can’t sustain
this.
• Debt signalling: signaling that you have high
expected future cash flow by taking on more debt.

• But not very useful in retail investment services, because any costly signal will come at the cost of returns

Question 24

Certification

Answer 24

• Similarly, good suppliers ask an agency to certify
their status (e.g. ”APK keuring”) Example: Moody’s AAA bond rating.
• In principle credit rating agencies should be able to
distinguish good and bad risks, but they failed to do
that in the case of the sub-prime mortgage bonds that
lead to the financial crisis.
• Also: can have perverse incentives. (e.g. the rating
agencies were paid by their clients, tried to
increase sales by putting out lenient ratings).

Question 25

Mutual funds

Answer 25

An investment vehicle that is made up of a pool
of funds collected from many investors for the
purpose of investing in securities such as
stocks, bonds, money market instruments and
similar assets. Mutual funds are operated by
money managers, who invest the fund’s capital
and attempt to produce capital gains and
income for the fund’s investors.

Question 26

Advantages of Mutual funds

Answer 26

• Allows retail investors to delegate investment
through simply buying shares in a fund
• Makes it possible to diversify a portfolio, which is
otherwise very difficult for a small individual
investor

Question 27

Mutual fund shares are bought and sold on the basis of its

Answer 27

Net Asset Value (NAV), this is
determined each day at the closing value of the
securities in the fund.

Question 28

Funds are typically marketed by

Answer 28

a Sponsor (e.g.
Vanguard), which sets it up as a legal entity,
organises the board of directors etc.

Question 29

The fund managers are then hired as

Answer 29

an external

entity. (and can actually be replaced)

Question 30

Regulation of Mutual funds, 4 pillars of similarity of the US and EU

Answer 30

• Transparency: The holdings of mutual funds are
publicly available (with some delays in reporting),
which ensures that investors are getting what they
pay for.
• Liquidity: Shares of mutual funds are redeemed
by the fund company on the trade date, which
assures daily liquidity for investors.
• Audited Track Records: Funds must maintain their
performance track records and have them audited for
accuracy, which ensures that investors can trust the
fund’s stated returns.
• Safety: If a mutual fund company goes out of
business, fund shareholders receive an amount of
cash that equals their portion of ownership in the
fund. Alternatively, the fund’s Board of Directors
might elect a new investment advisor to manage the
funds.

Question 31

The SEC prohibits a mutual fund from engaging in the

following activities unless

Answer 31

it meets strict financial and
disclosure requirements:
• Selling securities short
• Buying securities on margin
• Participating in joint investment or trading
accounts
• Distributing its own securities, except through a
sponsor

Question 32

Hedge funds

Answer 32

• Minimum inlay is very high (usual around $1
million)
• There is a maximum number of participants
• Are relatively illiquid: often impossible to withdraw
the first year
• Basically not regulated (although now have to
register with the SEC/AFM)
• Are free to invest in different financial instruments
(e.g. real estate, private companies, complicated
derivatives, etc.)
• Are free to choose any strategy they want (e.g. can
short the market, etc.

Question 33

Since hedge fund investors are considered

Answer 33

highly
knowledgeable, investor protection deemed
unnecessary.
• Result: Pooling equilibrium, (almost) all funds follow
2/20 fee rule:
• 2% of assets under management
• 20% of return

Question 34

Adverse selection solutions

Answer 34

1. Minimum standards
2. Reputation
3. Signaling
4. Certification

Question 35

Model from the supply side POV

Answer 35

x = fund's manager ability to beat the market in % above average return
c= annual cost as % of AUM
a = efficiency parameter a = x/c > 1
p= price of fund management as % of AUM

Assume a = 3/2 => x=(3/2)c

c is the supply side reservation price ps (the p at which a fund manager is willing to enter market) => p> ps = c

retail clients have ability and cost of 0 x=c=0

suppose there is a full info and customers know the quality (x) of the manager - > the reservation price will be pd= x=a*c=(3/2)c

the market viability condition is 𝑝𝑑 ≥ 𝑝 ≥ 𝑝s => (3/2)𝑐 ≥ 𝑝 ≥ c

Question 36

Under full information what two situations are possible

Answer 36

Case (a): A ‘buyers’ market emerges because demand is not
sufficient to exhaust the capacity of the industry. A lot of
fund managers remain unemployed. Seller competition then
drives each provider’s charges down to cost: 𝑝 = 𝑝𝑠 = 𝑐.
Case (b): A ‘sellers’ market emerges because demand
exceeds capacity. Buyer competition drives charges up to
𝑝 = 𝑝𝑑 = (3/2)𝑐.

Question 37

Assume there is no correlation between an

individual’ fund’s past and future performance

Answer 37

However, the law of averages makes it possible to assess
the performance of the whole industry from historical
data.

In this case, providers know their own quality but as a
client you can only form an estimate of quality based
on the historical market average: 𝑥̅. Thus:
p < client’s reservation price: 𝑝𝑑 = 𝑥̅ = (3/2)𝑐̅ (av cost)

If c is uniformly distributed on [0,2] the average cost is 1

Worst manager has a cost of c = 0 and x=0
Best manager has a cost of cmax = 2 and x = (3/2)*2 = 3

The WTP will be p = 1.5*1 = 1.5

But since this is smaller than cmax= 2, best quality leaves the market

Then this AS applies to any marginal manager, and we use cmax and psmax to represent the marginal values so:

𝑥̅= (3/2) 𝑐̅= (3/2)(cmax/2) = (3/4)cmax. So:
p < client’s reservation price: pd = 𝑥̅= (3/4)cmax.

This market cannot exist: the famous
adverse selection death spiral

Question 38

Clients POV

Answer 38

• You know that this acts as a cutoff: the best
manager will have costs of p and will outperform
by x = (3/2)p.
• But average outperformance is half as great:
• 𝑥𝑥̅= (3/2)(1/2)p = (3/4)p.
• You will not pay p in order to beat the market by
only (3/4)p.
• So, you DIY, and the market disappears

Question 39

Adding minimum standards to the model

Answer 39

setting a min standard which effectively
prevents any fund managers with quality x 2

Because this price is larger than 2, the reservation
price of the best fund manager, they are happy to
stay in the market