Information Asymmetry: Adverse Selection and Moral Hazard

The primary reason why people give their money to financial intermediaries instead of lending or investing the money directly is because of the risk that is present from the information asymmetry between the provider of funds and the receiver of those funds. A seller knows more about the sale item than the buyer. So the buyer would be taking a risk buying the item. The buyer asks, why is the seller selling?

Likewise, a borrower knows more about his financial condition and his future prospects than the lender. How can the lender be sure that the borrower will not simply disappear with the funds? Or that the borrower will take enormous risks. A company that sells stock may not put the money to its best use. It might be used to pay extravagant compensation to its CEO or to pay huge bonuses to bankers who practically destroy their company.

These examples illustrate the 2 types of risks that are present when there is information asymmetry:

  1. adverse selection, which is a risk exposure that exists before the money is lent or invested and
  2. moral hazard, which is a risk after the financial transaction.

Adverse Selection

Selecting whom to give your money is a very important part of controlling risk. Give it to a crook, and you lose your money. Give it to someone who is not good at handling money, and you could also lose it. In fact, without information about those seeking funds, theory goes that you must charge an average price for your money or sale item. But an average price would cause those who are better risks or have better products to shun your offer, while those with higher risks will seek your offer, resulting in adverse selection.

A good illustration of this principle was presented by George A. Akerlof in his article "The Market for Lemons" for which he shared the Nobel Prize in economics in 2001. Suppose you have 2 people who want to sell their car. The 1st person is a little old lady who rarely drove her car and kept it in good condition. The 2nd person drove his car during his wild teenage years — speeding, drag racing, and getting involved in a few fender benders, and to save on money, he changed the oil only once in a while.

They both come to a used car lot to sell their car, but if the car dealer or his customers couldn't distinguish between the cars, then he would offer an average price for both cars, since a customer will not pay more than an average price without some guarantee that a higher priced car is better than a lower-priced one. Well, the little old lady isn't suffering from dementia, so she won't accept less than what her car is worth, while the young man, knowing a good price for his car considering its history, gladly takes it. So what happens is that the car dealer stocks up on lemons because the lemon sellers gladly accept his average price while the owners of sound cars don't.

The above scenario is not reality because there are ways of distinguishing the quality of cars, such as the mileage and the year it was manufactured and the car can be inspected for dents and other damage. But fund seekers will be harder to distinguish.

For instance, if you offer an average interest rate for your loans, the people who are better risks will go elsewhere for their money, while the risky people will gladly take your money.

Moral Hazard

When you give money to someone, you want to be sure that you will get it back with interest. However, this is less likely if the money is misused or lost through excessive risk-taking. Moral hazard is the risk that the receiver of funds will not use the money as was intended or they may take unnecessary risks or not be vigilant in reducing risk.

For instance, investors who invested their funds with Bernard Madoff lost most of their $65 billion because Madoff was running a Ponzi scheme rather than investing the money as the investors intended, paying people who were withdrawing their money with money received from new investors. Madoff had not actually invested any of his client's money for years. During the 2008 Great Recession, more money was being withdrawn than was coming in, so the Ponzi scheme finally collapsed — decades after it began.

People who invested in American International Group (AIG) thought that their money was relatively safe because they were investing in an insurance company that had the highest credit rating given by the credit rating agencies. However, AIG was also selling credit default swaps on mortgage-backed securities (MBSs) that started to default in large numbers in 2008 requiring them to post more collateral than they had. Why did AIG take such risks? Because the traders who sold the credit default swaps (CDSs) were receiving huge bonuses and they didn't have to bear the risk — AIG did. But AIG wasn't concerned about risks because it was too big to fail, since they were selling most of these CDSs to banks and other investors. Hence, if AIG couldn't make the payments on the CDSs or post collateral as the CDS contracts required if AIG's credit rating dropped, then the government must bail them out; otherwise, many other banks would collapse if they did not receive the payments on their defaulted MBSs. Indeed, the government did bail them out, wiping out the stockholders of the company. Here, moral hazard resulted because the traders took the risks for huge profits and bonuses, but didn't have to bear the risks — indeed, most of them got their bonuses, anyway!

Another type of moral hazard, sometimes called morale hazard, occurs most frequently with insurance, where insurance coverage causes the insured to be less vigilant about controlling risk because they have insurance to cover any losses.

Minimizing Adverse Selection and Moral Hazard Risk

The risks of adverse selection and moral hazard makes direct financing expensive, especially for small firms, since people are unwilling to lend or invest money in unknown entities. With their expertise in gathering reliable information at reduced cost, financial intermediaries can extend financing to many firms or individuals who would otherwise not get it.

The cure for information asymmetry is more information about potential fund receivers. The best predictor of future creditworthiness is past creditworthiness. Checking the history of the fund applicant reduces both adverse selection and moral hazard. There are many databases on individuals and businesses that can be consulted to check their history. News sources can be consulted about many businesses.

For lending to individuals, lenders can check the loan applicant's credit files and credit scores, their employment history, and with the permission of the borrowers, lenders can even verify their income with the Internal Revenue Service.

For lending to businesses, lenders can check any credit ratings issued by the credit rating agencies for businesses, such as Moody's, as well as credit reporting agencies for businesses, such as Dun & Bradstreet. More information is available on businesses that seek direct financing through the issuance of stocks and bonds, because they are required by law to report significant financial information before offering their securities for sale, and to update that information periodically.

For individuals applying for insurance, insurers can consult credit reports, CLUE reports, and other databases. Medical records can be checked for health and life insurance applicants.

Requiring collateral can also reduce information asymmetry risks. Collateral reduces adverse selection by requiring a specific value of collateral, such as 20% down payment on a house, for instance. After all, look what happened when mortgage lenders were offering nothing-down loans — the credit crises of 2008 and 2009! Collateral also lowers moral hazard risk because the borrowers stand to lose their collateral if they do not make the required payments.

Requiring a minimum net worth also reduces adverse selection because only those individuals or businesses with sufficient assets over liabilities will be considered for a loan. Moral hazard is reduced because the borrower can be sued if they fail to make timely payments on their loans.

Reducing Moral Hazard

There are additional methods of reducing moral hazard. One method for equity finance, which is financing through the issuance of stock, is to require the managers to own a certain percentage of the company, which is often achieved through the granting of stock options as part of the compensation package.

Another method for debt finance through the issuance of bonds is to require restrictive covenants that prevent the bond issuer from taking too many risks or to restrict the amount of debt that can be added later. By law, all bonds are required to have a 3rd party trustee who ensures that the bond issuer will comply with the terms of the bond.

Smaller firms, who are unable or unwilling to obtain financing through the issuance of stocks or bonds, apply for loans. Lenders can lower their risk of moral hazard lending to these small firms by using the standard debt contract, sometimes called the optimal debt contract. Small firms often borrow money for specific projects, but it is difficult for lenders to determine the profitability of those projects. Additionally, costs would be incurred by investigating or monitoring the project. So, in addition to the traditional credit screening tools, the lender can stipulate via the contract that monitoring or investigating the project will not be undertaken as long as the borrower repays its debt. If the repayment is insufficient, delayed, or nonexistent, then the lender must spend some money for monitoring or investigating, to identify sources of revenue, which the lender can attach or levy to fulfill the repayment of the loan.

Reducing the Cost of External Financing

Both individuals and companies generally do not like to reveal too much information, put up collateral, or be restricted in what they can do. But the more information they are willing to divulge, the more collateral they are willing to put up, and the more they are willing to restrict their behavior to maintain creditworthiness, the cheaper will be their external financing.