1. Asymmetric Information ADVERSE SELECTION AND MORAL HAZARD

2. WHAT IS ASYMMETRIC INFORMATION? In financial markets, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, a borrower who takes out a loan has better information about the potential returns and risks associated with investment projects than the lender does. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into and after.

3. ACTIVITY David is a Banker. He has two aunts, named Louis and Sheila. Aunt Louise saves money and only borrows money when she needs it. Aunt Sheila likes to gamble and who has a get-rich plan, to become a millionaire, if she can just borrow $1000. Most of the time these plans or schemes never pay off. Which of these aunts is likely to ask David for a loan?

4. ADVERSE SELECTION Aunt Sheila, of course, because she keeps asking but David does not want to give her a loan she might not be able to pay back. If you know both of these aunts well – if your information was NOT asymmetric – you would not have a problem. You would know Aunt Sheila is a bad risk so you wouldn’t lend to her. If you didn’t know them very well you would most likely lend to Aunt Sheila cause she keeps asking you for the loan. Because of the possibility of adverse selection, you might decide not lend to either one of them even though Aunt Louise is a good credit risk.

5. MORAL HAZARD Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard is the risk (hazard) that the borrower might engage in activities that are bad (immoral) from the lender’s point of view because the borrower might not pay backthe loan. Because of this, lenders might not want to make the loan. As an example, Clay makes a loan to Uncle Melvin for $1000 to buy a computer. After Clay makes the loan Uncle Melvin uses the $1000 to gamble on a horse race. If his horse wins he makes $20,000 and lives very well. But if he loses, which is more likely, Clay does not get paid back and all Uncle Melvin loses is his reputation as a good uncle.

6. MORAL HAZARD If Clay knew what his Uncle would do he would keep him from going to the race track and would not be able to increase moral hazard. However, Clay does not know what his Uncle does because information is asymmetric. If Clay knew his uncle well the risk of moral hazard might discourage Clay from making the loan.

7. THE IMPORTANT ROLE OF FINANCIAL INTERMEDIARIES The problems created by adverse selection and moral hazard cause a problem to well-functioning markets. Financial Intermediaries can help with this problem. Larger financial intermediaries are better equipped to determine bad risks from good risks thus reducing the losses due to adverse selection. And they can also due a better job in monitoring parties they lend to thus reducing the losses due to moral hazard. Financial Intermediaries play an important role in the economy because they provide liquidity services, promote risk sharing, and solve information problems helping savers and borrowers. We will learn more about financial intermediaries later.