In financial market, one party often does not know enough about the other party to make accurate decisions. This inequality is called asymmetric information. For example, managers of a corporation know whether they are honest or have better information about how well their business is doing than the stockholders do. Lack of information creates problems in the financial system on two fronts: before the transaction is entered into and after. Adverse selection is an asymmetric information problem that occurs before the transaction occurs: Potential bad credit risks are the ones who most actively seek out loans.
Thus the parties who are the most likely to produce an undesirable outcome are the ones most likely to want to engage in the transaction. For example, big risk takers or outright crooks might be the most eager to take out a loan because they know that they are unlikely to pay it back. Because adverse selection increase the chances that a loan might be made to a bad credit risk, lenders may decide not to make any loans even though there are good credit risks in the marketplace. Moreover, adverse selection is one of two main sorts of market failure often associated with insurance.
Moral hazard can be present in almost any situation involving two parties coming into agreement with one another. In a contract, each party may have the opportunity to gain from acting contrary to the principles implied by the agreement. In financial market, moral hazard arises after the transaction occurs: the lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back.
For example, once borrowers have obtained a loan, they may take on big risk (which have possible high returns but also run a greater risk of default) because they are playing with someone else’s money. Even though moral hazard can be somewhat reduced by placing responsibilities on both parties of a contract, lenders may decide that they would rather not make a loan because moral hazard lowers the probability that the loan will be repaid. The presence of asymmetric information in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of those markets.
Economic analysis of the effects of adverse selection and moral hazard can help us understand financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises occur when there is a disruption in the financial system that causes such a sharp increase in adverse selection and moral hazard problems in financial markets that the markets are unable to channel funds efficiently from savers to people with productive investment opportunities.
as a result of this inability of financial markets to function efficiently, economic activity contracts sharply. To understand why banking and financial crises occur and more specifically how they lead to contractions in economic activity, we need to examine the factors that cause them. It should be noticed that all the factors are related with asymmetric information. For example, we suppose that there is asymmetric information between banks and firms such that banks are not able to identify which firm is of good quality and which is of bad quality.
These make banks less willing to lend, which leads to a decline in lending, investment, and aggregate activity. According to Mishkin (2001), four categories of factors can trigger financial crises: increase in interest rates, increases in uncertainty, asset market effects on balance sheets, and problems in the banking sector. 1. Increase in interest rates: individuals and firms with the riskiest investment projects are exactly those who are willing to pay the highest interest rates.
If market interest rates are driven up sufficiently because of increased demand for credit or because of a decline in the money supply, good credit risks are less likely to want to borrow while bad credit risks are still willing to borrow. Because of the resulting increase in adverse selection, lenders will no longer want to make loans. The substantial decline in lending will lead to a substantial decline in investment and aggregate economic activity.
Although we have seen that increase in interest rates have a direct effect on increasing adverse selection problems, increases in interest rates also play a role in promoting a financial crisis through their effect on both firms’ and households’ balance sheets. As a result, adverse selection and moral hazard problems become more severe for potential lenders to these firms and households, leading to a decline in lending and economic activity. There is thus an additional reason why sharp increases in interest rates can be an important factor leading to financial crises.
Increases in uncertainty: a dramatic increase in uncertainty in financial markets, due perhaps to the failure of a prominent financial or nonfinancial institution, a recession, or a stock market crash, makes it harder for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate activity.
Asset market effects on balance sheets: the state of firm’s balance sheets has important implications for the severity of asymmetric information problems in the financial system. A sharp decline in the stock market is one factor that can cause a serious deterioration in firms’ balance sheets that can increase adverse selection and moral hazard problems in financial markets and provoke a financial crisis.
Problems in the banking sector: banks play a major role in financial markets because they are well positioned to engage in information-producing activities that facilitate productive investment for the economy. The state of banks’ balance sheets has an important effect on bank lending. If banks suffer a deterioration in their balance sheets and so have a substantial contraction in their capital, they will have fewer resources to lend, and bank lending will decline.
The decrease in bank lending during a financial crisis also decreases the supply of funds to borrowers, which leads to higher interest rates. The outcome of bank panic is an increase in adverse selection and moral hazard problems in credit markets: there problems produce an even sharper decline in lending to facilitate productive investments that lead to an even more severe contraction in economic activity. On balance, financial crises are major disruptions in financial markets. They are caused and exacerbated by asymmetric information, which leads to two problems: adverse selection and moral hazard.