Obstacles to Matching Savers and Borrowers: Adverse Selection and Moral Hazard

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: Analyze the obstacles to matching savers and borrowers. 9.1 Explain the problems that adverse selection and moral hazard pose for the financial system. 9.2 Use economic analysis to explain the structure of the U.S. financial system. 9.3

3. Should You Crowd-Fund Your Startup? • Recently, crowd-funding has become a new way to fund startups through raising small amounts of money from large numbers of people. • Crowd-funding will likely help entrepreneurs by providing a new source of financing, but small investors face asymmetric information – one party to an economic transaction has more information than another party. • The asymmetric information problem occurs when the startups are likely to know much more about how likely they are to be successful than are small investors.

4. Key Issue and Question Here are the key issue and key question for this chapter: Issue: Following the financial crisis, many firms complained that they were having difficulty borrowing funds to expand their operations. Question: Why do firms rely more on bonds than on stocks as a source of external finance?

5. 9.1 Learning Objective Analyze the obstacles to matching savers and borrowers.

6. Obstacles to Matching Savers and Borrowers Obstacles to Matching Savers and Borrowers • The financial system’s role in bringing savers and borrowers together can be complex. Why? • Investors face various costs: The Problems Facing Small Investors Transactions costs are the costs of a trade or exchange, e.g., the brokerage commission charged for buying or selling a financial asset. Information costs are the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired.

7. 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 is the reduction in average cost that results from an increase in the volume of a good or service produced. Obstacles to Matching Savers and Borrowers

8. 9.2 Learning Objective Explain the problems that adverse selection and moral hazard pose for the financial system.

9. The Problems of Adverse Selection and Moral Hazard Asymmetric information is the situation in which one party to an economic transaction has better information than does the other party. Asymmetric information leads to two major problems in financial markets: • Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment. • Moral hazard is the risk that people will take actions after they have entered into a transaction that will make the other party worse off. The Problems of Adverse Selection and Moral Hazard

10. 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. The Problems of Adverse Selection and Moral Hazard

11. “Lemons Problems” in Financial Markets • Example: If 90% of the firms in the stock 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. The Problems of Adverse Selection and Moral Hazard

12. “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 is the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. • When lenders ration credit, all firms (good firms or lemons) may have difficulty borrowing funds. The Problems of Adverse Selection and Moral Hazard

13. 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. The Problems of Adverse Selection and Moral Hazard

14. 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. The Problems of Adverse Selection and Moral Hazard

15. The Use of Collateral and Net Worth to Reduce Adverse Selection Problems • To deal with firms’ information advantage, lenders often require borrowers to have collateral and high net worth. Collateralincludes assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan. Net worth is the difference between the value of a firm’s assets and the value of its liabilities. The Problems of Adverse Selection and Moral Hazard

16. How Financial Intermediaries Reduce Adverse Selection Problems Banks and other financial intermediaries specialize in gathering information about borrowers’ default risk. Relationship bankingreduces the costs of adverse selection and explains the key role banks play in providing external financing to firms. Relationship banking is the ability of banks to assess credit risks on the basis of private information about borrowers. The Problems of Adverse Selection and Moral Hazard

17. Making the Connection Has Securitization Increased Adverse Selection Problems in the Financial System? • Securitization 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 by changing banks’ focus of relationship banking to the originate-to-distribute business model—banks sell loans to others rather than holding them to maturity. • Securitization and the originate-to-distributemodel increased adverse selection problems by reducing banks’ incentive to distinguish between good borrowers and lemon borrowers. The Problems of Adverse Selection and Moral Hazard

18. Solved Problem 9.2 Why Do Banks Ration Credit to Small Businesses? 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? The Problems of Adverse Selection and Moral Hazard

19. Solved Problem 9.2 Why Do Banks Ration Credit? Solving the Problem Step 1Review the chapter material. Step 2Answer 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 3Answer part (b) by discussing whether it mattered that the period involved was near the end of a deep recession. During a recession, the number of lemon borrowers rose as the financial health of households and firms deteriorates. So many banks engaged in credit rationing by limiting the number of loans they offered rather than increasing interest rates. The Problems of Adverse Selection and Moral Hazard

