L9 - Asymmetric Information

Question 1

How is asymmetric information defined?

Answer 1

one part has better information than the other party

Question 2

What is adverse selection?

Answer 2

a market process in which ‘bad’ products or customers are more likely to be sleeccted than ‘good’ products

Question 3

How is Moral hazard defined?

Answer 3

• the risk that one party to a contract will change the behaviour to the detriment of the other party once the contract has been signed

Question 4

What do tranditional models assume about markets?

Answer 4

• Traditional models of markets assume that buyers have complete information about the product they are buying.
• However, sellers might have information about the product, for example its quality, that they withhold from buyers.
• Similarly situations might arise when the buyer of a product has information they withhold from the seller of the product.
• Asymmetric information exists whenever one party to an economic transaction possesses greater material knowledge than the other party to the transaction.

Question 5

What are some examples of asymmetric information?

Answer 5

• The seller of a good or service normally has greater knowledge than the buyer. This is especially important in the case of second hand goods such as cars, computers and so on.
• The buyer of insurance often has superior knowledge of risk in the transaction than the seller. –> lying to insurance courses, health insurance has specific exclusion clauses, are you less careful when you taken out insurance
• A customer applying for a bank loan will have greater knowledge about the use to which the funds will be put than the provider of the loan.
• Company managers possess greater knowledge of the company they manage than the owners of the company.
• Potential employees know more about their suitability for a particular appointment than the potential employer and so on.

Question 6

What do economist traditionally argue about allocation of resources in a market?

Answer 6

Traditionally economists argue that markets allocate resources efficiently. Prices reflect the value consumers place on a product (the value of the last marginal unit they consumed) and the value of the resources used to produce the product. In equilibrium, these two valuations coincide. Hence the argument that markets allocate resources efficiently

• but when asymmetric information exist supply and demand may be affected, consumers preferences may not be accurately reflected in the demand function, or supply doesnt reflect the value society places on the product (sub-optimal production decisiosn)

Question 7

What did Akerlof summise from the second-hand car market?

Answer 7

• Akerlof (1970) first outlined the problem using the example of second hand cars.
• The owners of second hand cars know the full story of the car, the buyers do not!
• The market consists of a whole range of second hand cars ranging from high quality to low quality. Following Akerlof (1970) we assume that only high quality and low quality second hand cars exist. Akerlof referred to the latter as ‘lemons’.

Question 8

what are the implication of Akerlof’s Model?

Answer 8

• Because of asymmetric information, buyers will only be willing to pay average prices for ALL cars. But this does NOT reflect the average quality of high value second hand cars offered for sale and is more representative of the average quality low value second hand cars.

Question 9

What is the formal problem of Akerlof’s Model?

Answer 9

Assume – Two kinds of cars high quality and low quality.

• Buyers and sellers can distinguish between the cars.
• There will be two markets – one for high quality and one for low quality.
• High quality market S_H is supply and D_H is demand for high quality. Low quality market S_L is supply and D_L is demand for low quality
• Sellers know more about the quality of the used car than the buyers, so how will buyers judge quality

The analysis above implies that the existence of asymmetric information leads to good quality cars being under-consumed and low quality cars being over-consumed in relation to the true preferences of consumers.

• Because of asymmetric information, the used car market adversely selects the cars that will be offered for sale.
• This implies that when asymmetric information is present, markets fail to allocate resources optimally.

Question 10

Why is asymmetric information a particular problem in financial markets?

Answer 10

In financial markets, economists distinguish between two problems arising from asymmetric information:

• Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment or granting a loan.
• Moral hazard is the risk that economic agents will take actions after they have entered into a transaction that will make the other party worse off. –> charge higher payment, but you have incentive to pay that as risky ventures have a higher payout if they work

Question 11

How does asymmetric information occur in the stock market?

Answer 11

• Assume 80% of stocks are good quality stocks with a price of €100 and 20% are lemons (poor quality stock) with a price of €20. –> the expected price of the stock is €84, but to a good firm this is below the fundamental value of the stock - market isnt allocating resources efficiently
• The implication is that good quality firms will be less willing to issue stock and will seek other sources of finance.
• Conversely poor quality firms will obtain more for their stock than its fundamental value and will issue more stock.

Question 12

How are banks affected by asymmetric information?

