Sound financial decisions require adequate andreliable financial information.

Asymmetric information refers to the inequalitiesin the quantity and quality of informationavailable across different locations within thefinancial system.

Asymmetric info leads to opportunism, wherebyinformed person benefits at expense of thosewith less info.

Lemons and Plums. A loan officer/ insuranceofficer cannot be sure without incurringsubstantial costs whether his or her potentialcustomer is a lemon (sour) or plum (sweet).

• Adverse Selection. immoral behavior that takesadvantage of asymmetric information before atransaction.

• An example of adverse selection is when peoplewho are willing to take high risk are more likelyto buy insurance, because the insurancecompany cannot effectively discriminate againstthem, usually due to lack of information aboutthe particular individual's risk but alsosometimes by force of law or other constraints.

• Moral Hazard. immoral behavior that takes advantage of asymmetric information after a transaction.

• An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it.

It is possible for lenders to do several things inresponse to prevent opportunism:

credit rationing screening monitoring

We also assumed that good quality borrowerspassively accept this situation. In reality, theseborrowers can use signaling to distinguish thequality of their project. Borrowers also have anincentive to build reputation.

Bank will charge same interest rate 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 this high interest rate 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 decreases the expected income of the bank, which leads them to desist from raising the interest rate.

Addresses adverse selection This is when banks use specialized

information prior to lending todiscriminate between good andbad borrowers.

As part of the process of applyingfor a loan, you fill in a detailedapplication form.

Banks can also obtain informationon creditworthiness from creditrating companies.

Banks also use the pattern ofdeposits and withdrawals toassess your credit risk. Individualsand businesses are monitored inthis way.

Banks often require borrowers to pledge collateral.Collateral implies that the borrower will lose something ofvalue in the event of default.

Suppose borrower a is low risk and borrower b is high risk.Investor a will be willing to accept a greater increase incollateral for a given interest rate reduction compared to b.

This tradeoff by borrowers allows banks to screen them byoffering different contracts.

Addresses moral hazard

To make sure funds are usedfor what the bank lent themfor.

Banks specialize inmonitoring so can do it atlow cost.

Low risk borrowers are negatively affectedby the lack of information on the part of thelender. They are penalized with a higherinterest rate.

One way of addressing this problem is theuse of credible signals to convey the qualityof the project.

In order to be effective a signal should becostly to all borrowers, but prohibitivelycostly to the high risk borrower.

3 signaling mechanisms are: collateral,internal funds and contractual clauses.

Borrowers send a signal about the quality of their project bypledging collateral.

A borrower who is willing to give up personal wealth in theevent of project failure is implicitly declaring that projectquality is high.

Sending this signal is costly. If project fails, the borrower losesthe pledged assets.

For riskier borrowers the signal is more costly because thelikelihood that they will lose the pledged assets is higher.

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.

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.

There are some real-world reasonsthat would prevent borrowersfrom behaving in an opportunisticway because of asymmetricinformation. One of these factorsis reputation.

Being in financial distress raisesquestions about the ability of amanagement team. It harms theirreputation.

The threat of losing its credit linedeters firms with a long-term viewfrom taking excessive risk.