ADDIS ABABA UNIVERISTY

COLLEGE OF BUSINESS AND

ECONOMICS
DEPRTAMENT MANAGEMENT
COURSE MANAGEMENT
FINANCIAL INSTITUTION
LECTURE NOTE

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 GROUP MEMBERS

• Name ID
1. Addisu Seyoum BEE/8405/11

2. Berket Gebre BEE/0641/11

3. Dawit Eshetu BEE/3131/11
4. Abraham Teklu BEE/3125/11
5. Dawit Tadesse BEE/0087/11
6. Ersom Alemayehu BEE/9941/11
7. Hanna Alemu BEE/6335/11
8. Kalkidan Habtamu BEE/5002/11
9. Fatuma Ussman BEE/6765/11
10. Jebesa Berhanu BEE/3662/11
11. Adil Teha BEE/4337/11

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Asymmetric information

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 Learning Objectives

 Understanding Asymmetric Information

 Asymmetric information and bank regulation
 Understand bank capital requirement
 Restriction on asset holdings and bank capital
requirements
 Political economy of the savings and loan crisis

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 Asymmetric information
The concept of Asymmetric Information centers on a situation in
which there is unequal knowledge between each party to a
transaction, that one party has better information than the
other party. This type of asymmetry creates an imbalance in a
transaction
Asymmetric information can occur in any situation involving a
borrower and a lender when the borrower fails to disclose
negative information about his or her real financial state, Or
the borrower may simply fail to anticipate a worst-case
scenario such as a job loss or an unanticipated expense.

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Why is information asymmetry important?

• Information asymmetry is a very important

concept because securities markets are subject
to information asymmetry problems. They
may take advantage of their privileged
position of information to earn excess profits.
They may take actions that are beneficial to
them but are detrimental to the interests of
investors.

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 Why is information asymmetry bad?

• This asymmetry creates an imbalance of power

in transactions, which can sometimes cause the
transactions to go awry, a kind of market
failure in the worst case. Examples of this
problem are adverse selection, moral hazard,
and monopolies of knowledge. Information
asymmetry extends to non-economic behavior.

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Types of asymmetric information
A. Adverse selection:
B. Moral Hazard

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 CONT..
CONT…
a. Adverse selection describes circumstances in which either
buyers or sellers have information that the other group does
not have. In these cases, when these two groups are informed
to different degrees, which creates asymmetric information.
The problem with asymmetric information, where one party
has more information than another, occurs before the
transaction takes place/pre-contractual problems. Used car
owners have more information than they disclose while
selling their cars. The people seeking insurance are more
likely to need insurance, which means that the decision-
maker usually has a poor selection.

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 Solutions to Adverse Selection
• We need to produce cheaper information (in the
financial sector – companies need to disclose
information). Companies are required to follow standard
accounting principles, the presence of rating firms, the
disclosure of information, collateral and net worth
requirements. For example, blogging, which can be
considered to be a new source of cheap information, has
reduced the role of insider information by preventing
people in power from withholding financial information
from the general public.

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• B. Moral hazard Is a situation in which a party is
more likely to take risks because the costs that could
result will not be borne by the party taking the risk.
This problem with asymmetric information takes
place after the transaction. For example, a person
with insurance against automobile theft may be less
cautious about locking their car because the negative
consequences of vehicle theft are now (partially) the
responsibility of the insurance company. Another
example can be individuals on welfare benefits; they
may be less likely to look for employment than if
there were in a situation where they didn’t have any
benefits.
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Asymmetric information and bank regulation

• Asymmetric information, is the fact that different

parties in a financial contract do not have the
same information, leads to adverse selection and
moral hazard problems that have an important
impact on our financial system. The concepts of
asymmetric information, adverse selection, and
moral hazard are especially useful in
understanding why government has chosen the
form of banking regulation.

