Money banking and the financial system 1e by hubbard and OBrien chapter 09

R. GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

9

Transactions Costs, Asymmetric
Information, and the Structure
of the Financial System

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
9.1

Analyze the obstacles to matching savers and borrowers

9.2

Explain the problems that adverse selection and moral
hazard pose for the financial system

9.3

Use economic analysis to explain the structure of the U.S.
financial system

© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

9

Transactions Costs, Asymmetric
Information, and the Structure
of the Financial System

BUYER BEWARE IN FINANCIAL MARKETS!
•The fraud case filed by the SEC against Goldman Sachs in 2010 highlights the
important problem of asymmetric information.
•In this case, asymmetric information means that Goldman Sachs, as the seller
of the Abacus collateralized debt obligations (CDOs), clearly had more
information than did the buyers.
•An Inside Look at Policy on page 272 discusses the role of bond rating
agencies in the Abacus case.

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Key Issue and Question

Here are the key issue and key question for this chapter:
Issue: During the 2007–2009 financial crisis, many economists noted
that problems in the market for bonds had the potential to deepen the
economic recession and slow the recovery because firms rely more
heavily on bonds than on stocks as a source of external finance.
Question: Why do firms rely more on bonds than on stocks as a
source of external finance?

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9.1 Learning Objective
Analyze the obstacles to matching savers and borrowers.

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The Problems Facing Small Investors

Transactions costs The cost of a trade or exchange; for example, the
brokerage commission charged for buying or selling a financial asset.

Information costs The costs that savers incur to determine the
creditworthiness of borrowers and to monitor how they use the funds acquired.

Obstacles to Matching Savers and Borrowers

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How Financial Intermediaries Reduce Transactions Costs

• Small investors and small- to medium-sized firms turn to financial
intermediaries to meet their financial needs.
• Transaction costs can be reduced by taking advantage of economies of
scale.
Economies of scale The reduction in average cost that results from an
increase in the volume of a good or service produced.

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9.2 Learning Objective
Explain the problems that adverse selection and moral hazard pose for the
financial system.

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Asymmetric information The situation in which one party to an economic

transaction has better information than does the other party.
Economists distinguish between two problems arising from asymmetric
information:
Adverse selection The problem investors experience in distinguishing low-risk
borrowers from high-risk borrowers before making an investment; in insurance,
the problem that those most likely to buy insurance are also most likely to file
claims.
Moral hazard The risk that people will take actions after they have entered into a
transaction that will make the other party worse off; in financial markets, the
problem investors experience in verifying that borrowers are using their funds as
intended.

The Problems of Adverse Selection and Moral Hazard
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Adverse Selection

• The seller of a used car has more information on the true condition of a car
than does a potential buyer.
• The prices that potential buyers are willing to pay reflect the buyers’ lack of
complete information on the true condition of the car.

•Because of asymmetric information, the used car market adversely selects the
cars that will be offered for sale.

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“Lemons Problems” in Financial Markets

• Consider a stock market example. If 90% of the firms in the market are good
firms and 10% are lemons, and the good firm’s share of stock is $50, then:

• So, you would be willing to pay $45.50 for a share of stock, but to a good
firm this is below the fundamental value of the stock.

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“Lemons Problems” in Financial Markets

• Adverse selection is present in the bond market as well.
• As interest rates on bonds rise, a larger fraction of the firms willing to pay the
high interest rates are lemon firms.

Credit rationing The restriction of credit by lenders such that borrowers
cannot obtain the funds they desire at the given interest rate.

• When lenders ration credit, firms—whether they are good firms or lemons—
may have difficulty borrowing funds.

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Attempts to Reduce Adverse Selection
• Disclosure of information to the SEC reduces the information costs of
adverse selection, but it doesn’t eliminate them for three reasons:
• Some good firms may be too young to have much information for potential
investors to evaluate.
• Lemon firms will try to present the information in the best possible light so
that investors will overvalue their securities.
• There can be legitimate differences of opinion about how to report some
items on income statements and balance sheets.

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Attempts to Reduce Adverse Selection

• Private firms have collected and sold information about firms to investors to
reduce adverse selection costs.
• Information is collected from sources such as firms’ income statements,
balance sheets, and investment decisions.
• Individuals who gain access to the information without paying for it are free
riders.

