Adverse Selection and asymmetric information
Why banking institutions and other financial intermediaries exist?
In about the last 75 years, the financial services business has become important industry. At first the banking industry performing as a full- service industry, operating directly or indirectly all financial services such as commercial banking, investment banking, stock investing services, insurance providers, etc. in the 1930s, the world shocked by the economic and industrial breakdown which lead separation of some of financial activities. In the 1970s and 1980s, new free financial services industries arisen such as mutual fund, brokerage fund, etc. which resulting in more separating of financial services function. In the 21st century, regulatory barriers, technology, and financial modernism alterations are a group of financial services can for a second time be presented by a particular financial services corporation.
Financial intermediaries play an important role in economy of directing finances or resources from individuals or firms who have surplus money or assets (suppliers of funds) to individual or firms who needed that money or finance (users of funds)There are tow element in the literature which helping explain the exictence of financial intermediaries the first element emphasizes financial intermediaries specification of liquidity and the second element concentrates on the ability of financial intermediaries to transform the risk that related to its assets. In both elements. Financial intermediaries and bank institution would be able to minimizing the cost of channeling finance between borrowers and lenders which in turn resulting in better distribution of source more precisely financial intermediaries are specialness in the specification of services such as:
- Information costs: the collection of finance in an FI provides better motivation to gather information about clients than individual did.
- Liquidity and price risk: FIs offer best services financial claims to household investors with more liquidity characteristic and with lesser price risk.
- Transaction cost services: a like to economies of scale in information production cost.
- Maturity intermediation: FIs know how to bear the risk of inequality in the maturities of their assets and liabilities.
- Transaction of monetary supply: although institution is medium in which financial policy measures by the central bank of country affects the rest of the financial system and the economy.
- Credit allocation: FIs are considered as the main, and sometimes only, resource of funding for specific segment of the economy, for example farming, small firm, and residential real estate.
- Intergenerational wealth transfers: FIs, particularly life insurance firms and pension funds, give investors with the capability to transmit funds from one generation to next generation. Payment services: the effectiveness by which depository institutions provide payment services like cheque clearing which has a fine impact on the economy. Denomination intermediation: FIs, for example mutual funds, let small savers to sweep away restrains to trading assets forced by large smallest value size. (Anthony&Marcia).
The character of financial intermediation: a firm that wanted to invest in new scheme or project may not be able to fund all investment from her own resources and in order to solve this issue it will has to resort to borrow to get all or part of needed funds. And also an investor or an individual with excess finance out of his/her current revenue may wish to give as loan these funds so that he|she may gain a benefit.
It would hence sound like logical for corporation or company wishing to get funds try to find the investors who wanting to loan their funds, and vice versa. A bank institution and other financial intermediary usually do this job, I mean the financial intermediaries channel fund from those who have surplus to those who have shortages funds.
Why do people give their money to financial intermediaries to invest it on behalf of them? And why financial intermediaries exist?
there are many reasons why financial intermediaries exist, but there are three key reasons: Different requirements of lenders and borrowers: business which has got a loan to finance its investment will expect to repay against this loans during the life of investment, of course this will has high credit risk, in contrast lenders in general will be tended to possess assets that are less exposure to risks such as default risk. The financial intermediaries will hold assets from borrowers as deposits for long period and then financial intermediaries will invest this deposit as a loan to firms or individual.
Transaction cost: the existence of transaction cost cause more problem for potential lender to find the presence of transaction costs makes it very difficult for a potential lender to find a suitable borrower to lend him his funds. Transaction cost is important issue for both lender and borrower, transaction cost include research costs of finding information about an appropriate lender or borrower. Verification costs lender must make sure that the information provided by borrower is correct and adequate.
Enforcement costs: in which the lender must ensure enforcement of the terms of the contract. And monitoring costs, the lender need to monitor the borrower activities in respect of watching a payment date.
Problem of information asymmetries: When there are asymmetries information this means that there is one party of transaction has more information than the other party. Situation in which at least some related information is known some and but not all parties involved. Information asymmetry causes markets to become inefficient, since all the market participants do not have access to the information they need for their decision making processes. Opposite of information symmetry
The main aim why investors give their finance or money to financial intermediaries instead of investing the fund by themselves is the risk that they are exposure to from the information asymmetry between the demander of funds and the supplier of those fund (provider and receiver)
It is obvious that a seller knows better about trade item than the buyer does.
