Asymmetric information in financial markets can lead to adverse selection and moral hazard problems. Adverse selection occurs before a transaction when one party has more information than the other. Moral hazard occurs after a transaction when the party with more information takes on more risk due to being insured. To address these issues, lenders can screen borrowers through application processes, credit checks, and monitoring loan usage. Borrowers can also signal their quality through collateral, investing their own funds, and accepting contractual obligations. Maintaining a good reputation further deters opportunistic behavior from borrowers.

2.  Sound financial decisions require adequate and
reliable financial information.
 Asymmetric information refers to the inequalities
in the quantity and quality of information
available across different locations within the
financial system.
 Asymmetric info leads to opportunism, whereby
informed person benefits at expense of those
with less info.

3.  Lemons and Plums. A loan officer/ insurance
officer cannot be sure without incurring
substantial costs whether his or her potential
customer is a lemon (sour) or plum (sweet).

4. • Adverse Selection. immoral behavior that takes
advantage of asymmetric information before a
transaction.
• An example of adverse selection is when people
who are willing to take high risk are more likely
to buy insurance, because the insurance
company cannot effectively discriminate against
them, usually due to lack of information about
the particular individual's risk but also
sometimes by force of law or other constraints.

5. • 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.

6. It is possible for lenders to do several things in
response to prevent opportunism:
 credit rationing
 screening
 monitoring
We also assumed that good quality borrowers
passively accept this situation. In reality, these
borrowers can use signaling to distinguish the
quality of their project. Borrowers also have an
incentive to build reputation.

7.  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.

8. Addresses adverse selection
 This is when banks use specialized
information prior to lending to
discriminate between good and
bad borrowers.
 As part of the process of applying
for a loan, you fill in a detailed
application form.
 Banks can also obtain information
on creditworthiness from credit
rating companies.
 Banks also use the pattern of
deposits and withdrawals to
assess your credit risk. Individuals
and businesses are monitored in
this way.

9.  Banks often require borrowers to pledge collateral.
Collateral implies that the borrower will lose something of
value 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 in
collateral for a given interest rate reduction compared to b.
 This tradeoff by borrowers allows banks to screen them by
offering different contracts.

10. Addresses moral hazard
 To make sure funds are used
for what the bank lent them
for.
 Banks specialize in
monitoring so can do it at
low cost.

11.  Low risk borrowers are negatively affected
by the lack of information on the part of the
lender. They are penalized with a higher
interest rate.
 One way of addressing this problem is the
use of credible signals to convey the quality
of the project.
 In order to be effective a signal should be
costly to all borrowers, but prohibitively
costly to the high risk borrower.
 3 signaling mechanisms are: collateral,
internal funds and contractual clauses.

12.  Borrowers send a signal about the quality of their project by
pledging collateral.
 A borrower who is willing to give up personal wealth in the
event of project failure is implicitly declaring that project
quality is high.
 Sending this signal is costly. If project fails, the borrower loses
the pledged assets.
 For riskier borrowers the signal is more costly because the
likelihood that they will lose the pledged assets is higher.

13.  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.

14.  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.

15.  There are some real-world reasons
that would prevent borrowers
from behaving in an opportunistic
way because of asymmetric
information. One of these factors
is reputation.
 Being in financial distress raises
questions about the ability of a
management team. It harms their
reputation.
 The threat of losing its credit line
deters firms with a long-term view
from taking excessive risk.