"An international financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds efficiently to those who have the most productive investment opportunities". Critically comment upon this statement.

The above quote by Mishkin (n.d.) is based on his original, slightly different quote in a 1996 working paper on financial crises, where he says,

"A financial crisis is a nonlinear disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently Channel funds to those who have the most productive Investment opportunities" (Mishkin 1996).

Both adverse selection and moral hazard are results of asymmetries of information. This concept, also called the concept of asymmetric information, was famously established by George Akerlof in his work on the "Market for Lemons" (1970). The basic idea is that one party to an (active or potential) agreement knows something that the other one does not know. Akerlof puts forward the example of the used car market: People willing to buy used cars never know whether they are being offered a good car (a "cherry") or a bad car (a "lemon"), so in the absence of the knowledge (which the seller usually has) they have to make the most educated guess they can come up with, which is that the respective car is of average quality. This also means they are only prepared to pay an average price. In this case, the sellers of cars with above-average quality will prefer not to sell their cars, which leaves the cars with former average quality and below on the market – setting a new, lower, average quality. The potential buyers adjust the price they are willing to pay for the lower average quality, which in turn pushes out the above-average cars yet again…and so on. In the worst case, the market disappears because of this asymmetry of information, although apart form the lack of "symmetric" (i.e. perfect) information it is perfectly competitive.

In his working paper "Understanding Financial Crises: A Developing Country Perspective", Mishkin (1996) explains the concept of asymmetric information and the resulting phenomena of adverse selection and moral hazard in the context of the financial and banking system. More specifically, both phenomena result from asymmetric information with regard to the risk profile of potential or actual borrowers and lenders in the credit market.

Adverse selection happens BEFORE the transaction occurs. In the case of asymmetric (i.e. imperfect) information, there are people or companies with bad credit risk in the credit market willing to borrow money knowing they may not be able to pay the loan back. The risk profile of their investment opportunities is unfavourable (comparatively low return vs. comparatively high risk), or speaking in terms of Modern Portfolio Theory (Markowitz, 1952) and the Capital Asset Pricing Model (Sharpe, 1964), their risk-return structure is not efficient and dominated by other combinations of risk and return (i.e. it is not on the efficient frontier, the curve of optimal risk-return combinations). These would-be borrowers would use the proceeds of the loans for high-risk projects, and if those do not work out, it is the banks that have to foot the bill. In other words, high-risk borrowers are particularly keen on borrowing money as their comparatively low net worth puts them into a position where they have little to lose. It is easy to see why they would want to exploit information asymmetries: For borrowers with sufficient net worth to settle any negative project outcomes (i.e. with enough money to pay off the loan even if the project goes belly-up), the expected net present value of the project is normally distributed (i.e. bell-shaped – for every positive outcome there is a negative one on the other end). They benefit from a surplus, and compensate the bank for a negative result. But for high-risk borrowers with little net worth, the structure of the entire transaction soon turns into that of the pay-off structure of a call option: Heads – they win, tails – they don't lose. And just like in the case of a call option, the higher the risk (i.e. the volatility), the better for the holder of the option, given the asymmetric payout structure.

Mishkin does not mention the concept of utility functions in this context. They represent the formal concept behind the rationale he discusses. Every expected value of a transaction is converted into a utility value, and as the function is usually not linear for investors and the total net worth is taken into consideration when calculating the value, it turns out that people with low net worth will always be more likely to risk more than those with high net worth – and the chance to turn the payout structure into that of an option (see above) will only further their cause.

It is easy to see that under these conditions banks will be reluctant to lend money, or only at high rates. High-quality would-be borrowers will then leave the market, and the same vicious circle starts as described above in the Lemons case.

In contrast to adverse selection, moral hazard occurs after the transaction has been agreed on. The borrower will engage in high-risk ventures if his net worth is low and he feels he might as well gamble on it. In general, the rationale mentioned above in connection with adverse selection applies: low-quality borrowers have every incentive to bet all the money they get from the bank on risky projects – thanks to the call option structure of the expected cash flows.

Taking these two phenomena resulting from asymmetric information into consideration, it is easy to see how Mishkin would come up with the introductory statement (see above). Both adverse selection and moral hazard, which have been shown to be part of financial crises in the wake of asymmetric information, lead to the inefficient allocation of assets: High-quality people/companies willing to borrow are crowded out by low-quality ones, which means that the best investment opportunities continue to lie dormant while sub-optimal investment projects are initially taken on – until the banks decide to refrain from extending loans altogether. In this case, banks will invest their liquid funds in assets with alow risk/return profile. Their investments will probably "dominate" the bad ones by low-quality investors, but they will still be inferior to the ones than cannot be carried out by high-quality investors due to the credit crunch.

References

Akerlof, GA and Maun, M 1970, 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism', Quarterly Journal of Economics, 84 (3), pp. 488-500.

Markowitz, HM 1952, 'Portfolio selection', Journal of Finance, 7 (1), pp. 77-91.

Mishkin, FS, 1996, 'Understanding Financial Crises: A Developing Country Perspective', in Bruno, M and Pleskovic, B (eds.) 1996, Annual World Bank Conference on Development Economics, World Bank, Washington D.C.

Mishkin, FS 2004, The Economics of Money, Banking and Financial Markets, Addison-Wesley, Reading.

Sharpe, WF 1964, 'Capital asset prices: A theory of market equilibrium under conditions of risk', Journal of Finance, 19 (3), pp.425-442.