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 Basic categories of banking regulation:

 The government safety net,

 restrictions on bank asset holdings,
 Capital requirements,
 Chartering and bank examination,
 Assessment of risk management,
 Disclosure requirements,
 Consumer protection, and
 Restrictions on competition.
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• Banks are particularly well suited to solving
adverse selection and moral hazard problems
because they make private loans that help
avoid the free-rider problem. However, this
solution to the free-rider problem creates
another asymmetric information problem,
because depositors lack information about the
quality of these private loans. This asymmetric
information problem leads to two reasons why
the banking system might not function well.

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First, before the FDIC started operations in 1934, a bank failure
(in which a bank is unable to meet its obligations to pay its
depositors and other creditors and so must go out of business)
meant that depositors would have to wait to get their deposit
funds until the bank was liquidated (until its assets had been
turned into cash); at that time, they would be paid only a
fraction of the value of their deposits.
If bank managers were taking on too much risk or were
outright crooks, depositors would be reluctant to put money in
the bank, thus making banking institutions less viable.

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• Second is that depositors' lack of information about
the quality of bank assets can lead to bank panics ,
which, can have serious harmful consequences for
the economy. To see this, consider the following
situation. There is no deposit insurance, and an
adverse shock hits the economy.
• As a result of the shock, 5% of the banks have such
large losses on loans that they become insolvent
(have a negative net worth and so are bankrupt).
Because of asymmetric information, depositors are
unable to tell whether their bank is a good bank or
one of the 5% that are insolvent.

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• Depositors at bad and good banks recognize that they may not
get back 100 cents on the dollar for their deposits and will want
to withdraw them. Indeed, because banks operate on a
"sequential service constraint" (a first-come, first-served basis),
depositors have a very strong incentive to show up at the bank
first, because if they are last in line, the bank may run out of
funds and they will get nothing.
• Uncertainty about the health of the banking system in general
can lead to runs on banks both good and bad, and the failure of
one bank can hasten the failure of others (referred to as the
contagion effect). If nothing is done to restore the publics
confidence, a bank panic can ensue.

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• A government safety net for depositors, can
short- circuit runs on banks and bank panics, and by
providing protection for the depositor, it can
overcome reluctance to put funds in the banking
system.
• Government safety net: Deposit insurance and the
FDIC/federal deposit insurance corporation
- Short circuits bank failures and contagion effect.
- Payoff method
- Purchase and assumption method

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 Moral Hazard and the Government Safety
Net.
• Although a government safety net has been successful at
protecting depositors and preventing bank panics, it is a
mixed blessing. The most serious drawback of the
government safety net stems from moral hazard, the
incentives of one party to a transaction to engage in activities
detrimental to the other party.
• Moral hazard is an important concern in insurance
arrangements in general because the existence of insurance
provides increased incentives for taking.

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 CONT..
• Moral hazard is a prominent concern in government
arrangements to provide a safety net. Because with a
safety net depositors know that they will not suffer
losses if a bank fails, they do not impose the
discipline of the marketplace on banks by
withdrawing deposits when they suspect that the
bank is taking on too much risk. Consequently, banks
with a government safety net have an incentive to
take on greater risks than they otherwise would.

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 Adverse Selection and the Government Safety
Net.
• A further problem with a government safety
net like deposit insurance arises because of
adverse selection, the fact that the people
who are most likely to produce the adverse
outcome insured against (bank failure) are
those who most want to take advantage of the
insurance.

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 "Too Big to fail"

• TOO Big to Fail." The moral hazard created by a government

safety net and the desire to prevent bank failures have
presented bank regulators with a particular quandary.
• Because the failure of a very large bank makes it more likely
that a major financial disruption will occur, bank regulators
are naturally reluctant to allow a big bank to fail and cause
losses to its depositors.

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 CONT..

• Government guarantees of repayment to large

uninsured creditors of the largest banks.
- Uses the purchase and assumption
method
• Increases moral hazard incentives for big banks
• Larger and more complex banks challenge regulation
-Increased "too big to fail" problem
-Extends safety net to new banking activities
-Increases incentives for risk taking
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 Bank Supervision:

• Chartering and Examination

Overseeing who operates banks and how they are
operated, referred to as bank supervision or more
generally as prudential supervision, is an important
method for reducing adverse selection and moral
hazard in the banking business.

