The Economics of Financial Intermediation Chapter 6 The Economics of Financial Intermediation

6.3 Information Asymmetries and Information Costs CONTENS 6.1 Flow of Funds: Direct and Indirect Finance 6.2 Role of Financial Intermediation 6.3 Information Asymmetries and Information Costs

6.1 Flow of Funds: Direct and Indirect Finance

6.2 Five Roles of Financial Intermediaries Pooling Savings Safekeeping and Accounting Providing Liquidity Risk sharing Information Services

A Summary of the Role of Financial Intermediaries 3.Providing Liquidity: Allowing depositors to transform their financial assets into money quickly, easily, and at low cost. 4.Risk sharing: Providing investors with the ability to diversify even small investments. 5. Information Services: Collecting and processing large amounts of standardized financial information.

A Summary of the Role of Financial Intermediaries Pooling Savings: Accepting resources from a large number of small savers/lenders in order to provide large loans to borrowers. Safekeeping and Accounting: Keeping depositors’ savings safe, giving them access to the payments system, and providing them with accounting statements that help them to track their income and expenditures.

6.3 Information Asymmetries and Information Costs 1. asymmetric information issuers of financial instruments – borrowers who want to issue bonds and firms that want to issue stock – know much more about their business prospects and their willingness to work than potential lenders or investors

Information Asymmetries and Information Costs 2. Adverse Selection potential borrowers know more about the projects they wish to finance than prospective lenders

Information Asymmetries and Information Costs If you can’t tell the difference between the two firms’ prospects, you will be willing to pay a price based only on the firms’ average quality. The result is that the stock of the good company will be undervalued. Since the managers know their stock is worth more than the average price, they won’t issue the stock in the first place. That leaves only the firm with bad prospects in the market.

Information Asymmetries and Information Costs 3. Solving the Adverse Selection Problem Disclosure of Information Collateral and Net Worth

Information Asymmetries and Information Costs 4. Moral Hazard Moral hazard arises when we cannot observe people’s actions, and so cannot judge whether a poor outcome was intentional or just a result of bad luck principal-agent problem The separation of ownership from control. When the managers of a company are the owners, the problem of moral hazard in equity financing disappears.

Information Asymmetries and Information Costs Moral Hazard in Debt Finance Because debt contracts allow owners to keep all the profits in excess of the loan payments, they encourage risk taking a good legal contract can solve the moral hazard problem that is inherent in debt finance. Bonds and loans often carry restrictive covenants

The Negative Consequences of Information Costs (1)Adverse Selection: Lenders can’t distinguish good from bad credit risks, which discourages transactions from taking place. Solutions include Government-required information disclosure Private collection of information The pledging of collateral to insure lenders against the borrower’s default Requiring borrowers to invest substantial resources of their own (2) Moral Hazard: Lenders can’t tell whether borrowers will do what they claim they will do with the borrowed resources; borrowers may take too many risks. Solutions include Forced reporting of managers to owners Requiring managers to invest substantial resources of their own Covenants that restrict what borrowers can do with borrowed funds

Financial Intermediaries and Information Costs The problems of adverse selection and moral hazard make direct finance expensive and difficult to get. These drawbacks lead us immediately to indirect finance and the role of financial institutions.

Much of the information that financial intermediaries collect is used to reduce information costs and minimize the effects of adverse selection and moral hazard

间接融资中：银行为中介 ....... 银行 ….. ….. …… L1,1 B1 L2,1 B2 Ln,1 L1,m L2,m Bm Ln,m

比较： 事前：信息揭示优势 information disclose 事中：设计契约优势design contract 事后：监督控制优势 monitor and control 并且，在产生信息过程中，有规模经济economy of scale效应。 问题：能根除代理问题吗？

Summary: Asymmetric Information Problems and Tools to Solve Them

Chapter 6 End of Chapter