Asymmetric Information Flashcards
What is asymmetric information?
Asymmetric information refers to when one party in a transaction possesses more information than the other.
What is an agency problem?
Conflict of interest between principal and agent in a relationship or contract.
What are two conditions under which an agency problem might arise?
- Agent has private information about herself that the principal cannot observe.
- The principal and the agent have different objectives.
Which two potential agency problems might arise?
Adverse selection
Moral hazard
What is adverse selection?
Since the principal cannot distinguish between good or bad, he requires average rates. Therefore, that is a good deal for bad agents and a bad deal for good agents. Thus, only bad agents remain. (This happens ex-ante)
What is moral hazard?
A situation where an agent has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. (Happens ex-post)
How did adverse selection occur at the Northern Rock bank?
the Northern Rock bank got in trouble in the mortgage crisis, therefore they had to be rescued with a loan of the Bank of England.
To pay back this loan, they started the Mortgage Redemption Program to allow borrowers to pay off any outstanding balance.
There is adverse selection in this program, because only the bad borrowers who cannot get a better loan elsewhere will stay at the bank.
How did moral hazard occur at Bear Stearns?
Bear Stearns is a US Investment Bank that was heavily involved in CDO trading during the mortgage crisis. They were acquired by the NYFed through JPMorgan Chase to avoid a system-wide crisis with other over-leveraged banks. Since the bank will get rescued if they fail, they have an incentive to increase risk taking. (Too big to fail)
Describe how adverse selection and moral hazard fit in the relationship between interest rates and credit defaults.
High risk borrowers will be more likely to accept higher interest rates (adverse selection).
Higher interest rates lead to more defaults (moral hazard).
To empirically test the adverse selection and moral hazard separately at the South African bank, how should we approach this?
Assign different interest rates before and after signing the contract.
In the South African Bank test, the error term includes credit risk and behavior of the borrowers. How will this affect the coefficient we are looking for and how can we solve this?
Credit risk and behavior are correlated with the coefficient we are trying to estimate and therefore the coefficient will be upward biased. We can solve this by assigning interest rates randomly.
What are three types of data we can use for empirical testing?
Observational data
Field experiment
Lab experiment
What is an advantage and a disadvantage of a field experiment?
A field experiment gives a causal relationship.
However, it raises doubts about external validity (sample group)
What is a solution for moral hazard in auditing?
Mandated rotation (Sarbanes-Oxley act)
How does mandated rotation influence an agent in communicating bad news?
Mandated rotation reduces the incentives of an agent to hide bad news because it will have a negative effect on the agent if its successor finds the hidden news.