Answer 12

• A bank has a population of borrowers to lend to and, whilst these will be a whole spectrum of risk categories, for simplicity we divide these into safe and risky borrowers.
• banks usually lend on trust, they have done business with you before, but if you now see opportunities you wouldnt have normally taken (your risk profile has changed), the banks dont necessary know that you are going to take more of these risky investments
• High risk firms have an incentive to conceal their level of risk exposure in order to borrow at lower rates.
• to solve this issue banks lumped different risk categories together and take the average, this means that low risk borrowers are having to pay a higher rate of interest compared to the risk category they fall into, high risk firms are charged a lower rate of interest that the risk category they would be placed into
• in the world of insurance, business risk is the only thing that cant be insured against,
• as high risk firms have more incentive to pay the interest, banks are selecting the wrong customers, markets are failing again.

Question 13

What are the problems small investors face due to asymmetric information?

Answer 13

• Small firms to medium sized are more dependant on loan finance than large firms and depend on financial intermediaries to meet their financial needs.
• Banks know a great deal about their customers, but problems of asymmetric information, leading to adverse selection and moral hazard, still exist

Question 14

What are the problems small firms face due to asymmetric information?

Answer 14

Smaller firms are inherently more risky than larger firms and are many times more likely to go bankrupt.

Banks cannot solve the problem by charging higher rates of interest to risky borrowers because these borrowers have an incentive to conceal their true exposure to risk

A particular problem arises during a recession as witnessed during the heavy recession of 2008.

The financial health of firms and households deteriorated markedly and the number of ‘lemon borrowers’ increased relative to the number good quality borrowers.

• firms went bust during the recession, which led to even more loan contracts not being fulfill - banks tried to cover themselves which led to credit rationing but this forced even more businesses to close

Question 15

What is the role of information providers?

Answer 15

• The problem is partly alleviated by private firms who collect and sell information on other firms.
• Information is collected from such sources as firms income statements, balance sheets and investment decisions.
• The information advantage banks gain from this allows them to reduce the cost of adverse selection and explains the key role banks play in providing external finance to firms.- this only works if the information is correct though

Question 16

Why is the problem of asmmetric information and moral hazard not so easily overcome?

Answer 16

• During the financial crisis, the rating agencies were approached to re-structure debt arising from the burst of the property bubble.
• There are allegations that different rating agencies were approached with a view to issuers of CDO’s receiving the highest rating.
• When defaults started rising, questions were asked about how the ratings were derived.

Question 17

The problem of providing an accurate rating of a firm?

Answer 17

In reality, providing an accurate rating is fraught with difficulty.

Some potentially good quality firms might be quite young and there might be insufficient history to enable an altogether accurate assessment of the quality of these firms to be made.

lemon agencies have the incentive to portray their firm in the best light, which may not be necessarily true

Question 18

What is Securitisation?

Answer 18

-Securitisation involves bundling loans such as mortgages into securities that can be sold in financial markets. –> moves the assets off the balance sheet of the banks

The traditional focus of banking has been relationship banking and an originate to hold model ( i make you a loan and hold it till maturity). The emergence of securitisation changed the focus of banks into an originate to distribute model

• they will make the loan, bundle it up in the securitisation, and sell it to the market where they will receive payments from the markets, and the buyer of the bundle receive interest from components of the securitised debt
• as banks have moved toward the originate to distribute model, banks have less incentive to look at who they are making the loans to, as they are no longer holding onto the risk

Question 19

What is the basic model of the banking firm?

Answer 19

• If all other interest rates are given, financial intermediaries face an exogenous upward-sloping supply curve of deposits (S_D ).
• The endogenous supply of loans (S_L- determined by S_D ) is also a rising function of the interest rate. PQ is the supply price of intermediation. This must cover the cost of management and the cost of capital.
• The demand for loans is given by (D₀ ).
• In this simple world, we can identify the equilibrium interest rate(s) and the equilibrium quantity. (Note this is a massive oversimplification and we ignore the range of different assets and liabilities banks have on their books.

Question 20

In the basic model of a banking firm want can we learn from the interest rates?

