Asymmetric Information

Question 1

What is asymmetric information?

Answer 1

Asymmetric information refers to when one party in a transaction possesses more information than the other.

Question 2

What is an agency problem?

Answer 2

Conflict of interest between principal and agent in a relationship or contract.

Question 3

What are two conditions under which an agency problem might arise?

Answer 3

1. Agent has private information about herself that the principal cannot observe.
2. The principal and the agent have different objectives.

Question 4

Which two potential agency problems might arise?

Answer 4

Adverse selection
Moral hazard

Question 5

What is adverse selection?

Answer 5

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)

Question 6

What is moral hazard?

Answer 6

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)

Question 7

How did adverse selection occur at the Northern Rock bank?

Answer 7

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.

Question 8

How did moral hazard occur at Bear Stearns?

Answer 8

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)

Question 9

Describe how adverse selection and moral hazard fit in the relationship between interest rates and credit defaults.

Answer 9

High risk borrowers will be more likely to accept higher interest rates (adverse selection).
Higher interest rates lead to more defaults (moral hazard).

Question 10

To empirically test the adverse selection and moral hazard separately at the South African bank, how should we approach this?

Answer 10

Assign different interest rates before and after signing the contract.

Question 11

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?

Answer 11

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.

Question 12

What are three types of data we can use for empirical testing?

Answer 12

Observational data
Field experiment
Lab experiment

Question 13

What is an advantage and a disadvantage of a field experiment?

Answer 13

A field experiment gives a causal relationship.
However, it raises doubts about external validity (sample group)

Question 14

What is a solution for moral hazard in auditing?

Answer 14

Mandated rotation (Sarbanes-Oxley act)

Question 15

How does mandated rotation influence an agent in communicating bad news?

Answer 15

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.

Question 16

What is a loan officer?

Answer 16

A loan officer gets assigned multiple corporate borrowers to monitor and she has to recommend an amount of lending and assess the riskiness of repayment.

Question 17

Describe the dual role of a loan officer.

Answer 17

Active monitoring versus passive monitoring. Active monitoring involves really a hands-on approach with close contact and visits to the borrower. The passive monitoring is more waiting for problems to arise instead of solving them early.

Question 18

What is the IRR in the context of a loan officer?

Answer 18

Internal Rate of Riskiness. It assesses how risky a borrower is.

Question 19

What are the two sources of information used for the IRR?

Answer 19

Verifiable information like leverage ratio, collateral etc.
Non-verifiable information like competence or reliability

Question 20

Describe how a loan officer may land in a potential situation of moral hazard.

Answer 20

When the loan officer detects some bad unverifiable information, it means he did not do his job as an active monitor well enough which may harm his reputation. Therefore, he has an incentive to hide the bad information.

Question 21

Describe the potential tradeoff in case of bad news of a loan officer when there is no rotation?

Answer 21

When the loan officer observes bad unverifiable information about the firm, he has the option to tell everyone the bad news. On the one hand, this damages his reputation as active monitor but demonstrates his reputation as passive monitor

Question 22

How do mandated rotations fix the loan officer problem?

Answer 22

When the loan officers are rotated every three years, the loan officers have an incentive to report the bad news because if his successor finds the bad news, it destroys his reputation.