AN ECONOMIC ANALYSIS OF FINANCIAL SYSTEM:

IMPACT OF TRANSACTION AND INFORMATION COSTS

Prepared by -
Dr. Toufic A. Choudhury
An important feature of financial markets is that they have substantial transaction and
information cost. How do these costs affect the financial markets? How do the financial
markets try to mitigate or address those costs and problems? In addition, the following
analysis will help us to understand why indirect mode of finance (banking market) is in a
better position (as compared to direct mode of finance/security markets) to address the
problems related to transaction and information costs.

Transaction Costs
Financial transactions (between SEU and DEU) are not costless. High transaction costs are
therefore, a major problem in financial markets, specially in securities markets. Suppose, you
are a retail or small investor and you have only Tk. 10000 to invest. With this small amount
of fund, you can purchase only a small number of undiversified shares and on the other hand,
you will have to bear a significant brokerage fee (as compared to your volume of investment).
In the bond market, the problem is more acute as the smallest denomination of bond market is
sometimes very high. For all these reasons, small investors or SEUs do not have easy access
to securities markets. Fortunately, financial intermediaries (indirect mode of finance) have
evolved to reduce transaction costs and allow small savers and borrowers to benefit from
their existence. Therefore, the question is, how come the financial intermediaries can address
the problems related to high transaction cost and ensure the access of small savers and
entrepreneurs.

The financial intermediaries can reduce the transaction costs because of two reasons:
Economies of Scale and Expertise. The financial institutions can bundle the funds of many
SEU (mainly small) together so that they can take advantage of economies of scale, resulting
in lower transaction cost per Tk.100/Tk. 1000 of investment as the size (scales) of transaction
increases. The presence of economies of scale on the part of financial institutions explain
why they are in a better position to address the problem of high transactions costs. The
clearest example of financial intermediaries that enjoy economies of scale are: mutual funds,
commercial banks, investment banks etc. A mutual fund is a financial intermediary that sells
shares to individuals and then invests the big pooled funds in stocks and bonds. Because it
buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transactions

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costs. These costs savings are then passed on to individual investors. The lowering of
transaction costs by the financial intermediaries has become also possible because they are
better able to develop expertise (compared to individual investors) for managing funds.
Mutual funds, commercial banks and other financial intermediaries develop expertise in
financial technology so that SEUs (specially small) are attracted to avail the expert services
of financial institutions.

Information Costs
To understand the financial structure more effectively, let us now turn to the Role of
Information in the Financial Market. In a financial transaction between SEU and DEU,
one party often does not know enough about the other party to make accurate decisions. This
inequality is called Asymmetric Information. For example, a borrower who takes out a loan
usually has better information about the potential returns and risks associated with the
investment projects than the lender does. Lack of information creates problems in the
financial system on two fronts: before the transaction is entered into and after.

Adverse Selection is the problem created by asymmetric information before the transaction
occurs. Adverse selection in financial markets occurs when the potential borrowers who are
the most likely to produce an undesirable (adverse) outcome-the bad credit risks-are the ones
who most actively seek out a loan and are thus most likely to be selected. Because adverse
selection makes it more likely that bad credit risks might be selected, lenders may decide not
to make any loans even though there are good credit risks in the marketplace.

Moral Hazard is the problem created by asymmetric information after the transaction
occurs. Moral hazard in the financial markets is the risk (hazard) that the borrower might
engage in activities that are undesirable (immoral) from the lender’s point of view, which
make it less likely that the loan will be paid back. Because moral hazard lowers the
probability that the loan will be repaid, lenders may decide that they would rather not make a
loan.

How adverse selection problem interferes with the efficient functioning of a market has been
outlined in a famous article by George Akerlof, a Nobel prize-winner. It is referred to as the
“lemons problem” because it resembles the problem created by lemons in the used-car
market. Potential buyers of used cars are frequently unable to assess the quality of the car;
that is, they cannot tell whether a particular used car is a good car that will run well or a

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lemon that will continually give them grief. The price that a buyer pays must therefore reflect
the average quality of the cars in the market, some-where between the low value of a lemon
and the high value of a good car.