Answer 20

• Note in our representation, the differential i₀ i₁ is the cost of intermediation and the total cost of intermediation is i₀ i₁ (OT).
• (Note that if deals could be done privately between ultimate lenders and ultimate borrowers, banks could be by-passed and this would be the total saving available to society - this being the total cost of intermediation.)
• For example, for the same volume of business (OT) at a random rate of interest of i₂ the borrower would pay a lower rate of interest and the lender would receive a higher rate of interest than by dealing with a bank.
• Alternatively, if the supply curve of funds made available directly to borrowers were the same as that offered to banks, the volume of deals would rise to OB at a rate of interest of i₃.

Question 21

Why do banks exist?

Answer 21

• Banks may possess particular expertise enabling them to do what other firms cannot do so that they possess monopoly attributes or:
• They do what can be done by other firms but they possess certain attributes which give them a comparative advantage.
• Banks, therefore, become vulnerable if they lose their monopoly power or their comparative advantage is eroded

Question 22

How has the bank’s monopoly power eroded over time?

Answer 22

• Technology has lowered barriers to entry. –> reduced the fixed costs of entering a market
  
  • Banks needed a widely dispersed network of banks, but now banks like Monzo have no physical buildings.
• Deregulation has lowered barriers to entry.
• Customers are now better informed about alternatives (internet).
  
  • For example, the development of money market mutual funds (some of which now incorporate payments facilities) challenges the traditional monopoly of banks in the supply of transactions balances.

A core competency of banks is the information base they have about their customers. But technology is reducing the cost of acquiring information. E.g. loyalty cards, rating agencies, increased disclosure of information –> what stop other providers from gathering this information?

Question 23

What are some specific examples of what is eroding the bank’s monopoly power?

Answer 23

• New technology and declining entry barriers - challenges their comparative advantages
  
  • Internet, electronic order books
• The development of credit scoring techniques
  
  • widely known now
• disclosure laws - how much information banks can keep secret has decreased
• The emergence of rating agencies has had a similar effect

Question 24

What happens when the supply price of banking services rise?

Answer 24

• banks may become less competitive vis-a-vis the alternative suppliers of intermediation services.
• In addition, competitive pressures have eroded the ability of banks to engage in cross-subsidisation.
  
  • No longer have to have a branched network, can use the internet

If the different section of the banks was unbundled and could be specifically identified, new firms could emerge to compete for a particular part of the bundle.

*

Question 25

What is Cross subsidisation?

Answer 25

Cross subsidisation is the practice of charging higher prices to one type of consumers to artificially lower prices for another group.

State trading enterprises with monopoly control over marketing agricultural exports are sometimes alleged to cross-subsidise, but lack of transparency in their operations makes it difficult, if not impossible, to determine if that is the case.

Question 26

What has competition done to endowment profits?

Answer 26

• Endowment products - make regular contributions to a policy and get paid a lump sum
• has eroded it to the extent that competition is forcing banks to pay rates of interest on a higher proportion of deposits (costs have gone up), and rates of interest are now similar to market rates
  
  • Less competitive

Question 27

What has led to the lower costs of alternative suppliers?

Answer 27

• If the costs of alternative providers of banking services fall, relative to those of traditional banks, the latter are then vulnerable.
• Financial innovation and the power of new delivery technology has increased the relative competitiveness of the capital market vis-a-vis banks. –> electronic order books
• New technology has also facilitated other developments.
• For example, supermarkets offer banking services but do not need to maintain a branch network. Deregulation has also encouraged change.
• the internet has allowed consumers to change their perceptions and value the services of banks less highly - can shop around for better value
  
  • if a bank goes bust what will happen to our money? - consumers have shared diversifying their risk across multiple banks and financial services

Made banks vulnerable

Question 28

What are the seven reasons why banks still exist today?

Answer 28

What factors gave rise to the emergence of banks and have these become less important in recent years?

The ‘existence literature’ identifies seven reasons for the emergence of banks:-

• Information advantages
• Imperfect markets
• The theory of delegated monitoring
• Control theory
• The Insurance role of banks Regulatory subsidies
• The special role of banks in the payments system

Question 29

How has the information advantages that rationalises the existence of banks been challenged?

Answer 29

• Information advantages Banks have advantages as providers of capital over the capital when company equity isn’t traded. But the nature of information is changing and the cost of acquiring information has become cheaper - by technology
• The overall effect is to erode the information advantage of banks.
• As more efficient information channels emerge and the cost of gathering information falls, the nature of the relationship between the banks and the capital market has changed.
  
