Adverse selection

1. Occurs when one party in a transaction has better information than the other party

2. Before transaction occurs

3. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected

4. Because customer can’t distinguish between good and bad securities. In result good securities undervalued and firms won’t issue them; bad securities overvalued so too many issued

5. Investors won’t want to buy bad securities, so market won’t function well

Tools that can help solve adverse selection problems

Private production and sale of information

· Free-rider problem interferes with this solution

Government Regulation to increase information

· For example, annual audits of public corporations

· Doesn’t eliminate the problem

Financial Intermediation

· Analogy to solution to lemons problem provided by used car dealers

· Avoid free-rider problem by making private loans

Collateral and Net Worth

Moral Hazard

1. Occurs when one party has an incentive to behave differently one an agreement is made between parties

2. After transaction occurs

3. Hazard that borrower has incentives to engage in undesirable activities making it more likely that won’t pay loan back

4. Moral hazard in equity contracts (the principal-agent problem)

· Result of separation of ownership by stockholders (principals) from control by managers (agents)

· Managers may act in their own interest rather than in interest of the stockholders-owners

Tools to help solve the problems

1. Monitoring and enforcement of restrictive covenants

2. Government regulation to increase information

3. Financial intermediation

4. Net worth

5. Debt contracts

Functions of financial intermediaries

I. Financial intermediaries:

1. Depository Institutions (banks)

· Commercial banks

· Other types in other countries (mutual savings banks)

2. Contractual Savings Institutions

· Life insurance companies

· Fire & casualty insurance companies

· Pension funds, government retirement funds

II. Engage in process of indirect finance

III. More important source of finance than securities markets

IV. Needed because of transactions costs and asymmetric information

Financial institutions

Investment Intermediaries

· Finance companies

· Mutual funds

· Money market mutual funds

2. Other types (securities firms – financial middle-men)

o Investment banks

o Security brokers and dealers

o Venture capital firms

Дата добавления: 2015-11-14