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

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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