20. Moral Hazard • Moral hazard is an outcome of asymmetric information. Moral Hazard in the Stock Market • The organization of large, publicly traded corporations results in a separation of ownership from control. • Firms are owned by shareholders but run by top management (CEO, CFO, COO, etc.) The principal–agent problem is the moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals). The Problems of Adverse Selection and Moral Hazard

21. 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. The Problems of Adverse Selection and Moral Hazard

22. 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 is a clause in a bond contract that places limits on the uses of funds that a borrower receives. The Problems of Adverse Selection and Moral Hazard

23. 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. A venture capital firm raises equity capital from investors to invest in start-up firms. A private equity firm (or corporate restructuring firm) 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. The Problems of Adverse Selection and Moral Hazard

24. In Your Interest Making the Connection Is It Safe to Invest Through Crowd-funding? • Does crowd-funding overcome the problems of transaction costs and asymmetric information? • Crowd-funding sites act as financial intermediaries that reduce transaction costs for investors. • There is no clear evidence that crowd-funding sites reduce information asymmetries. • Crowd-funding sites do not invest in the startups themselves and so do not reduce the principal-agent problem. The Problems of Adverse Selection and Moral Hazard

25. 9.3 Learning Objective Use economic analysis to explain the structure of the U.S. financial system.

26. Conclusions about the Structure of the U.S. Financial System • Three key features of the financial system: • 1. Loans from financial intermediaries are the most important external source of funds for small- to medium-sized firms. • Smaller firms cannot borrow directly from savers because transactions costs are too high. • They cannot sell bonds or stocks because of the adverse selection and moral hazard problems that arise from asymmetric information. Conclusions about the Structure of the U.S. Financial System

27. Figure 9.1 Sources of External Funds to Small- to Medium-Sized Firms Small- and medium-sized businesses rely on loans and trade credit as their major sources of external finance. Conclusions about the Structure of the U.S. Financial System

28. Three key features of the financial system: • 2. The stock market is a less important source of external funds to corporations than is the bond market. • Most of the trading on the stock market involves existing shares, not new shares of stock. • In recent years, corporations have actually bought back from investors more stock than they have issued. • Moral hazard is less of a problem with debt contracts than with equity contracts. Conclusions about the Structure of the U.S. Financial System

29. Figure 9.2 External Sources of Funds to Corporations Corporations rely on stocks and bonds as major sources of external funds. Conclusions about the Structure of the U.S. Financial System

30. Three key features of the financial system: • 3. Debt contracts usually require collateral or restrictive covenants. • Large household loans use the good being purchased as collateral. • Many corporate bonds also specify collateral. • To reduce moral hazard, both loans and bonds typically contain restrictive covenants. Conclusions about the Structure of the U.S. Financial System

31. By reducing transactions and information costs, financial intermediaries can offer higher interest rates for savers and lower interest rates for borrowers. • Commercial banks, investment banks, and other financial firms are continually searching for ways to earn a profit by expediting the flow of funds from savers to borrowers. Conclusions about the Structure of the U.S. Financial System

32. Making the Connection In Your Interest Corporations Are Issuing More Bonds; Should You Buy Them? • As interest rates on U.S. Treasury bonds declined to record low levels, demand for corporate bonds increased, driving down their yields as well. • The declining yields on corporate bonds resulted in a very small default risk premium over the Treasury bonds while the corporations’ default risk did not change. • The record low yields on long-term corporate bonds were also subject to significant interest-rate risk in the future. Conclusions about the Structure of the U.S. Financial System

33. Making the Connection In Your Interest Corporations Are Issuing More Bonds; Should You Buy Them? The figure shows an index of yields on investment grade corporate bonds prepared by Bank of America Merrill Lynch. Conclusions about the Structure of the U.S. Financial System

34. Answering the Key Question At the beginning of this chapter, we asked the question: “Why do firms rely more on bonds than on stocks as a source of external finance?” Both the bond and stock markets are subject to problems of moral hazard as firms may not use investment funds for their intended purpose. The problem of moral hazard is less serious in the case of bonds than stocks, so investors are more willing to buy bonds than stock.