Financial structure, asymmetric information, asset bubbles

Question 1

The financial structure of a country can be explained as a response to both transaction costs and asymmetric information. Define asymmetric information and the problems it creates in both banking and financial markets.

Answer 1

asymmetric information occurs when one party to an economic transaction possesses greater material knowledge than the other party

Problems: adverse selection (lenders cannot fully evaluate creditworthiness of each borrower. Charge average rates. More risky borrowers use services more. Inefficient 2. moral hazard (one party to a transaction has incentive & ability to shift costs to another party

Question 2

List five tools/mechanisms that financial intermediaries use to reduce asymmetric information, when advancing loans to a company or business? (5 marks)

Answer 2

1. obtain more information (screen potential borrowers ) 2. impose controls on short term flows (circuit breakers, trading halts) 3. government regulation 4. Use financial intermediary - eg bank profits from information gathering by offering private loans
2. require collateral
3. insert restrictive clauses into debt contracts to limit borrowers’ behavior (to lessen moral hazard

Question 3

Asset bubbles are a topical issue for macro policy makers and portfolio managers. Outline the arguments for and against a central bank targeting excessive asset prices

Answer 3

Note (Glenn Stephens): it is not the asset, it is the debt behind it that is an issue - leverage and then collapse - credit bubbles that burst threaten the stability of the financial system more directly than equity bubbles (debt held by banks are highly leveraged) - Cost - could try to temper asset prices in something that is not a bubble at all - cost - if using MP for asset bubble, costs may be higher elsewhere - eg increase unemployment due to higher rates/slower economy
Over regulation will hurt asset prices and efficiency