Fundamentals of Banking Asymmetric Information & Banking ECO 473 - Money & Banking Dr. D. Foster

Direct & Indirect Finance Most external financing is done through intermediaries.

Banks Reduce Transaction Costs Banks reduce the cost of acquiring assets. Many costs are fixed. Bank assets are highly liquid. Economies of scale. e.g., using standard loan contracts as legal fees are averaged over many loans Transactions costs are very low for lines of credit.

Adverse Selection Those most eager to make a deal are the least desirable to the other party. Bad risks want loans. Firms with lots of risk want to sell bonds. Risk drives up interest rate & drives out low risk borrowers. If this problem persists …

Moral Hazard Post-contractual change in behavior that puts other party at increased risk. Will borrower really be prudent and repay? Will company really be prudent and max. profits? Does insurance reduce vigilance? Markets cannot form if this persists.

Principal-Agent Problems The action of the agent is contrary to the desires of the principal. Workers shirk at their jobs. Managers are also agents - they work for owners- shareholders. Can bond-holders and stock-holders really monitor the firm? Problems: Enron, Arthur Anderson

How do Banks Deal with Asymmetries? Screen borrowers. Avoids free rider problems with information. Requirements for collateral and net worth. Shifts risk to the borrower; avoids adverse selection. Also, mitigates moral hazard. Imposing covenants and monitoring. Reduces moral hazard. Variable interest rates and credit rationing. Some tolerance for risk. Should the government get involved with asymmetries?

Cases involving asymmetric information Enron -- Stock price: $83 Feb 2001; $0.21 Dec 2001 -- Business: trading energy futures -- Overvalued assets; hid losses -- Downfall took Arthur Andersen -- Employee with 401k in Enron lose out Bernie Madoff -- Wall Street banker since 1960s -- Prominent philanthropist -- Client losses = $50 billion -- “Ponzi” scheme began in 1991 -- “Model” unreplicated; targeted charities

Fundamentals of Banking Asymmetric Information & Banking ECO 473 - Money & Banking Dr. D. Foster