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The Use of Collateral and Net Worth to Reduce Adverse Selection Problems

Collateral Assets that a borrower pledges to a lender that the lender may seize
if the borrower defaults on the loan.

Net worth The difference between the value of a firm’s assets and the value of
its liabilities.

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How Financial Intermediaries Reduce Adverse Selection Problems

Relationship banking The ability of banks to assess credit risks on the basis
of private information about borrowers.

The information advantage banks gain from relationship banking allows them to
reduce the costs of adverse selection and explains the key role banks play in
providing external financing to firms.

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Making the Connection

Has Securitization Increased Adverse Selection Problems in the
Financial System?
• In the episode involving Goldman Sachs’s Abacus CDOs, one of the buyers,
IKB, expected Abacus to be a good CDO. According to the SEC, however, it
was designed to be a lemon.
• The Abacus CDO resulted from the process of securitization, which involves
bundling loans, such as mortgages, into securities that can be sold in
financial markets.
• The increase in securitization may have led to an increase in adverse
selection. Securitization and the originate-to-distribute business model may
reduce banks’ incentive to distinguish between good borrowers and lemon
borrowers.

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Solved Problem

9.2

Why Do Banks Ration Credit?
During the spring of 2010, an article in the Economist magazine claimed
that small businesses are not getting access to credit.
a. Why would banks be unwilling to make loans to small businesses?
If the banks believe some of the loans are risky, why wouldn’t they just
charge a higher interest rate to compensate for the risk?
b. Does it matter that the period involved here was shortly after the end of
a deep recession?

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Solved Problem

9.2

Why Do Banks Ration Credit?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by explaining how raising interest rates on loans can
increase adverse selection problems for banks.
High interest rates may attract less creditworthy borrowers. A small business that is close
to declaring bankruptcy may be less concerned about having to pay a high interest rate
than would a borrower in better financial health.
Step 3 Answer part (b) by discussing whether it mattered that the period involved
was near the end of a deep recession.

During a recession, the financial health of households and firms will deteriorate, and the
number of lemon borrowers rises relative to the number of good borrowers. So many
banks engaged in credit rationing by limiting the number of loans they offered rather than
increasing interest rates.

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Moral Hazard
• Moral hazard arises because of asymmetric information: The borrower
knows more than the lender does about how the borrowed funds will actually
be used.
Moral Hazard in the Stock Market
• The organization of large, publicly traded corporations results in a separation
of ownership from control.
Principal–agent problem The moral hazard problem of managers (the
agents) pursuing their own interests rather than those of shareholders (the
principals).

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Moral Hazard in the Stock Market
• Managers have an incentive to underreport profits so that they can reduce

dividends and retain the use of the funds.
• To reduce this problem, the SEC requires managers to issue financial
statements.
• Boards of directors meet infrequently and may not be independent of top
managers.
• Some boards of directors use incentive contracts to align the goals of
managers with the goals of shareholders.
• Compensation tied to the firm’s profits, however, may lead managers to
undertake risky investments.

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Moral Hazard in the Bond Market

• There is less moral hazard in the bond market than in the stock market.
• To reduce moral hazard in bond markets, investors insert restrictive
covenants into bond contracts.

Restrictive covenant A clause in a bond contract that places limits on the
uses of funds that a borrower receives.

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How Financial Intermediaries Reduce Moral Hazard Problems
• Financial intermediaries have evolved to fill the gap left by the
ban on banks making equity investments in nonfinancial firms.

Venture capital firm A firm that raises equity capital from investors to invest
in start-up firms.

Private equity firm (or corporate restructuring firm) A firm that raises
equity capital to acquire shares in other firms to reduce free-rider and moral
hazard problems.
• A market for corporate control provides a means to remove top management
that is failing to carry out the wishes of shareholders.

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Making the Connection

Why So Many Ponzi Schemes?
• Ponzi schemes derive their name from Charles Ponzi, an Italian
immigrant who lived in Boston in the 1920s.
• Ponzi schemes are an extreme form of moral hazard.
• During the financial crisis of 2007–2009, the most spectacular one was
a Ponzi scheme run by Bernard Madoff.
• Investors were lured by Madoff because, not only were many legitimate
investments earning high returns, but the ever increasing complexity of

financial securities made the claims of Ponzi schemes seem more
plausible.

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9.3 Learning Objective
Use economic analysis to explain the structure of the U.S. financial system.

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