Therefore the risk would be taken by the buyer.
Similarly the borrower knows better about his financial circumstances than the lender, for example a firm that sells equity or stock may not put the money invest it in appropriate way.
There are some types of risks which are existing when there is information asymmetry, adverse selection and moral hazard
It is a crucial part of controlling risk that is selecting whom to fund your finance. It has to be given to a firm or an individual that or who will handle the money in best way.
A fine example explanation of adverse selection was presented by Gorge A. in his article "the market for lemons" for that he won the nopel price in economics in 2001(Suppose you have 2 people who want to sell their car. The 1st person is a little old lady who rarely drove her car and kept it in good condition. The 2nd person drove his car during his wild teenage years-speeding, drags racing, and getting involved in a few fender benders, and to save on money, he changed the oil only once in a while.)
Moral hazard is known as the risk that the beneficiary of funds will misuse the fund has been given to him as was agreed or they might get unnecessary risks or not pay require attention in reducing hazard.
As example, investors who put their money in American International Group (AIG) considered that their investments were thought that their money was somewhat more secure for the reason that AIG invested their money in an insurance firm which had been rating by credit rating agencies as highest credit rating. Though AIG was vending credit default swaps on mortgage-backed securities (MBS) which began to default in huge numbers in 2008 demanding the investors to place extra guarantee more than they had. So AIG taken more risks because the investors who traded the credit default swaps were getting large bonuses and they did not have to taken the risk as AIG did.
At this point, moral hazard occurs as the investors getting risks for moral hazard resulted because the traders took the risks for enormous earnings and bonuses, other than they have to bear risks.
There is another kind of moral hazard Another type of moral hazard, that is called morale hazard, take place repeatedly in insurance companies, in which the policy of the insurance firm compensation causes the insured to be less observant controlling risk, since they own insurance to compensate them any potential losses John Dobson (1993).
Minimizing adverse selection and moral hazard risk
Risks that related to adverse selection and moral hazard make financing very expensive for firms particularly small companies, because investors are not wanted to lend or borrow money in indefinite entities
In order to handle the adverse selection and moral hazard the financial intermediaries need to check the investor s creditworthiness in the past and their history of fund, there are a lot of databases on both investors and firms which can be useful in checking their past financial history.
Also there are another methods use to minimize moral hazard such as equity finance which is a mode of finance through the issuance of stock, in this method the manager possess a particular proportion of the firm.
Another method for debt finance by issue bonds.
Generally individuals and firms do not prefer to give so much information and put up collateral.
The process of financial intermediation
Financial intermediaries transforms assets by hold the long-term, high risk, claims from the borrowers and funds this by issuing deposit with the characteristics of low-risk and short-term by doing this process financial intermediaries channel the finance that pass through it. Also financial intermediaries will take deposit from borrower funds for short period and give it to lender fund as loan for long period, in addition to transformation of liquidity of funds, financial intermediary also transform default risk, and financial intermediary is able to reduce the risks through diversifying its funds. The intermediary can take information on target
The consequences of financial intermediation
The existence of financial intermediaries has impact on:
- the utility of individual lenders and borrowers
- the level of economic development.
The Hirschleifer model: is a tow period investment model is based on assumptions of the model which are shown in Bukle and Thompson (1998) section 2.4.
This model enables us to understand the process of lending and borrowing that take place in financial system as well as a means of lending borrowing used by financial institution.
There are tow choices for financial intermediaries, first choice is to use its own assets to create goods or services for consumption, the second choice is it will investment to provide consumption in the second period (march 21,2008)
Financial intermediaries have been able to fulfill a number of functions efficiently in this sense financial intermediareis can transform the risk of assets for reason that they can find a solution for a market failure and overcome an information asymmetry problem which arises in credit markets because borrowers know better about their scheme than lenders do. This information asymmetry can be of an ex ante nature resulting in adverse selection and generating moral hazard, or it can be of an ex post nature causes costly state verification and enforcement hence information asymmetry may be the main reason that financial intermediation exist. financial intermediaries specialize in gathering information, assessing projects, monitoring borrowers
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