Professional Documents
Culture Documents
Spring 2014
Overview
Lecture 3
The information asymmetry
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Moreover, banks reduce the adverse selection problem by Moral hazard in debt contracts is lower than in equity
asking the borrower to provide collateral against the loan. contracts but still present. Debt contracts require borrowers to
Collateral is property promised to the lender if the borrower pay fixed amounts and let them keep any profit above this
defaults. Thus, amount. Consequently, borrowers have incentives to take
it reduces the losses of the lender in the event of a default. investments riskier than lenders would like.
Therefore, financial intermediaries solve the adverse
How to reduce/solve the problems arising from moral hazard in
selection problem, whereas the private production of
equity markets?
information and government regulation only reduce it. Several tools can be used:
The presence of adverse selection explains:
A. Monitoring
1. why bank loans are the most important source of funds raised B. Government regulation to increase information
externally, C. Financial intermediaries active in the equity market
2. why indirect finance is more important than direct finance. D. Debt contracts
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A. Stockholders can engage in the monitoring (auditing) of firms Monitoring is expensive in terms of money and time (a costly
activities to reduce moral hazard. Monitoring is needed: state verification). If you know that other stockholders are
paying to monitor the activities of the firm you hold stocks in,
to ensure that information asymmetry is not exploited by one you can free ride on the activities of the others.
party at the expenses of the other, As every stockholder can free ride on others, this reduces the
because the value of equity contracts cannot be certain when the amount of monitoring that would reduce the moral hazard
contract is made, (principalagent) problem. This is the same as with adverse
because the value of many financial contracts (i.e., future return selection and makes equity contracts less desirable.
on a stock) cannot be observed or verified at the moment of
purchase, and the post-contract behaviour of a counterparty B. Governments have incentives to reduce the moral hazard
determines the ultimate value of the contract, problem. Several measures are used: laws to force firms to
the long-term nature of many financial contracts implies that adhere to standard accounting principles (i.e., to make profit
information acquired before the contract is agreed may become verification easier); laws to impose penalties on people who
irrelevant at the maturity due to changes in conditions. commit the fraud of hiding/stealing profits.
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A. Investors are more likely to take on riskier investment projects
How to reduce/solve the moral hazard problems in debt markets? when using borrowed funds than when using their own funds.
Thus the moral hazard problem can be reduced by increasing
Although debt contracts reduce the amount of moral hazard in the stake of personal net worth (the difference between
comparison to equity contracts, they do not solve the problem. personal assets and liabilities).
Borrowers have incentives to take investments riskier than B. A restrictive covenant is a provision aimed at restricting the
lenders would like: borrowers get all the gains from a risky borrowers activity. There are four types of possible covenants:
investments if they succeed, but lenders lose most, if not all, 1. Those which discourage undesirable behaviour by the
of their loan, if borrowers fail. borrower (i.e. not to undertake risky investment projects).
The solution to the problems of moral hazard lies again in financial Examples:
intermediaries. However, other tools also can be used: to use the debt contract only to finance specific activities,
A. making debt contract incentivecompatible such as the purchase of a fixed asset;
(i.e., aligning the incentives of borrowers and lenders), to prohibit the firm from issuing new debt, or disposing
B. monitoring and enforcement of restrictive covenants. of its assets;
to restrict dividend payments if some ratios have not reached
a critical level;
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