Asymmetric information and corporate financial structure

1
Asymmetric information and corporate financial
structure

• Chap 8, Mishkin
• Combine with Aplia, experiment on Market for
  lemons

2

• Corporate financial structures across developed
  nations reveal some common features
• The methods of financing in order of importance
  are bank loans and non-bank loans (56), bonds
  (32) and stocks (11)
• implying indirect finance is more important
  than direct finance and banks form the single
  most important type of intermediary
• Only a few large corporations have access to
  securities markets.
• Collaterals are a common feature in debt
  contracts. These contracts also place substantial
  restrictions on activities
• Financial systems are heavily regulated
• This chapter and the accompanying in class
  experiment Market for lemons try to show how
  these features are a product of asymmetric
  information problems and transactions costs in
  corporate financing.

3
Equilibrium price and trade under adverse
selection A dealer sells two types of used cars
(i) good quality or peaches/plums (sweet) and
(ii) bad quality or lemons (sour). Buyer
doesnt know which car is which. Buyer value for
peaches 3000 Buyer value for lemons
1500 Cost of peaches to seller 2500 Cost of
lemons to seller 1000 Number of buyers
40 Number of peaches 15 Number of lemons
15
4
Equilibrium under full information buyer can
observe the quality of the car.
p
p
Q
Q
Market for peaches
Market for lemons
Equilibrium in market for peaches ( _____, ____
) Equilibrium in market for lemons ( _____ ,
____ ) Total gains from trade
_________________________________
5
Equilibrium under hidden information Buyer
doesnt know the quality of the car and has
pessimistic beliefs.
price
Equilibrium in the market for used cars ( ____,
___) Only ____ quality cars are traded. ____
quality cars are driven out of the market because
_____________. Total gains from trade
quantity
6
Equilibrium under hidden information
(contd.) What other belief structures are
possible for buyers to have? ____________
price
Is it possible to have an equilibrium with
the alternative belief structure? Hint In
equilibrium the belief structure must be
sustainable.
quantity
7

• Lemons (adverse selection) problem in stock and
  bonds markets
• When a lender cannot distinguish between
  good stocks (bonds) and bad stocks (bonds),
  he/she is willing to pay only a price that
  reflects the average quality of the stocks
  (bonds). As a result good stocks (bonds) drop
  out of the market and only bad stocks (bonds)
  remain.
• Ways to reduce adverse selection problems are,
• private production and sale of information by
  specialized firms private companies produce and
  sell information that distinguishes good from
  bad
• example S P, Moodys
• this arrangement however can cause its own
  problem - free riding
• A free rider is one who doesnt pay for but
  benefits from the purchase of others.
• Govt. regulation to increase information
  regulating securities markets in a way that
  encourages firms to reveal information about
  themselves.
• example SEC requiring independent audits

8

• financial intermediation intermediaries can
  produce information themselves and provide
  guarantees of their products.
• collateral and net worth collateral reduces
  the consequences of adverse selection to the
  lender by reducing the losses in the event of a
  lemon purchase
• net worth firms assets liabilities performs
  a similar function as a collateral

9
Conflicts of interest - a special type of
moral hazard problem in financial
markets Financial intermediaries essentially
bundle multiple different types of services.
Conflict of interest is a type of moral hazard
problem which arises when an institution has
multiple objectives or interests and there are
conflicts between those objectives. Example 1
investment banks research and underwrite
firms There is a conflict of interest between
their brokerage (serving the investor) and
underwriting (serving the issuer) services. It is
possible that they might bias their research
reports to serve issuers if gains are high
enough. Example 2 auditing and consulting in
accounting firms As auditors they must be
truthful to the investors/shareholders, as
consultants on taxes, accounting etc. they must
serve the interests of the firm managers.