Econ 160 Money and Banking - Chapter 8

Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in the United States. Explain why this might create more problems than solutions in the financial system of a developing country.

Although it might seem a good idea to "copy and paste" regulatory frameworks that ensure the soundness of a financial system from one country to the other, this is usually not a good idea. Developed and developing countries have quite different financial systems. Incorporating a system of deposit insurance will surely result in an increase in deposits at financial intermediaries. However, without proper regulations (i.e., prudential regulation and supervision) to limit the moral hazard problems associated with a system of deposit insurance, banks will probably accept more risks than they would otherwise do. This is obviously not a desired consequence. The increase in moral hazard problems will probably offset the benefit derived from avoiding bank runs (the most immediate effect of a system of deposit insurance).

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

Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and prosecuting fraud.

Suppose you go to your local bank, intending to buy a certificate of deposit with your savings. Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next individual who enters the bank and applies for a car loan.

During your visit at the bank, you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off. However, you would probably like to know that individual better, in particular, his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time-consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan.

How can asymmetric information problems lead to a bank panic?

Even though banks are well suited to overcome the adverse selection and moral hazard problems inherent in lending because they make private loans and have incentives to invest in information production about the borrowers to whom they lend, bank depositors face an asymmetric information problem of their own: They do not know as much as bank managers do about how much risk banks are taking and are uncertain about the safety of their deposits and their banks' ability to pay them back in full. If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not. This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are scrambling to withdraw their deposits before their banks run out of cash, and in extreme cases can lead to a contagion in which a large number of banks fail within a short period of time.

How can economies of scale help explain the existence of financial intermediaries?

Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks' large scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transactions costs, explain why financial intermediaries exist and are so important to the economy.

Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Explain why banks might require that much collateral in such a financial system. Comment on the consequences of such a system for economic growth.

Financial intermediaries operating in countries with relatively weak property rights and legal systems usually require a lot of collateral when making loans. The rationale for that behavior is that in the event that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its loan. Therefore, requesting extra collateral might help the bank speed up the process. In practice, a bank that has requested two other houses as collateral for a mortgage has better chances to recover its loan in the event of default. Of course this means that fewer individuals will have access to mortgages (even those with excellent credit risk are left out), since it is quite difficult to come up with such an amount of collateral (usually having your parents as cosigners and using your parents' house as collateral is not enough). Inefficient financial systems make access to credit much more difficult in some countries, but it is fair to say that this might be the result of inefficient legal systems. As explained earlier, inefficient financial systems contribute to lower economic growth rates. This example illustrates how difficult it can be for a young individual to buy a house, resulting in less expenditure in residential investment.

For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding: United States; Germany; Japan; Canada. Comment on the similarities and differences among the countries' funding sources.

For each country, the largest (most important) is listed first, and smallest (least important) is listed second, as reported in Figure 1 in the text. United States: Nonbank loans; Stocks. Germany: Bank loans; Bonds. Japan: Bank loans; Stocks. Canada: Bank loans; Stocks. For the United States, bank loans are relatively unimportant, but for the other countries, this makes up a very large part of overall external financing. For these countries (with the exception of the United States), stock and bond financing are relatively unimportant.

In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous value. A few years later, Argentina announced it would pay back 25% of the face value of its debt. Comment on the effects of information asymmetries on government bond markets. Do you think investors are currently willing to buy bonds issued by the government of Argentina?

Information asymmetries are also present in government bond markets. Usually investors resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack of information results in huge losses for bondholders. In this respect, the problem is not significantly different from an investor who decides which corporate bond to buy, although it may be fair to say that information about corporate bonds is more standardized (making it easier to compare firms). After the Argentinean default, investors were willing to buy bonds issued by its government only at a significant risk premium, making it very costly for Argentina to raise funds in bond markets.

Why are financial intermediaries willing to engage in information collection activities when investors in financial instruments may be unwilling to do so?

Investors in financial instruments who engage in information collection face a free-rider problem, which means other investors may be able to benefit from their information without paying for it. Individual investors therefore have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. Since they will reap all the benefits from the information they collect, their information collection activities will be more profitable. They thus have greater incentive to invest in information collection.

Which relationship would you expect to exist between measures of corruption and living standards at the country level? Explain by which channel corruption might affect living standards.

One would expect corruption measures to be negatively correlated with living standards. Corruption usually deters investment, since it undermines the legal system. Countries in which corruption is prevalent have trouble encouraging individuals or companies to invest in them. Corruption affects living standards by undermining the efficiency of the legal system, thereby lowering investment, one fundamental ingredient to economic growth, the basis of higher living standards.

Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards?

One would expect the group of countries with more efficient legal systems to exhibit higher living standards. Legal systems are an important part in the lending process, precisely because they are part of the mechanisms of enforcement of contracts that deal with the moral hazard problem. Costly, slow, and inefficient legal systems do not promote lending and thereby funding of investment opportunities.

How do standardized accounting principles help financial markets work more efficiently?

Standardized accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better. Standardized accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to over- or understate profits, thereby reducing the principal-agent (moral hazard) problem.

Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan, the bank will keep the house title until you pay back the loan. Which problem of asymmetric information is the bank trying to solve?

The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general, the bank does not "keep the house title", but it places a lien on it instead to prevent the house owner from selling the house without its supervision. In this case, the bank wants to make sure that you do not sell the house, get the money and never pay back the loan.

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

The free-rider problem means that private producers of information will not obtain the full benefit of their information-producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

What steps can the government take to reduce asymmetric information problems and help the financial system function more smoothly and efficiently?

The government can produce information about borrowers and provide it to investors free of charge, it can require borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern the behavior of financial institutions so they do not take on too much risk. These prudential regulations for banks include banning certain activities and asset categories considered too risky, establishing minimum capital requirements, and requiring disclosure of financial information to regulators and investors.

Suppose that in a given bond market, there is currently no information that can help potential bond buyers to distinguish between bonds. Which bond issuers have an incentive to disclose information about their companies? Explain why.

The issuer of a good quality (low risk) bond would have an incentive to disclose information, whereas the issuer of a bad quality (high risk) bond would not. This is because when information is created and made available, potential bond buyers can make a better decision. The issuer of the bad quality bond will most probably end up receiving a lower price than the average price. Note that in the absence of information, every bond sells at the average price.

Explain how the separation of ownership and control in American corporations might lead to poor management.

The separation of ownership and control creates a principal-agent problem. The managers (the agents) do not have as strong an incentive to maximize profits as the owners (the principals). Thus, the managers might not work hard, might engage in wasteful spending on personal perks, or might pursue business strategies that enhance their personal power but do not increase profits.

"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.

True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less, because the collateral can be sold to make up any losses on the loan. Thus, adverse selection is not as severe a problem.

Explain why dating can be considered a method to solve the adverse selection problem.

When a couple dates, they are (explicitly or implicitly) extracting information about the significant other. At the same time, they are sharing information about themselves. This information flow helps both individuals to make better decisions about a probable (or not) future life together. In this way, one can think that this process is formally no different from the one in which the loan officer tries to choose the right borrower.

Which problem of asymmetric information are prospective employers trying to solve when they ask applicants to go through a job interview. Is that the end of the information asymmetry?

When prospective employers ask job applicants to go through a job interview, they are trying to solve the adverse selection problem. Prospective employers want to know more about potential workers, much in the same way loan officers want to know more about potential borrowers. As it is the case with a loan transaction, the information asymmetry does not end here, since if hired, worker and employer will have to solve the moral hazard problem. Usually employers try to solve this problem with paying schemes that encourage workers to provide more effort.

Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why?

Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don't lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off.