The owner of a used car, by contrast, knows better whether the car is a peach or a lemon. If
the car is a lemon, the owner is more than happy to sell it at the price the buyer is willing to
pay which is somewhere between the value of a lemon and a good car. However, if the car is
a peach, the owner knows that the car is undervalued by the price the buyer is willing to pay,
and so the owner may not want to sell it. As a result of this adverse selection, very few good
used cars will come to the market. Because the average quality of a used car available in the
market will be low and because very few people want to buy a lemon, there will be few sales.
The used-car market will then function poorly, if at all.

Lemons in the Securities and Banking Markets

A similar lemons problem may arise in both securities and banking markets. Suppose that one
investor is unable to distinguish between good issuing company and bad issuing company
because of lack of information. In that case, the investor may select a bad script instead of a
good security paper. Or, the investor at best offer an average price (average of prices of
securities of good and bad companies). At the average price, the bad companies will be
willing to sell their scripts, but the good companies will not. Eventually, buyers will stop
purchasing securities of bad companies and good issuing companies will stop their supply of
scripts and consequently, the security market will not function properly.

Likewise, in the banking markets also, if the lenders do not have adequate information about
prospective borrowers, then they might select a bad borrower instead of a good borrower.
Ultimately, if the availability of information does not improve, banks will eventually stop
lending.

Tools to Solve Adverse Selection Problems

In the absence of asymmetric information, the lemons problems goes away. Therefore, the
solution to the adverse selection problem in financial markets is to eliminate asymmetric
information by furnishing people supplying funds with full details about the individuals or
firms seeking to finance their investment activities. One way to provide this information to
saver-lenders is to have private companies collect and produce information that distinguishes
good from bad firms and then sell it.

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The system of private production and sale of information does not completely solve the
adverse selection problem in securities markets, because of the so-called free-rider problem.
The free-rider problem occurs when people who do not pay for information take advantage of
the information that other people have paid for. If a large number of investors act or willing
to act as free-riders, then the companies generating and purchasing private information will
be discouraged to do the same and eventually asymmetric information problem will be
worsened.

Another solution of adverse selection problem is to engage governments for producing

information to help investors distinguish good firms from bad firms and provide it to public
free of charge. The directions of governments might compel the firms to have independent
audit, in which accounting firms certify that the firm is adhering to standard accounting
principles and disclose information about their sales, assets and earnings. However,
disclosures requirements do not always work well because of unethical practices of
companies, accounting firms and government officials.

So far we have seen that private production of information and government regulations
lessen but do not eliminate the adverse selection problem. How come financial intermediaries
can do that? A bank will always lend fund to the borrowers after generating information
relating to business and entrepreneurs. Unless the banker brings the borrower into his
confidence and understand properly his creditworthiness, the banker is not supposed to lend
fund. Moreover, banks data are also not possible to be shared by the outsiders, reducing the
scope of free-riding problem of the financial markets.

Another measure for preventing adverse selection in the financial market is enforcing
collateral and net worth for borrowers. Collateral, property promised to the lender if the
borrower defaults, reduces the consequences of adverse selection because it reduces the
lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell
the collateral and use the proceeds to make up for the losses on the loan.

Net worth (also called equity capital), the difference between a firm’s assets (what it owns)
and its liabilities (what it owes), can perform a similar role to collateral. If a firm has a high
net worth and defaults on its debt payments, the lender can take title to the firm’s net worth,
sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the
more net worth a firm has in the first place, the less likely it is to default because the firm has

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a cushion of assets that it can use to pay off its loans. Hence when firms seeking credit have
high net worth, the consequences of adverse selection are less important and lenders are more
willing to make loans.

The imposition of adequate collateral and high net worth on the risky borrowers is easily
possible by financial intermediaries rather than individual investors and capital issuance
authorities. From the above discussion, it may be discerned that the financial intermediaries
(rather than individual investors) can better handle or address the adverse selection problem
of the financial markets.