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 Assessment of risk management

• Assessment of Risk Management quality of the bank's

balance sheet at a point in time and whether it complies
with capital requirements and restrictions on asset
holdings.
• Although the traditional focus is important for reducing
excessive risk taking by banks, it is no longer felt to be
adequate in today's world, in which financial innovation
has produced new markets and instruments that make it
easy for banks and their employees to make huge bets
easily and quickly.

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 Disclosure requirements

• Disclosure The free-rider problem indicates that

individual depositors Requirements and other bank
creditors will not have enough incentive to produce
private information about the quality of a bank's assets.
• To ensure that there is better information for depositors
and the marketplace, regulators can require that banks
adhere to certain standard accounting principles and
disclose a wide range of information that helps the
market assess the quality of a bank's portfolio and the
amount of the bank's exposure to risk.

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 Consumer protection
• The existence of asymmetric information also suggests that
consumers may not have enough information to protect themselves
fully. Consumer protection regulation has taken several forms. First
is "truth in lending," mandated under the Consumer Protection Act of
1969, which requires all lenders, not just banks, to provide
information to consumers about the cost of borrowing including a
standardized interest rate (called the annual percentage rate, or APR)
and the total finance charges on the loan.
• The Fair Credit Billing Act of 1974 requires creditors, especially
credit card issuers, to provide information on the method of assessing
finance charges and requires that billing complaints be handled
quickly. Both of these acts are administered by the Federal Reserve
System under Regulation.

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 Restrictions on competition
• Although restricting competition propped up the health of
banks, restrictions on competition also had serious
disadvantages: They led to higher charges to consumers and
decreased the efficiency of banking institutions, which did not
have to compete as hard. Thus, although the existence of
asymmetric information provided a rationale for
anticompetitive regulations, it did not mean that they would
be beneficial.
• Indeed, in recent years, the impulse of governments in
industrialized countries to restrict competition has been
waning. Electronic banking has raised a new set of concerns for
regulators to deal with.

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 Bank Capital Requirements

 Bank capital
 Capital is the accounting residual that remains after
subtracting a banks fixed liability from its assts. It is
what is owned to the banks owners , shareholders
after liquidating all the assets at their accounting
value.
 A bank capital is a stock or equity put up by the
banks owner. the bank then takes in deposits or
other debt liabilities and use the debt and equity to
acquire asset, which means also making loans.

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 CONT..

Importantly, capital is a source of funds that the bank uses

to acquire assets. This means that, if a bank were to issue
an extra dollar of earnings, it can use this to increase its
holdings of case, securities, loans, or any other assets.
When the bank finances additional assets with capital, its
leverage ratio rises.
bank(and many non financial intermediaries) issue a far
larger proportion of debt(relative to equity) than non
financial firms have. Recent data shows that non financial
firms have between $0.80 and $1.50 worth of debt
liabilities.
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 Cont..

Role of bank capital bank capital acts as self

insurance, providing a buffer against
insolvency and, so long as it is sufficiently
positive, giving bank management an
incentive is designed to manage risk
prudently.
A banking system that is short of capital can
damage the broader economy in three ways

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 Cont..

• First, an undercapitalized is less able to supply

credit to healthy borrowers.
• second, weak banks may evergreen loans to
zombie firms, adding unpaid interest to a loans
principal to avoid taking loses and further
undermining their already weak capital position.
• finally, in the presence of wide spread capital
shortfall, the system is more vulnerable to wide
spread panic.
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 Capital requirements

• Capital requirements are regulatory standards

for banks that determine how much liquid
capital(easily sold assets)they must keep on
hand, concerning their overall holdings. Also
known as regulatory capitals, these standards
are set by regulatory agencies, such as the
bank for international settlements(BIS), the
federal deposit insurance corporation(FDIC),
or the federal reserve board(the fed).
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 Cont..

