Asymmetric Information in Financial Markets
Adverse Selection
- Banks need to tell apart good (peaches) and bad (lemons) borrowers when they lend money.
- Because they don't have all the info (asymmetric information), banks charge an average interest rate.
- This means:
- Good borrowers might not take the loan because it's too expensive.
- Bad borrowers will take the loan, which is risky for the bank.
- Banks should check (evaluate) borrowers carefully beforehand to charge the right rate.
Moral Hazard
- This happens after the loan is given; banks can't control what borrowers do with the money.
- Borrowers might try riskier things (projects), which could lead to big losses.
- Banks handle this by:
- Credit Rationing: Limiting how much they lend.
- Setting rules (loan covenants) for how the money can be used.
- Keeping a close watch (monitoring) on things.
- Banks are good at dealing with these problems