How Moral Hazard Affects the Choice between Equity Segment (Security Market) and
Debt Segment (Banking and Security Market) of Financial Market

Moral Hazard is the asymmetric information problem that occurs after the financial
transaction takes place. The problem may arise in both equity and debt part of financial
markets. Equity contracts, such as common stock, are claims to a share in the profits and
assets of a business. Equity contracts are subject to a particular type of moral hazard called
the principal-agent problem. Managers work for the stockholders who own most of the
firm’s equity (called the principals) are not the same people as the managers of the firm, who
are the agents of the owners. This separation of ownership and control involves moral hazard
in that the managers in control (the agents) may act in their own interest rather than in the
interest of the stockholder-owners (the principals) because the managers have less incentive
to maximize profits than the stock-holder-owners do.

The principal-agent problem would not arise if the owners of a firm had complete
information about what the managers were up to and could prevent wasteful expenditures or
fraud. The principal-agent problem, which is an example of moral hazard, arises only because
a manager has more information about his activities than the stockholder does-that is, there is
asymmetric information. The principal-agent problem would also not arise if there was no
separation of ownership and control.

Tools to help solve Principal Agent Problem

One way for principals to reduce this moral hazard problem is for them to engage in a
particular type of information production, the monitoring of the firm’s activities; auditing the
firm frequently and checking on what the management is doing. The problem is that the
monitoring process can be expensive in terms of time and money, as reflected in the name
financial economists give it, costly state verification. Costly state verification makes the

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equity contract less desirable, and it explains, in part, why equity is not a more important
element in our financial structure. This sort of monitoring also suffers from free-rider
problem. When other principals will come to know that someone else is spending money for
monitoring the company, they will try to take a free ride. Eventually overall monitoring by
principals will decrease.

As with adverse selection, the government has an incentive to try to reduce the moral hazard
problem by generating and supplying information to public fee of cost. Governments
Regulations can force firms to adhere to standard accounting principles that make profit
verification easier. They also pass laws to impose stiff criminal penalties on people who
commit the fraud of hiding and stealing profits. However, these measures can only be partly
effective. Catching this kind of fraud is not easy; fraudulent managers have the incentive to
make it very hard for government agencies to find or prove fraud.

One financial intermediary that helps reduce the moral hazard arising from the principal-
agent problem is the venture capital firm. Venture capital firms pool the resources of their
partners and use the funds to help budding entrepreneurs start new businesses. In exchange
for the use of the venture capital, the firm receives an equity share in the new business.
Because verification of earnings and profits is so important in eliminating moral hazard,
venture capital firms usually insist on having several of their own people participate as
members of the managing body of the firm, the board of directors, so that they can keep a
close watch on the firm’s activities.

Moral Hazard arises with an equity contact, which is a claim on profits in all situations,
whether a firm is making or losing money. If a contract could be structured in such a way that
there would be a reduced need to monitor mangers, in that case the contract would be more
attractive than the equity contract. The debt contract has exactly these attributes because it is
a contractual agreement by the borrower to pay the lender fixed (of return) amounts at
periodic intervals. When the firm has high profits, the lender receives the contractual
payments and does not need to know the exact profits of the firms. If the managers are hiding
profits or are pursuing activities that are personally beneficial but don’t increase profitability,
the lender doesn’t care as long as these activities do not interfere with the ability of the firm
to make its debt payments on time. The advantage of a less frequent need to monitor the firm,
and thus a lower cost of state verification, helps explain why debt contracts are used more
frequently than equity contracts to raise capital.
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Moral Hazards and Debt Markets
Debt contracts are also subject to moral hazard. Because a debt contract requires the
borrowers to pay out a fixed amount of return and allow them to keep any profits above this
amount, the borrowers have an incentive to take on investment projects that are riskier than
the lenders would like.

In order to reduce moral hazard problem of debt market, the lender should increase the Net-
Worth of the borrowers. When borrowers have more at stake because their net worth (the
difference between their assets and liabilities) is high, the risk of moral hazard – the
temptation to act in a manner that lenders find objectionable – will be greatly reduced
because the borrowers themselves have a lot to lose.

