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Understanding Asymmetric Information and Its Impact on Indirect Finance, Study notes of Finance

The concepts of asymmetric information, specifically moral hazard and adverse selection, and their significance in indirect finance. Indirect finance, primarily comprised of debt contracts, is contrasted with direct finance, which can be debt or equity. The document highlights the importance of indirect finance due to informational asymmetries and transaction costs. Using the 'lemons' market example, the document illustrates how intermediaries help resolve informational asymmetry problems, allowing for the efficient allocation of resources. The document also discusses the role of collateral in mitigating moral hazard and adverse selection, and its potential impact on economic development and monetary policy.

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Financial Structure
ECON 40364: Monetary Theory & Policy
Eric Sims
University of Notre Dame
Fall 2017
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Financial Structure

ECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Fall 2017

Readings

I (^) Text: I (^) Mishkin Ch. 8

Sources of External Funding

Why is Financial Intermediation so Important?

I (^) Chiefly for two reasons:

  1. Transactions costs
  2. Informational asymmetries I (^) Transaction costs: cheaper to finance projects on a large scale, which means it is efficient to pool lots of small resources and have an intermediary invest it rather than each small saver doing the investment directly I (^) We will focus mostly on informational asymmetries

Adverse Selection

I (^) The buyer of a product (e.g. a car, a stock) doesn’t know the true “type” of the seller of the product (e.g. good or bad, risky or safe) I (^) Only knows the average type of the seller I (^) Hence, buyer will only be willing to pay the average valuation, which is more than the bad type but less than the good type I (^) This tends to drive sellers who are a good type away and attract sellers who are a bad type I (^) But then buyer knows this, and entire market can fall apart I (^) Easy to understand through an example – “lemons” in the market for used cars

Lemons Example

I (^) After Ackerlof (1970) I (^) Suppose there are two types of used cars: lemons (bad) and peaches (good) I (^) Sellers know whether they have a lemon or a peach, but buyers only know the fraction of lemons and peaches out there I (^) Suppose each type has the following valuations:

Valuation Peach Lemon Buyer $20,000 $15, Seller $18,000 $13,

I (^) Without informational asymmetry, both kinds of cars would be sold – buyers value each type more than sellers

Alternative Example

I (^) Suppose valuations are now:

Valuation Peach Lemon Buyer $20,000 $12, Seller $18,000 $13,

I (^) Buyer values lemons less than seller. With symmetric information, only peaches would be sold I (^) Suppose probabilities of peaches and lemons are same as above. Average valuation from buyer’s perspective is now is $16, I (^) Since this is less than seller’s valuation, peaches will not be sold I (^) But then buyer knows she can only buy a lemon, but doesn’t want a lemon I (^) End result: market breaks down and no cars are sold

Dealing with the Lemons Problem in the Used Car Market

I (^) Most used car deals are through dealerships, not person-to-person transactions I (^) Sort of easy to understand why I (^) The dealership serves as an intermediary and helps solve the informational problem I (^) The dealership gets good at determining lemons vs. peaches, and can offer warranties to buyers to ensure that the buyer isn’t dealing with a lemon I (^) Hence, intermediaries who specialize in resolving informational asymmetry problem naturally arise in the car market I (^) Similarly in financial markets

Example: Risky and Safe Firms

I (^) There are two types of firms who need 1 unit to undertake a project I (^) Project succeeds or fails with a given probability I (^) Firm types and payoffs are:

Safe Firm Risky Firm Payoff in “good” state 4 8 Payoff in “bad” state 0 0 Prob. of “good” state (^12 )

I (^) Expected return the same for both firms, but lender would prefer to loan to safe firm since it is less risky

One Kind of Debt Contract

I (^) Suppose there is only one kind of debt contract: bank lends firm one unit, firm promises to repay R (gross) units if project succeeds, 0 otherwise (it can’t pay back in event low state occurs) I (^) Borrower only has to pay back in event good state materializes. Borrower expected payoffs are:

Safe =

( 4 − R)

Risky =

( 8 − R)

I (^) Borrower will only take a loan if his/her expected payout is non-negative I (^) Hence, if R > 4, safe firms won’t take loan I (^) If R > 8, neither firm will take loan

Lender Problem

I (^) Lender’s opportunity cost of funds is 1 – if it doesn’t earn at least 1 in expectation, it won’t make a loan I (^) If lender charges R > 8, it will make no loan and hence “earns” 1 (i.e. keeps its money) I (^) If it charges R ≤ 4, both types of firms will take the loan I (^) If it charges R > 4, only the risky type firm will take the loan I (^) Suppose fraction q of firms are risky, and 1 − q are safe. Lender expected payout:

R ≤ 4 E (payout) = ( 1 − q)

R

Safe

+q

R

Risky

4 < R ≤ 8 E (payout) =

R

Pooling vs. Separating Equilibrium

I (^) A pooling equilibrium is a value of R (i.e. a debt contract) in which both types of firms take a loan I (^) A separating equilibrium is a value of R in which only one type of firm gets a loan, and the other type of firm chooses to sit out I (^) Let’s first look for a pooling equilibrium to see if one exists (i.e. focus on R ≤ 4). Can write lender’s expected payout as:

E (payout) =

q

R

I (^) Suppose q = 0.9, so most firms are risky. Expected payout must be at least 1. Solve for the “break-even” R:

R ≥ 3.

I (^) So 3.6364 ≤ R ≤ 4 would be a pooling equilibrium, whereas 4 < R ≤ 8 would be a separating equilibrium.

Equilibrium

I (^) A pooling equilibrium exists for 3.64 ≤ R ≤ 4 I (^) A separating equilibrium exists for 4 < R ≤ 8 I (^) Don’t know which equilibria we’ll end up at I (^) But if it’s separating equilibrium, safe firm doesn’t get a loan, which is a bad outcome relative to symmetric information case I (^) If it’s pooling equilibrium, interest rate charged to safe firm may be “too high” relative to symmetric information case and interest rate charged to risky firm is “too low” I (^) This will tend to over-attract risky firms and deter safe firms from getting loans

Adverse Selection and Collateral

I (^) Collateral is an important feature of many debt contracts I (^) A firm receiving funds pledges some collateral that can be seized in the event that the firm defaults I (^) Banks can offer different kinds of contracts – some require posting more collateral and some require less collateral but charge higher interest rates I (^) This offering different kinds of contracts can get firms to voluntarily reveal their type