  • banks have an incentive to disclose information because the capital market will process them more efficient

Question 30

How have imperfect markets that rationalise the existence of banks been challenged?

Answer 30

• Imperfect and incomplete financial markets are often cited as a rationale for the existence of banks - needed to intermediate between borrowers and lenders
• . It has also been argued the securitisation (bundling poorer products together) and financial innovation take us closer to a world of complete markets.
  
  • cost is falling making the market more complete and efficient

Question 31

How does the theory of delegated monitoring rationalise the existence of banks?

Answer 31

• The theory of delegated monitoring is important because, as contracts are necessarily incomplete, borrowers need to be monitored to ensure their behaviour maximises the probability that loans will be repaid.
• By delegating this role to banks, the problems of asymmetric information and moral hazard are likely to be dealt with more effectively
  
  • can pool information - huge economies of scale in monitoring
  • diversify - sell the information

How much better are banks at monitoring than other agencies: credit scoring techniques, rating agencies, disclosure laws that make it necessary to disclose information, so banks are the only organisations who can perform this role.

Question 32

What is control theory in banking?

Answer 32

• A bank is better to apply to resolve the problems of moral hazard as it has superior control mechanisms
• Control theory this concept is allied to the role of monitoring
• One control mechanism to combat moral hazard could be staggering a loan
  
  • lend money to a borrower in sections, in which the bank will require the money to be used for a specific purpose, this is to stop the borrower taking the money and using it for something else
    
    • prove to me that you did what you said and you will get the second tranche of the loan
• Could require collateral

Question 33

How has the control theory that rationalises the existence of banks been challenged?

Answer 33

• The implication of control theory is that banks, because of the factors noted above, can exercise control as proxy equity holders - this occurs in Germany and the Netherlands, where banks take a large equity stake in the companies that they work with - this doesn’t occur in the UK though
• This further implies that banks have lower control and enforcement costs and that the distinction between debt and equity should not be dawn to rigidly even in market-based systems like the UK

Question 34

What is the Insurance Role of a Bank?

Answer 34

The Insurance role of banks in providing insurance that conventional insurance companies are unable to provide because the nature of the risks do not meet the standard characteristics of explicitly insurable risks -

• e.g. business failure is an uninsurable risk - what are the factors that cause the success and failure of a firm
• Banks have the facilities to pool risk - and the bigger the size of the pool (the larger number of depositors) the more predictable they become

By pooling risks, a bank is able to provide liquidity insurance to risk-averse depositors facing private liquidity risks. This is what enables banks to hold non-marketable assets.

Question 35

What did (Dowd, 1996) say about the insurance role of Banks?

Answer 35

“The bank thus transforms imperfectly marketable, longer-term assets into fully marketable, short term liabilities, And in the process provides its debt holders with insurance against the contingency that they will be caught short by an unexpected liquidity shock”. (Dowd, 1996)

Question 36

How has the insurance role of banks that rationalises the existence of banks been challenged?

Answer 36

• the insurance role of banks has rationalised their existence as they are big enough and in the lending business to pool risk
• But due to deregulation others can provide this service e.g. unit trusts now offer banking and deposit facilities
• Some argue that customers that deposit with banks can earn a high level of interest for a give liquidity - is a powerful enough point for the argument for banks to exist

Question 37

What are Regulatory Subsidies in banking?

Answer 37

• Regulatory subsidies might give banks a comparative advantage not available to other providers and therefore might provide a rationale for the existence of banks.
• These subsidies are in the form of what might be termed protective regulation’ (deposit insurance, the implicit lender of last resort facilities and regulation that limits competition etc.).
• However, due to deregulation, banks have been opened up to competition, removing the comparative advantages of regulatory subsidies as new entrants can capitalise on them too

Question 38

What payment advantages did Banks have that is now being challenged?

Answer 38

Payments advantages are sometimes suggested as something banks have a monopoly through their role in the payments mechanism.

The challenge to banks comes on two fronts:

• • The assumption that all transactions require money –> not just cash;
• The assumption that only banks can issue money

Technology has challenged this - Paypal, Monzo, Unit Trust have deposit facilities –> there is no need for checks and the old method of payment in banks

Money is a convenient medium of exchange that facilitates trade and implies that transactors do not need information on the other party as might be the case if a settlement were made through the transfer of other assets.

