Asymmetric Information

1
Asymmetric Information

• Solutions
• In our last lecture we assumed fairly passive
• behaviour on the part of lenders. However,
• intermediaries exist partly because they are
• able to effectively address information
• asymmetry.
• It is possible for lenders to do several things
• in response to this problem
• credit rationing
• screening
• monitoring
• We also assumed that good quality
• borrowers passively accept this situation. In
• reality, these borrowers can use signaling
• to distinguish the quality of their project.

2
Asymmetric Information

• Credit Rationing
• Recall that the bank will charge rAlt ras lt rB
• when unable to distinguish good and bad
• projects. This tends to reward bad projects
• and penalize good ones.
• Safe projects have a lower rate of return. So
• ras will eliminate the profits of these projects.
  
• This will leave only the risky projects in the
• market.
• Banks can raise the interest rate to
• reflect the greater risk of their loan portfolio.
  
• But this makes it harder for these riskier
• projects to obtain positive profits as well.
• The paradox is that an interest rate rise

3
Asymmetric Information

• Credit Rationing
• The positive effect of a higher interest rate
• (an increase in income if the project
• succeeds) is outweighed by the negative
• effect (the attraction of projects with a low
• probability of repayment.
• At the new interest rate there will remain
• risky projects with a low probability of
• repayment. Thus we are in a situation of
• credit rationing.
• In credit markets changes in price do not
• equalize demand and supply. Higher
• demand bids up the interest rate, but supply
• can remain unresponsive.

4
Asymmetric Information

• Screening
• Addresses adverse selection
• This is when banks use specialized
• information prior to lending to discriminate
• between good and bad borrowers.
• As part of the process of applying for a loan,
• you fill in a detailed application form.
• Banks can also obtain information on
• creditworthiness from credit rating
• companies.
• Banks also use the pattern of deposits and
• withdrawals to assess your credit risk.
• Individuals and businesses are monitored in
• this way.

5
Asymmetric Information

• Collateral as a Screening Mechanism
• Banks often require borrowers to pledge
• collateral. Collateral implies that the
• borrower will lose something of value in the
• event of default.
• We expect a negative relationship between
• collateral and the interest rate. Both are
• used to compensate for risk.
• Suppose borrower a is low risk and
• borrower b is high risk. Investor a will be
• willing to accept a greater increase in
• collateral for a given interest rate reduction
• compared to b.

6
Asymmetric Information

• Monitoring
• Addresses moral hazard
• To make sure funds are used for what the
• bank lent them for.
• Banks specialize in monitoring so can do it
• at low cost (see car dealer example on
• pg282 of handout).
• Venture capitalists Invest in risky new
• projects. Obtain an equity stake in the
• company. Monitor activities of management.

7
Asymmetric Information

• Signaling
• Low risk borrowers are negatively affected
• by the lack of information on the part of the
• lender. They are penalized with a higher
• interest rate.
• One way of addressing this problem is the
• use of credible signals to convey the quality
• of the project.
• Trustworthy signals are those that bear an
• immediate cost to the borrower. Their
• benefit is access to credit on less stringent
• conditions.
• In order to be effective a signal should be
• costly to all borrowers, but prohibitively
• costly to the high risk borrower.

8
Asymmetric Information

• Collateral as a Signaling Mechanism
• Borrowers send a signal about the quality of
• their project by pledging collateral.
• A borrower who is willing to give up
• personal wealth in the event of project
• failure is implicitly declaring that project
• quality is high.
• Sending this signal is costly. If project fails,
• the borrower loses the pledged assets.
• For riskier borrowers the signal is more
• costly because the likelihood that they will
• lose the pledged assets is higher.

9
Asymmetric Information

• Internal Funds as a Signaling Mechanism
• Similar to collateral. Borrower showing
• confidence in his project.
• Riskier borrowers will be less willing to
• invest their own money relative to low risk
• borrowers.
• Internal funds carry an opportunity cost to
• the borrower by investing his own money in
• the project he loses the return he would get
• from an alternative investment e.g. the stock
• market or a bank deposit.
• The bulk of investment in both developed
• and developing countries is done with
• internal funds.

10
Asymmetric Information

• Contractual Clauses as a Signaling
• Mechanism
• Credit agreements contain a series of
• clauses that protect the rights of the lender.
• The acceptance of these clauses is a
• positive signal to the bank and can result in
• a lower interest rate for the borrower.
• Negative clauses inhibit certain actions by
• the company. E.g. restrictions on the
• transfer of assets without prior authorization
• from the bank.
• Positive clauses state certain actions that
• the borrower must take. E.g. periodic
• provision of financial reports.

11
Asymmetric Information

• Reputation
• There are some real-world reasons that
• would prevent borrowers from behaving in
• an opportunistic way because of
• asymmetric information. One of these
• factors is reputation.
• Being in financial distress raises questions
• about the ability of a management team. It
• harms their reputation.
• Firms do not have once off projects. They
• will require financing for a series of projects
• over their lifetime. Need to maintain a good
• reputation with providers of credit.
• The threat of losing its credit line deters
• firms with a long-term view from taking