Adverse/moral Flashcards
whats adverse selection?
Adverse selection arises when AI occurs before the transaction (e.g. a car sales rep might know more about the true condition of a car than a buyer)
whats moral hazard?
Moral hazard arises when AI occurs after the transaction (e.g. an employee might know more about his effort than his employer)
adverse selection in equity market
A company’s stock price depends on the market’s expectation of future profits
If good companies cannot credibly signal to the market their own profitability, then “bad” companies can post exaggerated forecasts (Enron, Parmalat, Tesco)
The market will become wary of the profitability of all stocks
The good companies will not receive share prices reflecting their own profitability and might even not sell shares
adverse selection in debt market
Lenders typically charge a higher interest rate (or offer lower prices if buying bonds) if there is a higher probability of borrower default
If borrowers’ creditworthiness cannot be differentiated, the lender will charge an interest rate which covers the average likelihood of default
Good borrowers might not want to borrow at this interest rate
The lender might then stop lending at all.
adverse selection solutions (4)
Private production and sale of information about profitability and/or creditworthiness but
Credibility of the information requires independent verification which can create an additional problem (conflict of interest)
The free rider problem discourages individual effort to verify. If I pay for information and act on it, then others copy me for free.
Government regulation to increase information
FCA in the UK oversees disclosure of information by private financial companies and can audit them (fact 5)
Collateral and net worth
Collateral is an item of value which is used to secure a loan.
This can protect creditors in the event of default or bankruptcy (fact 7)
Financial intermediation
Financial institutions are better able to verify the creditworthiness of a borrower.
Moral hazard in equity markets
Shareholders of publicly traded firms are the principals
Managers are their agents
Managers are supposed to maximise firm profits on behalf of owners, but separation of ownership and control means
Managers might pursue personal objectives (commit fraud, network for personal gain)
Even when not pursuing purely private benefit, managers can take excessive risks in maximising short-term profits on behalf of shareholders
Golden handshakes and a bonus culture encourage this
Remuneration panels are made up of board members of other companies
moral hazard in debt market
Debt contracts create a moral hazard problem of their own
Limited liability means that if the borrower cannot repay the agreed amount, the penalty is usually restricted to bankruptcy and denial of future credit
Borrowers therefore have an incentive to take on projects that are riskier than the lenders would like
Once again, incentive-incompatibility arises
solutions to moral hazard in equity (4)
Monitoring of managers behaviour
Free-rider problem affects shareholders. Some might be willing to pay for monitoring, others free-ride.
Government regulation and legal oversight
Laws against mismanagement and corruption but consider the cases of Enron, Tesco.
Use debt rather than equity to finance business
Debt contracts limit the agent’s repayment obligation to a fixed amount which leaves the agent free to retain surplus profits – giving incentive to maximise firm profits (however, moral hazard can still arise, see next). Monitoring only takes place when a payment is not made.
-With equity, managers must be monitored all the time.
Financial Intermediation
FI can monitor actions more effectively than the general public
solutions to moral hazard in debt market
Require borrowers to prove their net worth and ask for collateral
Helps restore incentive compatibility
Restrictive Covenants
Restrictions on where the funds can be kept and how they can be withdrawn
Requirements to insure against losses
Upkeep of collateral
Provide information through periodic audits
Financial Intermediation
FI can enforce covenants and monitor use of funds better than the general public