Question 39

What basic question do we face about the traditional bank/

Answer 39

• Are banks necessary for banking?
• Is banking necessary for banks?
• Is banking a declining industry?
• Are banks declining firms?
• Will the traditional integrated structure of the banking firm survive?

Question 40

Are Banks necessary for banking?

Answer 40

• The answer is ‘No’ in that there is now little that banks do that could not equally well be done markets, non-bank financial institutions or non-financial banking institutions (supermarkets)
• As entry barriers are eroded, a wider range of new competitor has emerged. Whatever else, the clear implication is that markets will become more contestable
  
  • as the traditions area of banking have been segregated, there is no need for a high-fixed cost branch network with new entrants specialising in specific areas of banking (lower fixed costs)

Question 41

Is Banking necessary for Banks?

Answer 41

• Generally, the answer is again ‘No’. In principle, banks are not restricted to the provision of ‘banking’ business and just as insurance companies have diversified in banking, so banks have diversified into insurance.
• The traditional distinctions are being eroded quickly and it is a matter of doubt that traditional ‘banks’ and traditional ‘insurance companies’ will exist for much longer
• What about the regulatory issues that might restrict banks to diversify?
  
  • Why don’t they diversify into areas that aren’t so regulated - technology and algorithms are less regulated at the moment

Question 42

Is banking a declining industry?

Answer 42

• Let’s begin by considering what banking actually is. ‘Traditional banking’ implies financial intermediation. Debt contracts dominate both sides of the balance sheet.
• On the asset side, banks are highly geared and their debt contracts are far larger than their equity base. These are non-marketable, held until maturity and not re-priced on the basis of changing market signals.
• On the liabilities side, their balances are defined as money and form the core of the payments system.

Whether banking is a declining industry is whether the services of a financial intermediary can be provided by other firms

• Entry barriers have declined, protective regulation has disappeared and consumer demand has switched away from suppliers of traditional banking functions.
  
  • Securitisation - parcelling up no marketable debt, putting their brand on it and marketing it - taking it off banks balance sheets
  • Payment methods can be performed by other non-bank suppliers

Question 43

Are Banks Declining Firms?

Answer 43

An industry can be in decline, but this does not imply that each component firm in the industry is declining. Through diversification, banks might not be declining, though their industry is in decline

Question 44

Will the traditional integrated structure of the banking firm survive?

Answer 44

• The traditional banking firm is vertically integrated with that it manufactures and provides the products and services it offers to customers and undertakes all of the component processes of the products and services it offers.
  
  • the different components of traditional banking have been separated and identified and are now marketable - now opened up to competition
    
    • Thus these roles can now be provided by specialised non-banks suppliers
    • Banks in this sense become nothing more than a broker

Question 45

How can the problem of Moral Hazard be reduced?

Answer 45

• necessity for financial intermediaries to participate in delated monitoring (Diamond, 1984)
  
  • As unlike small scale investors, large investment banks have the capacity to reduce the cost of gather information by exploiting economies of scale, while also having the facilities to monitor and audit borrowers when required
• Furthermore, they also have the ability to apply different restrictive covenants to further deter borrowers from engaging in undesirable behaviours (Mishkin and Eakins, 2018).
• As well, post-financial crash, the formation of the Financial Conduct Authority means that there will be more scrutiny place on financial intermediaries so that they do not partake in any unsavoury financial conduct at the detriment of their customers (Casuet al. 2015).
  
  • Frank-Dodd And Volker rule

Question 46

How can the problem of Adverse Selection be reduced?

Answer 46

• “Job Market Signalling” (Spence, 1973), which surmises that if the more informed party provides credible and observable ‘signals’ to the counterparty, they will be able to differentiate themselves from other agents and convince the other group of their ‘quality’.
  
  • In the case of the previous loan example, by divulging the characteristics of the investment project.
• In addition, (Rothschild and Stiglitz, 1976) explored the actions of financial intermediaries referring to this process as ‘screening’.
  
  • Continuing from the earlier example, a lender could screen the borrower by assessing their company’s financial statements and credit history.
• Although Stiglitz does states that due to insufficient empirical evidence it is difficult to predict the application in the real world, further arguing that the basis for their analysis was on the uncompetitive insurance market; therefore, adverse selection may still be rife in a real, highly competitive financial market.