Another way of describing the solution that high net worth provides to the moral hazard
problem is to say that it makes the debt contract incentive-compatible; that is, it aligns the
incentives of the borrower with those of the lender. The grater the borrower’s net worth, the
greater the borrower’s incentive to behave in the way that the lender expects and desires, the
smaller the moral hazard problem in the debt contract is, and the easier it is for the firm to
borrow. Conversely, when the borrower’s net worth is lower the moral hazard problem is
greater, and it is harder for the firm to borrow.

As a lender, in order to restrict borrowers to practice moral hazard, in addition to enforce

higher net worth, some provisions (restrictive covenants) may be incorporated into the debt
contracts that restricts borrowing firms activities. Restrictive covenants are directed at
reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable
behavior of borrowing entities.

Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it
completely. It is almost impossible to write covenants that rule out every risky activity.
Furthermore, borrowers may be clever enough to find loopholes in restrictive covenants that
make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A
restrictive covenant is meaningless if the borrower can violate it knowing that the lender
won’t check up or is unwilling to pay for legal recourse. Because monitoring and
enforcement of restrictive covenants are costly, the free-rider problem arises in the debt
securities (bond) market just as it does in the stock market.

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As we have seen before, financial intermediaries, particularly banks, have the ability to
avoid the free-rider problem as long as they primarily make private loans. Private loans are
not traded, so no one else can free-ride on the intermediary’s monitoring and enforcement of
the restrictive covenants. The intermediary making private loans thus receives the benefits of
monitoring and enforcement and will work to shrink the moral hazard problem inherent in
debt contracts.

SUMMING UP

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. Tools to
help solve these problems involve the private production and sale of information, government
regulation to increase information in financial markets, the importance of collateral and net
worth to debt contracts, and the use of monitoring and restrictive covenants. A key finding
from this theoretical analysis is that the existence of the free-rider problem for traded
securities such as stocks and bonds indicates that financial intermediaries, particularly banks,
should play a greater role than securities markets in financing the activities of business. Or, in
other words, indirect mode of finance or financial intermediaries are in a better position to
address the problems of asymmetric information in financial markets (than direct mode of
finance or securities markets.)

SUMMARY Asymmetric Information Problems and Tools to Solve Them

Asymmetric Information Problem Tools to Solve It

Adverse selection Private production and sale of information

Government regulation to increase information

Financial intermediation

Collateral and net worth

Moral hazard in equity contracts Production of information: monitoring

(Principal-agent problem) Government regulation to increase information

Financial intermediation

Debt contracts

Moral hazard in debt contracts Net worth

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 Monitoring and enforcement of restrictive covenants

Financial intermediation

Reference: Mishkin, F.S. and Eakin. S.G: Financial Markets and Institutions. Pearson
Education. (Chapter 15: PP373-402)

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 QUESTIONS

1. Describe two ways in which financial intermediaries help lower transaction costs in the
economy.

2. Would moral hazard and adverse selection still arise in financial markets if information
were not asymmetric? Explain your answer.

3. How can the existence of asymmetric information provide a rationale for government
regulation of financial markets?

4. “The more collateral there is backing a loan, the less the lender has to worry about
adverse selection”. Is this statement true, false, or uncertain? Explain your answer.

5. How does the free-rider problem aggravate adverse selection and moral hazard
problems in financial markets?

6. Explain, in what way, transaction costs influence the financial structure of a country.

7. What do you mean by Asymmetric Information problems of financial markets? What

are the consequences of Asymmetric Information?

8. What is lemons Problem? How it is related to securities market and banking market?

9. How do free-rider problem worsen the adverse selection possibility of financial

markets?

10. In what way, financial intermediaries are superior than anybody else in addressing
adverse selection problem of financial markets?

11. Explain the tools for solving the adverse selection problems of financial market.

12. Why are private production and sale of information and also government regulations
not very effective in addressing adverse selection problems?

13. What is the role of collateral and net worth in addressing the problems of adverse
selection?

14. Why moral hazard in equity financial instruments is also known as Principal-Agent
problem?

15. Why are privet monitoring and government regulations are unlikely to address the
moral hazard problems of financial markets?

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