Capital requirements are often tightened after an economic

recession, stock market crash, or another type of financial crisis
The fundamental theorem of corporate finance the Modigliani
miller(MM) theorem states that, under a specific set of
circumstances, firms(including banks) will be indifferent between
debt and equity finance.
the question of how to set capital requirements depends in part
on the factors causing the MM violating that leads banks to
prefer debt to equity. The candidates are numerous, ranging
from distortionary government debt subsidies(in the form of
explicit and implicit guarantees) to information asymmetries that
make collateralized short term debt finance relatively attractive

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 The basis of capital requirements
• Capital requirements are set to ensure the
banks and depository institutions holdings are
not dominated by investments that increase
the risk of default. They also ensure that banks
and depository institutions have enough
capital to sustain operating losses(OL) while
still honoring withdrawals.

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 Benefits and Drawbacks
• Capital requirements aim not to keep banks
solvent but by extension, to keep the entire
financial system on a safe footing. In an era of
national and international finance, no bank is
an island as regulatory advocates note a shock
to one can affect many.

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Pros
 Ensure banks stay solvent, avoid default
 Ensure depositors have access to funds
 Set industry standard
 Provide way to compare, evaluate institution
Cons
 Raise costs for banks and eventually
consumers
 Inhibit banks ability to invest
 Reduce availability of credit loans
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 Restriction on Asset Holdings and Bank Capital
Requirement

• The need to minimize moral hazard associated with the

government safety net and the associated costs for the
taxpayers, created the next form of necessary regulations, bank
capital requirements and restrictions on asset composition.
• This form of regulations prohibits banks from holding volatile
assets such as common stocks and from lending to particular
categories or specific borrowers, over a certain amount, and it
also requires them to hold a specific amount of equity capital,
in order to make them more accountable in negative
outcomes.
 

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 Political Economy of the Savings and Loan Crisis

• The relationship between voter-taxpayers and the

regulators and the politicians creates a particular type of
moral hazard problem—the principal-agent problem. This
idea can explain part of the problem during the S&L Crisis.
• Regulators and politicians are ultimately agents for voter-
taxpayers.
2008 housing Crisis
• com bobble
• 2001. 9/11
• FEDERAL RESERVE Interest rate 1%

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 What is a Mortgage
• Mortgages are a lone payed in a given time
agreed with the borrower.
• Two main types of mortgages
 Prime mortgages
 Subprime mortgages

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• Prime mortgages
Borrowers who’s credit rating or score is high.
Have stable income and less debit
• Subprime mortgage
Borrowers who’s credit rating is low ; Have high
debit and most likely to don’t afford the
Mortgage

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 Five main party’s that were impacted directly

• Home owners
• Lender’s
• Investment banks
• Credit rating company’s
• Intuition investors ; pension fund, insurance, mutual funds
How mortgage works
• Home owners Lender’s Investment banks
• Lender’s ; give mortgages to home owners for 20 years to pay
• The lender’s ; Start saleling mortgages to investment 🏦 banks as securities
• The investment banks ; also start sale ling this securities to intuition investors
• intuition investors ; started investing in this securities because they believe
the value of a house will go up in value no matter what.

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How the Crises begin
• Started from the lenders when they lowered the criteria or standard to
borrowers who could receive the Mortgage.
• Lenders started giving subprime mortgage a low score barrows
• The investment 🏦 banks bought the subprime mortgage assuming the value
of houses will go up no matter what.
Credit rating company’s
• Credit rating company’s work is by giving investment grades intuition
investors.
Examples are;
AAA : triple A ( high score assets)
• AA: double A
• A: one A
BBB : triple B ( lower score assets)
• Examples of credit rating company’s
 Moody’s
 S&P
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In Final Stage of crises
• Subprime mortgage started to default because they could
no afford the payment
• Prime mortgages prayers started to stop paying because
they house started to deprecated
• When The intuition investors started lost their investment
Full out to the Mortgage crises  
• Home owners lost their job
• Pension fund, insurance company mutual funds lost their
investment
• Investment banks like Leman brothers went bankrupt
• Countries like U.S , GREEK , ICE Land want to political and
economic crises
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